May 23, 2013

Joe Fath Joe Fath, portfolio manager of the T. Rowe Price Growth Stock Fund.

In recent years, companies in a range of industries have decided to move production back to North America, reversing a decades-old pattern of outsourcing to China and elsewhere. Many analysts are hopeful that such "in-sourcing" will help drive U.S. economic growth in the coming years, primarily by boosting manufacturing employment. T. Rowe Price Growth Stock Fund Portfolio Manager Joe Fath believes we are only in the early stages of "reindustrialization," but he is keeping a close eye on the companies and sectors that are already benefiting from increasing U.S. manufacturing competitiveness.

Factors driving insourcing

Given the many moving parts in the global economy, a number of factors have been at work in encouraging companies—both U.S. and foreign—to move production back to the U.S. in recent years. Fath and other T. Rowe Price managers and analysts agree that several drivers have been especially important:

  • Rising wage costs in China have narrowed the once-massive cost advantage enjoyed by Chinese manufacturers. Boston Consulting Group, which was early to identify the insourcing trend, reports that Chinese wages were 20 times lower than those in the U.S. in 2000, on the eve of China's entry into the World Trade Organization. The wage gap has narrowed considerably in recent years, however, as the supply of new workers from the Chinese countryside has slowed and as a rise in the cost of living in China's cities has prompted demand for higher wages.
  • "Transportation costs have gone up pretty dramatically," notes Fath, which has added to the final costs of goods produced in China and elsewhere overseas. High oil prices and a sharp decline in shipbuilding following the financial crisis of 2008 have raised the price of container shipping.
  • Rapid prototyping, short product cycles, and other facets of the digital age have increased the importance of locating production near design and end markets—what Fath terms "near sourcing." Nearby factories offer companies the chance to limit inventory while assuring quality control, he notes.
  • Producing overseas often means sharing trade secrets and technologies. This has meant particular problems in areas, including China, where intellectual property protections are weak. Many companies have chosen to avoid this risk by moving production to the U.S.
  • Finally, Fath believes that the recent boom in U.S. energy production from shale reserves may have been the "tipping point" for many companies' decision to locate manufacturing in the U.S. Sustainable and reliable sources of oil and gas supply are highly appealing to manufacturers—especially as energy supplies from the Middle East, Russia, and elsewhere periodically come under threat. As a result, companies have been willing both to repurpose existing production facilities and to build new ones.

How reindustrialization will affect the U.S. economy

Just as the decline in U.S. competitiveness played out over several decades, Mr. Fath cautions that we are only in the early innings of the process of reindustrialization. A rebound in manufacturing is likely to move out through the economy like a slow-moving shockwave, driving change in some industries and sectors well before it hits others.

Among the first to feel the effects have been energy-intensive industries that can take the most advantage of the new domestic shale supplies. Primary among them, in turn, has been the petrochemical industry, which produces chemicals derived from petroleum for use in plastics, dyes, fertilizers, and other products. Fath notes that petrochemical firms plan to spend about $125 billion on new projects in the coming decade—more than a 12-fold increase over the previous 10 years—now that they are assured of a steady stream of supply.

Fath sees opportunities in the companies that will serve this buildout, as well as in providing equipment to the booming domestic energy sector. Among them, he points to Flowserve, the leading provider of flow control equipment, including pumps, valves, and seals. The Texas-based company is diversified internationally, but one-third of its sales come from North America.

Transportation firms have also been among the first to feel the tremors. Mexico has benefited enormously from rising Chinese production costs, which have helped lure back to the maquiladoras (free-trade zones along the U.S. border) manufacturing that had been lost to China in the early 2000s. With wages now roughly on par with China, Mexico offers the additional benefit of being right across the border from U.S. end markets. Greg McCrickard, portfolio manager of the T. Rowe Price Small-Cap Stock Fund, notes that, "in a lot of cases, you can now produce things in Mexico cheaper than you can in China."

Fath points to rail operator Kansas City Southern as benefiting from the increased demand for transportation from Mexican factories, as well as from demand for moving energy supplies—notably crude oil—within the U.S. Kansas City Southern's rival, Union Pacific is well poised to exploit demand for transportation of crude from the Midwest to refineries along the Gulf Coast.

Eventually, sectors of the economy that have little to do with energy or manufacturing stand to benefit as well. After declining since the late 1970s—and tumbling over the last decade—manufacturing employment in the U.S. has begun to grow again over the past several years. To be sure, it is debatable how powerful this rebound will become—or whether the U.S. will ever fully recapture the millions of manufacturing jobs it lost. The spread of factory automation means that far fewer workers are needed in new plants, and some of the jobs that leave China will wind up in Mexico or in other low-cost developing markets.

Nevertheless, any turnaround in manufacturing employment will bring broader benefits to the economy, which should, in turn, help retailers, housing-related industries, and other businesses. Fath believes that a long-term and patient approach will be necessary to find many of these opportunities. "We're in the early innings," he notes. "It's something that will take many, many years to play out, but it's very encouraging."

All funds are subject to market risk, including possible loss of principal. The securities mentioned by Mr. Fath represented 1.8% of the Growth Stock Fund as of 3/31/14.

The views contained herein are as of April 2014 and may have changed since then.