A US Manufacturing Renaissance
(February 12, 2012)
Dear Subscribers and Readers,
As we wind down MarketThoughts.com at the end of this month, it is important that we finish off by discussing structural trends that will have a significant impact on our subscribers—in their investment portfolios and personal lives. One such trend, as we have covered, is the potential “Renaissance” of the U.S. manufacturing industry, as recently discussed in a Boston Consulting Group study. Specifically, the study asserts that as Chinese wages continue to grow relative to those of the US, a significant portion of capital-intensive industries located on the coast of China will relocate back to the US. As illustrated in the following chart (courtesy of Boston Consulting Group), today, the average Chinese wage is about 10% of US wages; by 2015, the ratio will have increased to 17%-- which is a tipping point for many capital-intensive industries that are located on the Chinese coast.
The US relocation will bring other auxiliary benefits, such as just-in-time inventories, the elimination of supply chain/shipping risks, and the elimination of shipping costs and tariffs. Just as important, while some industries can still take advantage of lower wage rates through relocation to central China or other countries like Vietnam, those locations do not have the labor expertise or the infrastructure to be a reliable manufacturing hub for these capital-intensive industries. This is already happening, as we have previously discussed. Quoting the Boston Consulting Group study:
The early evidence of such a shift is mounting.
Outdoor Greatroom Company moved production of its fire pits and some outdoor shelters from China to the U.S., citing the inconvenience of having to book orders from Chinese contractors nine months in advance.
- NCR moved production of its ATMs to a plant in Columbus, Georgia, that will employ 870 people by 2014.
- The Coleman Company is moving production of its 16-quart wheeled plastic cooler from China to Wichita, Kansas, owing to rising Chinese manufacturing and shipping costs.
- Ford Motor Company is bringing up to 2,000 jobs back to the U.S. in the wake of a favorable agreement with the United Auto Workers that allows the company to hire new workers at $14 per hour.
- Sleek Audio has moved production of its high-end headphones from Chinese suppliers to its plant in Manatee County, Florida.
- Peerless Industries will consolidate all manufacturing of audio-visual mounting systems in Illinois, moving work from China in order to achieve cost efficiencies, shorter lead times, and local control over manufacturing processes.
The reallocation of production is still in its early stages, but we believe it will accelerate in the years ahead. The impact of the changing cost equation will vary from industry to industry. Products in which labor accounts for a small portion of total costs and in which volumes are modest, such as auto parts, construction equipment, and appliances, will be among those that companies reevaluate in terms of their options for supplying the North American market. But the manufacture of goods with relatively higher labor content that are produced in high volumes will likely remain in China. Finally, companies that make mass-produced, labor-intensive products, like apparel and shoes, may move production from China to other low-cost nations.
Of course, this doesn't mean manufacturing plans will shut down en masse on the Chinese coast and relocate back to the US. It merely means whatever are being manufactured in the Chinese coast (goods bound for the US today) will be instead be used to satisfy domestic demand in China, as Chinese disposable income continues to grow at a +15% annualized pace. Finally, Boston Consulting Group predicts that this “US Manufacturing Renaissance” will add approximately US$100 billion to annual US output each year, and 2 to 3 million US jobs over the next five years. This addition in jobs will shave 2% off the unemployment rate; however, I remain skeptical of the 2 to 3 million jobs number, as companies will likely continue to invest in automation over the next five to ten years. In addition, such a creation of jobs would result in significant wage pressures, even in non-union states such as South Carolina, Alabama, and Tennessee. Between potential wage inflation and more investment in automation, I believe a net addition of 1 to 1.5 million in US manufacturing jobs due to this phenomenon over the next five years is more likely.
Let us now discuss the most recent action in the U.S. stock market using the Dow Theory. Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown in the following chart from July 2008 to the present:
For the week ending February 3, 2012, the Dow Industrials declined 61.00 points, while the Dow Transports declined 114.79 points. Given that the Dow Industrials enjoyed a five-week 644.67-point run and closed at a four-year high the week before last, I am not surprised about last week's correction. In fact, we are looking for the correction to continue over the next several weeks. That said, with the Fed committed to an extremely dovish policy (near-zero Fed Funds until 2014; and potential QE3 later this year), the Dow Industrials will likely surpass the 13,000 level decisively over the next several months. We remain bullish on US and US financial stocks (although we could experience a short-term correction over the next several weeks), but since we are dissolving MarketThoughts.at the end of this month, we will not make any more moves in our DJIA Timing System.
I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys. The four-week moving average of these sentiment indicators increased from 22.6% to 23.9% for the week ending February 10, 2012. Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 2001 to the present:
Since hitting a multi-year low of -11.3% in early October, the four-week MA has surged by a whopping 35.2%. The four-week MA is now at its most overbought level since early March 2011. As such, we would not be surprised if the market continues to correct over the next several weeks. That said, with the European Sovereign Debt Crisis on the backburner—and combined with cheap US$ swap lines, a dovish Fed, and the resilience of the US economy—we continue to look for a rally in US stocks and US financial stocks over the next several months.
I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index. For newer subscribers, I want to provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator. Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.
When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls. As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms. This makes the indicator a perfect contrarian indicator. Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators. Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:
Ever since breaking 100 in mid-December, the 20 DMA had been on an upward tear until three weeks ago, spiking to as high as 123.9. The 20 DMA finally corrected over the last three weeks, however, declining from 123.9 to 103.4. In fact, it is now lower than its 50 DMA. This pullback was much needed as this indicator was getting very overbought in the short-run. That said, our other sentiment indicators remain overbought on a short-term basis—hence, the market will likely continue to correct over the next several weeks. Over the next several months, though, we remain bullish on US stocks and US financial stocks.
Conclusion: Last week, we discussed that with US jobs growth now recovering, it is likely that both corporate credit demand and bank lending will reinforce this positive trend. Consequently, this further reinforces our belief that US GDP growth this year would surpass 3%. With the Chinese economy and wages still growing strongly, and with the US$ still weak, we expect US manufacturing to experience a “Renaissance” over the next five years as more capital-intensive industries relocate their manufacturing production back into the US. Existing manufacturing facilities in China will merely shift to catering to its growing domestic consumption base. Such a Renaissance will further propel US employment—providing at least an additional 1 to 1.5 million manufacturing jobs in low-cost states such as South Carolina, Alabama, and Tennessee over the next five years—and lowering the national unemployment rate by 1% to 1.5%. This will provide a strong cushion in the US deleveraging process and a significant tailwind to US housing prices.
Henry To, CFA, CAIA