What can we expect in manufacturing in 2020?

The manufacturing sector is in a recession. It’s been over ten years since the period of 2008-2009 when manufacturing took a significant downturn. This pattern of fluctuation tends to repeat itself after long periods of expansion, so this manufacturing cycle doesn’t come as a complete surprise.

Whether this sector downturn will turn into a full-blown economic recession remains to be seen. But in the meantime, indications show that the downturn will have a substantial impact on manufacturers and will last from some time.

Exhibit 1. Industrial Production Index (1975 – 2019)

We are just at the beginning of a down cycle, and the sector is showing signs of financial decline. Profit margins are getting squeezed. Plant utilization is decreasing. Inventories are building up, and receivables are becoming stretched. As the downturn persists, with continued deterioration, many companies will become stranded, finding it increasingly difficult to earn the cost of capital.

Exhibit 2: Preliminary Financial Results of the Manufacturing Sector

Like the 2008-2009 recession, the current manufacturing contraction is global, which means that manufacturers cannot export the problem of slowing sales and look for growth abroad.

As we look to understand what happened, we find that in a matter of six months, U.S. manufacturers took devastating losses. From Q2 to Q4/2008, companies experienced a decrease in Return in Net Assets from 7.5% for small firms to 12% for large firms (Exhibit 3). Ultimately, the most extensive set-backs included the restructuring of assets, significant declines in operating income and non-operating income, and substantial increases in receivables.

Exhibit 3. Financial Results of Manufacturing Companies in 2008

The manufacturing sector has been headed down a negative course for some time. Three determinants are at the center of it and are likely to continue in the year ahead.

The first is a worldwide contraction in manufacturing, related to slowing global growth. The contraction involves the U.S. as well as the eurozone’s biggest economies (Germany, France, Italy, and Spain), the U.K., Japan, Canada, South Korea, and Mexico. For most of these economies, the PMI manufacturing activity index has trended below 50 for some time, a condition that points to a problem more significant than just the U.S. alone. Manufacturers in these markets face similar challenges of falling revenues and increased pressure on margins. Unless global growth picks up, this trend is not likely to reverse soon.

Exhibit 4. Declining Global Manufacturing

Second, the U.S. balance of trade of manufactured goods has been decreasing since 2016. This trend has been particularly hard for Industrial Supplies and Materials, Capital Goods, and Automotive Vehicles, Parts, & Engines, and is extending across other manufacturing industries. Reasons for the drop include a stronger dollar, rising factory wages in the U.S., and productivity improvements in competitive industrialized nations like Germany, France, the U.K., South Korea, and Japan. As a result, the need to manufacture in the U.S. for export markets is no longer a given assertion, a condition that will not change anytime soon.

Exhibit 5. An Unfavorable U.S. Balance of Trade in Manufacturing

The third determinant is the economic unpredictability created by the trade tariffs and geopolitical uncertainty. Companies usually plan over five-to-ten year horizons, including asset investments with a life duration of 10 to 20 years. In the current business climate, however, everyday platforms for selling products and buying supplies have become extremely unstable, which makes most planning virtually futile. As a result, the real effect is cutbacks in capital spending and lower business confidence, which continues the downward cycle.

This high-level of uncertainty is quantifiable. The Economic Policy Uncertainty Index tracks economic uncertainty. High levels of risk foreshadow declines in investments, output, and employment that contribute to sharp economic declines and slow recovery periods afterward. As of September 2019, the U.S. index hovered around 250, a high measure based on a normalization of 100.

Exhibit 6. U.S. Economic Policy Uncertainty Index (1/1985 – 9/2019)

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The downturn in manufacturing will be around for a while, and many businesses will find the next 12 months stressful. For most managers, calculating the immediate impact of contracting demand on sales, prices, and margins is reasonably straightforward. They can explain it in a spreadsheet. Less clear is how to reframe the company strategy and update long-term investment plans in alignment with a market experiencing industry cutbacks and continued trade uncertainty. Leaders will need to focus on two strategies: (1) how to build resilience and grow during the downturn, and (2) how to navigate new global trade.

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