Why manufacturing malaise matters

Manufacturing and GDP

I often hear people downplaying weak manufacturing data because the service sector is bigger. But it’s not size that matters, but variance. Imagine you have a portfolio of 17% tech stocks and 83% cash. What would drive the return of your portfolio? The tech stocks would punch above their weight because they’re more volatile. And so it is with manufacturing.

Although it accounts for just 17% of advanced economy GDP, we find it accounts for around half of the downturn in GDP during recessions because it’s more prone to boom and bust.

Why is this the case? The reason is that many services are acyclical, meaning that they do not vary much over the business cycle. For example, spending on education, health, rent and utilities tends to be stable regardless of economic conditions. By contrast, consumer spending on durable goods (such as cars or washing machines) or business investment (machinery) is cyclical for several reasons.

First, many goods last a long time so a new purchase can be delayed. We all need to use data daily, but we don’t always need to buy a new mobile phone. Second, spending on these expensive, long-lasting items tends to be more sensitive to higher interest rates and tighter credit conditions, as we are seeing now. There’s also an accelerator effect. Machines are used to make other goods. So when demand for consumer goods fall, we usually see a knock-on effect on replacement demand for depreciating capital goods.

European PMI problems

We’re seeing broad-based weakness in factory data: manufacturing PMIs have been signalling contraction for some time, bank lending surveys point to weaker business investment, and hard data on German factory orders have failed to recover from a recent slump. The optimistic view is that it’s an isolated manufacturing inventory correction, driven by a post-COVID rotation from goods to services. We’re meeting people in person rather than getting a new laptop for Teams calls.

But the level of US consumer goods spending remains well above its pre-COVID trend – a shoe waiting to drop. And the anticipated rebound in Chinese retail sales following the reopening of the country’s malls post lockdown has failed to materialise, likely reflecting continued property-market woes.

The latest European PMIs and German IFO survey suggest the weakness in manufacturing is spreading to services, particularly associated services like transport and logistics. We remain more pessimistic than consensus on growth, believing that the pain from tighter credit conditions will spread. We expect advanced economies to fall into recession and central banks to be slow to react because of stubborn inflation.