August 22, 2012
|Brian Berghuis, manager of the T. Rowe Price Mid-Cap Growth Fund|
For the past three decades, the default decision for U.S. corporations has been to outsource manufacturing to lower-cost countries. Now, however, the cost/benefit equation is changing. Rising wage pressures in Asia and other emerging markets, U.S. dollar depreciation, and overextended supply lines—a risk brought home by last year's Japanese tsunami—have encouraged many firms to "in-source" factory production back to the U.S.
Further encouraging this trend are robust gains in U.S. industrial productivity, more flexible labor markets, and lower energy costs (especially compared with America's leading manufacturing rivals). The resulting manufacturing renaissance could contribute materially to U.S. growth over the next decade, producing both investment winners and losers in the process.
- For the first time in several decades, both U.S. and foreign companies are building—or seriously considering—new manufacturing plants in the United States, either to meet U.S. domestic demand or to serve as global export platforms.
- While the in-sourcing trend reflects improved U.S. labor cost competitiveness, global companies are also focusing on a number of other factors—such as greater business predictability, more secure supply chains, and relatively stable political and legal environments—that make the U.S. more appealing for fixed investment.
- Most manufacturing relocations currently are coming from other developed nations, including Japan, Germany, and Canada. However, firms are also considering the advantages of in-sourcing production from China and will soon act if labor costs in China continue to rise at the current 15%—20% annual rate.
- Productivity gains and slow wage growth have produced strong gains in U.S. labor cost competitiveness relative to key developed world trading partners, including Germany, Japan, and Canada (Figure 1).
- Since 1980, U.S. manufacturing unit costs (wages net of productivity gains) have been essentially flat. This has given company managers more confidence that they can forecast future labor costs and effectively offset wage increases through productivity improvements.
- Labor costs are rising rapidly in many emerging market countries, and these gains are not being offset by productivity growth. While China and other developing countries still have a labor cost advantage versus the U.S., firms have less confidence that they can absorb future wage gains without significant margin pressure.
- The U.S. dollar has fallen significantly against the euro since 2000, even after the impact of the recent European debt crisis. From the end of 2000 through May 31, 2012, the dollar has depreciated 16% against the euro.
- Thanks primarily to euro appreciation, German manufacturing per hour compensation costs—which roughly equaled the U.S. in 2000—are now 33% higher. The euro would have to return to parity with the dollar to eliminate this cost differential.
- The U.S. dollar has depreciated 30% against the Chinese yuan since 2005—at a time when Chinese manufacturing wages have been rising rapidly. The Boston Consulting Group has estimated that after adjusting for productivity, Chinese labor costs are now only 30% cheaper than in the U.S.1 After shipping and inventory costs, the advantage drops to single digits. Continued rapid wage growth in China could quickly close the gap.
* 2008 prices
Source: International Energy Agency
- The large decline in U.S. manufacturing employment over the past 30 years has been the result of strong labor productivity gains and the introduction of new technologies, not just outsourcing (Figure 3). This means that any rebound in U.S. manufacturing payrolls is likely to be limited.
- However, economic studies suggest that manufacturing growth has a strong employment multiplier effect. Research by the Economic Policy Institute found that for every job created in manufacturing, 2.9 jobs were created in supporting sectors, such as services.2
- All else being equal, a gain of one million manufacturing jobs (enough to return U.S. factory employment to the 2007-2010 average) could lower the U.S. unemployment rate to 7.5%. Indirect hiring (using the 2.9-to-1 multiplier cited above) could reduce it to 5.7%—at or near the current consensus estimate of the lowest unemployment rate consistent with stable inflation.
- Academic studies have identified significant gains from the geographic clustering of manufacturing and related functions, such as research and development, product design, and marketing.3 These synergies, while hard to quantify, are real and could further enhance the potential economic benefits of U.S. reindustrialization.
- A U.S. manufacturing revival could create upside revenue potential for certain companies and industries. Firms in the industrials sector are obvious beneficiaries, but increasing manufacturing activity in the U.S. could also spark demand for utilities, energy producers, and other sectors.
- If manufacturing growth and related employment multiplier effects lead to more rapid gains in U.S. employment and disposable income, consumer-related companies, such as homebuilders, consumer lenders, and U.S.-focused retailers, may also benefit.
- Technology is likely to play a key role in the manufacturing revival, as 3-D printing and other innovations allow for greater customization and lower inventory costs. U.S. firms have taken the lead in many of these emerging technologies and stand to benefit further from proximity to customers.
2"Updated Employment Multipliers for the U.S. Economy," Economic Policy Institute, August 2003.
3See, for example, Mercedes Delgado, Michael E. Porter, and Scott Stern, "Clusters, Convergence, and Economic Performance," Institute for Strategy and Competitiveness, March 2011, at www.isc.hbs.edu/pdf/DPS_Clusters_Performance_2011-0311.pdf.
The views are as of August 1, 2012, and may have changed since that time. This information is provided for informational purposes only and is not intended to reflect a current or past recommendation or investment advice of any kind. Opinions and commentary do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.