Manufacturing is back, but don’t thank Trump

2018 is shaping up to be the best year for U.S. manufacturing since 2011. New orders are rising at their fastest pace since late 2003, according to the closely-watched monthly survey from the Institute for Supply Management.

That’s quite a turnaround, given that the sector suffered a mild recession in the year through mid-2016. The recovery has little, if anything, to do with the election of President Trump; it’s mostly a story about oil prices and the global economy.

{mosads}U.S. crude oil prices peaked at $107 per barrel in June 2014, before plunging to just $26 in February 2016. At the time, most analysts thought the drop in oil prices would be a clear net positive for the economy, because it triggered a 44-percent fall in gasoline prices. Consumers quickly found themselves with spare cash, which was promptly spent.

The potential adverse impact on rest of the economy, however, was glossed over, largely because economists hadn’t updated their thinking to take account of the shale revolution. In the pre-shale days, the oil industry’s capital spending wasn’t very sensitive to short-term shifts in oil prices.

The industry was dominated by the major producers in the Gulf of Mexico, whose balance sheets could absorb the pain of lower prices, at least for a while. The shale world is different. Small, highly-leveraged firms dominated the sector, and when prices fell they had to react quickly in order to survive.

Relatively few people work in the oil sector, so the only way for shale producers to preserve cashflow when income drops is to slash capital spending. The oil sector is by far the most capital-intensive part of the economy, spending some $990,000 per employee per year at the peak, in 2014.

Manufacturing capex, by contrast, was about $19,000 per employee. After the drop in oil prices, investment in oil extraction equipment and structures, i.e., oil wells, plunged by 63 percent from peak to trough in the second quarter of 2016, taking over $100 billion per year out of the economy.

Fracking is an American invention, and much of the equipment used in the shale business is domestically-produced. If you’re an equipment maker, or a parts supplier, and your customers cut their spending by 63 percent, you have a big problem.

In short, the crash in capital spending among frackers reverberated through the whole energy ecosystem, hitting activity in logistics, real estate and finance, as well as manufacturing. 

At the same time, manufacturing outside the U.S. was struggling too, with China’s authorities experimenting unsuccessfully with an attempt to rebalance growth away from heavy industry, while in Europe the effects of the 2012 sovereign debt crisis lingered.

The U.S. manufacturing recession, though, was not transmitted into the rest of the economy, thanks to the ongoing support from the Fed’s near-zero interest rates and its swollen balance sheet. By late 2016, oil prices had doubled from their lows, and fracking activity was beginning to recover. The grim dynamic of 2015-to-16 started to reverse.

The international backdrop was changing for the better too. China switched back to more aggressive pro-growth policy, and the European Central Bank’s program of quantitative easing was driving down borrowing costs and raising asset prices.

The outcome has been a broad-based global manufacturing upturn, which likely has some way left to run in the U.S. and elsewhere. But this is no raging boom. U.S. manufacturing output rose an almost-respectable 2.3 percent in the year to November, but back in the late 1980s, when the ISM survey was as strong as it is now, the sector was expanding by about 8 percent. 

Structural change means that manufacturing now is very different than back in the 1980s, and it accounts for a much smaller share of the economy, too. Just 8.5 percent of the workforce is employed in manufacturing, after halving over the past 30 years.

The sector punches above its weight in terms of political visibility, though, and the president will undoubtedly seek to take the credit for the upturn in activity and recent job gains.

But the days when manufacturing could make a sustained, material difference to the performance of the overall economy are gone, and threatening trade wars with China and attempting to rewrite NAFTA aren’t going to change that.

Indeed, they might even accelerate the decline of the sector, as global businesses choose to focus their attention elsewhere, on countries where the business environment is stable and predictable. Everyone used to say that about the U.S.

Ian Shepherdson is the chief economist and founder of Pantheon Macroeconomics, a provider of economic research to financial market professionals. Shepherdson is a two-time winner (2003, 2014) of the Wall Street Journal’s annual U.S. economic forecasting competition.