Manufacturing Momentum – Will It Last?

In late April, the Wall Street Journal reported in a front page headline story that manufacturing grew four times faster than the overall economy in the first quarter. Federal Reserve data showed that manufacturing rose at a 9.1% level while overall GDP growth for the first quarter was initially reported at 1.8%. The key question for investors is: will this vigorous rate of growth continue and, if so, for how long? As the Journal reported, the stock market has rejoiced at this manufacturing surge and rewarded investors. The Index of Leading Economic Indicators and ISM (Institute of Supply Management) manufacturing surveys have repeatedly been above economists’ expectations and propelled the market forward. The manufacturing recovery has been the key contributor to the emerging comeback from the recession. As in past recessions, it fell further and then climbed faster than other areas of the economy.

By focusing on the manufacturing sector, this article will expand on the prospects for positive growth outlined in the previous piece rather than exploring the downsides to the growth picture. Those headwinds will be explored in future articles.

A look at the details of the manufacturing rebound helps explain what is going on. In the first quarter of 2011, auto production surged at an annualized rate of nearly 30%. High-tech production was another component showing strong growth. It grew at a 39% rate in the first quarter. Excluding autos and high-tech, factory production grew at annualized gain at 5.6% during the first quarter. Exports of building, farming and mining equipment to emerging markets and resource rich countries contributed to this overall growth.

Auto production is rapidly growing as a result of rebound from the recession, troubles encountered by Japanese auto exporters, and federal incentives to purchase energy efficient cars produced in the United States. Auto sales ran at seasonally adjusted annual rate of 13.1 million in the first quarter according to Autodata Corp. At the depth of the recession in 2009, only 10.4 million vehicles were sold for the full year. Since then, auto sales have been increasing at steadily higher rates. Potentially, there is still a great deal of catch up. Annual U.S. sales were 16.8 million on average from 2000 to 2007, according to Autodata. The recession has left in its wake a substantial amount of pent up demand. More than 8 million additional cars would have been sold over the past two years had the sales rate remained steady. As cars age, maintenance costs increase making replacement a desirable option for many consumers. For each year consumers hold off replacing vehicles, the pent up demand increases. In addition, some consumers want to trade up to more recent styles. These individuals are driving the recovery in new car sales as recessionary fears recede.

While issues about quality control at Toyota and the slowdown of Japanese production following the earthquake have contributed to the rosy picture, the driving force for increased U.S. auto production has been a pickup in demand. The recent increase in gas prices to near $4.00 on a national level could slow down the pace of increased sales. It could also increase demand for more fuel efficient vehicles thereby aiding sales.

High tech manufacturing has been driven forward by a number of factors. Companies flush with cash have been replacing equipment after postponing purchases during the depths of the recession. These replacements are being made for both technological and energy efficiencies. Additional capacity is needed to service a public that is spending even more time on high tech phones, pads, and other new products. Some of the new product production takes place in the United States. The falling dollar is also making domestically manufactured high tech products cheaper compared to products produced in countries such as Germany where the euro has appreciated in relation to the dollar, thereby increasing demand and sales. The forward downside risks to the almost 40% growth experienced in the first quarter are an appreciating dollar as the Fed tightens its monetary policy, and product absorption – that is, as consumers and businesses have sharply increased new product purchases, there will be time lapse before they are ready to buy replacements.

While automobiles and high tech have been the stars of the manufacturing recovery, the breadth of the industrial production pickup has been impressive. This is especially so in the export sector where a weak dollar and third world development have combined to significantly improve sales of companies such as Caterpillar, Boeing, United Technologies and Honeywell.

There have been some recent signs that the manufacturing surge is slowing based on surveys by Federal Reserve regional banks and the ISM. The most recent readings of these indexes have fallen slightly below the peaks reached earlier in the year. The Manufacturers’ Alliance, a research group, estimates that the growth rate for manufacturing will slow to 4% in the second half of 2011, still a healthy pace of recovery.

For the macroeconomic investor, the manufacturing recovery looks to be well-grounded. This will help provide momentum for the overall economy and limit the downside risk for stock market investors.

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