Manufacturing recession ending due to housing, inventories bounce

• The US manufacturing sector hit a rough patch in 2019 that led some to call it a “manufacturing recession.”
• The “manufacturing recession” idea drew a lot of attention since a downturn in the sector could disrupt the 2020 election and the broader US economy.
• But there are two big reasons that manufacturing is likely to bounce back: low inventories and a strong housing market.
• Neil Dutta is head of economics at Renaissance Macro Research.
• This is an opinion column. The thoughts expressed are those of the author.
• Visit Business Insider’s homepage for more stories.

US manufacturing has hit a rough patch over the past year. This weakness in the industry has garnered widespread attention for both political and economic reasons.

First, with the 2020 election in focus, many observers are quick to note that manufacturing employment has slipped in a number of important swing states. Given the electoral importance of these states, weakness in critical industries is thought to make President Trump’s path to reelection more difficult.

Second, manufacturing tends to be cyclically sensitive; as a result, factory production is thought by many to turn ahead of a broader economic slowdown. With Boeing’s production shutdown rippling through the sector, many expect that the worst is yet to come.

I disagree. Instead of the manufacturing “recession” as many pessimistic experts are warning about, it’s more likely that manufacturing output will turn up this year for two reasons in particular: inventory rebuilding and stronger housing. 

Context is important

To see why a bounce back is likely on the horizon, it’s good to compare the current weakness to past manufacturing troubles.

Most recently, the US suffered a manufacturing contraction from 2014 to 2016 and this one differs in two important ways:

1. The weakness is not as pronounced. In 2015, manufacturing production fell 2.0%; in 2019, manufacturing output declined 1.3%.
2. While the weakness is somewhat shallower, it is more widespread. In 2019, the output from about 70% of the manufacturing sub-industries contracted. By contrast, it was closer to 50% in 2015.

In other words, the last factory recession saw fewer industries contracting, but the contraction was deeper. By contrast, we now have a milder contraction spread across more industries. 

Two reasons manufacturing is going to pick up

Manufacturing production follows the ups and down of inventories,. As it stands, inventories are too low and the need to bring inventories in-line with final sales will benefit US factories.

Over long periods of time, inventory investment does not matter much to growth, as it grows broadly in-line with demand, but it can contribute a meaningful amount to the cyclical swings in growth.

For example, over the last five years, the average contribution from inventories to GDP growth is zero. However, over the last year, inventory investment cut US GDP growth by an average of 0.4 percentage points per quarter. As a result, inventories are running well below final sales. 

The nearby figure helps tell the tale. The bars show the change in private inventories while the dashed line shows the change needed for inventories to keep pace with final sales. At the moment, inventories are about $60 billion below the pace needed to match final demand.

Doing the math, getting inventories up to “where they should be” implies a boost to GDP growth of about 0.3 percentage points on average per quarter this year, a sharp positive swing. Of course, as inventories can often undershoot final sales, they can overshoot as well. Thus, as factories work to fulfill the increased orders the lift to manufacturing production can be substantial. 

Second, our testing shows that a pick up in the housing sector will help to lead to a boost for manufacturing.  So the housing sector’s strong finish to 2019 is a good sign for manufacturing activity.

Intuition can easily back-up this formal analysis. The lift from the housing market came from signed contracts on new homes. A home is sold and then it is built, which requires the production of construction materials. After completion, a family moves in and fills it with durable goods – appliances, furniture, autos – all of which requires factories to turn the lights on. 

Our chart below plots new home sales growth against manufacturing production 12 months later. The regression line is positively sloped as one would expect. That is, stronger new home sales in year one coincides with stronger manufacturing production in year two.

Doing the math, the 20% run-up in new home sales last year implies about 5.5% manufacturing production growth in 2020. We doubt factory production will end up being this strong, but directionally, the rebound makes sense. Manufacturing production is likely to be stronger this year than last. 

The signs of a rebound in factory activity may already be in motion. Regional PMIs and manufacturing surveys have already turned up. Excluding a large Boeing related drop in aerospace manufacturing, factory output would have been slightly positive in January. For investors, the pick-up in US factory activity is worth watching. As concerns around Boeing and coronavirus subside, now may be the time to pick-up industrial stocks. 

Neil Dutta is head of economics at Renaissance Macro Research. He analyzes global economic and cross-asset market themes, providing leading-edge forecasts for institutional clients.