Some Perspective on the Alleged 'Industrial Recession'

Editors’ Note: MarketMinder does not recommend individual securities. The below simply represents a broader theme we wish to highlight.

If there was a dominant theme in financial media today, it was this: The world’s heavy industry is in trouble. IHS Markit’s flash Purchasing Managers’ Indexes (PMIs) showed manufacturing contracting in the eurozone, Germany and Japan. Honda closed a plant in the UK this week, fueling warnings an “industrial recession” would spark more closures worldwide. Japanese exports tanked in January, evidently another sign of weak demand for manufactured goods. On its face, none of this news is good. Yet it also isn’t terribly new, nor does it center on a large portion of the global economy. We suspect it is the sort of weakness stocks will see through.

The culprit for weak manufacturing readings and Japanese trade is likely China. Most blame it on tariffs, but as we have discussed before, we think you can pin it on last year’s crackdown on the shadow banking industry, which is a spooky-sounding term for non-traditional private lenders. China has long had a two-speed financial system. In one lane, you had large state-run banks, which lent mainly to large state-run firms, which come with an implicit government guarantee. But these large state-run firms aren’t the backbone of China’s economy. That honor goes to its bazillions of small and midsized private firms. Because they didn’t come with government guarantees, and state-run banks had to reckon with strict official loan quotas, private firms were crowded out. Hence, as recently as this global expansion’s early years, private firms that wanted to borrow to fund investment were forced to loan sharks and other shady characters.

A few years ago, the Chinese government—which was trying to engineer a shift from a manufacturing-based economy to services and consumption—decided small business owners shouldn’t have to put life and limb at risk to secure capital. So officials encouraged the shadow banking industry to extend credit to small businesses. Much of this credit took the form of off-balance sheet loans, which banks packaged and sold to investors as high-yielding securities. After a few years of this, China’s service sector was booming, but so was private sector debt. Some of it started defaulting, which confused people who had bought these high-yielding securities thinking they were “safe,” scuttling the government’s plans to let market forces govern credit markets. So last year, to contain the problem, officials sought to dismantle the shadow banking industry. The goal was to move all the activity to traditional bank lending. But big state-run banks still didn’t want to lend to small private firms lacking an implicit government guarantee. As a result, China’s vast private sector was capital-starved. In large measure, you can thank that for the sharper-than-expected slowdown in China last year.

This weaker demand should be temporary. Chinese officials announced a mountain of stimulus over the past couple of months, including subsidizing small-business loans, freeing up more bank reserves to back lending, cutting taxes for small and midsized companies, making it easier for creditworthy firms to issue bonds, and plowing about $200 billion into fiscal stimulus. It appears to be starting to bear fruit, if last month’s gangbusters Chinese loan growth is any indication. As this stimulus continues making its way to small businesses, private sector demand should stabilize, boosting Western and Japanese factories’ order books.

Honda’s closure is a separate matter—unrelated to China or its other supposed culprit, Brexit. It is rather more reminiscent of the plant closures GM announced last year. Honda isn’t closing its Swindon factory tomorrow. Rather, the plant will shut in 2021, when Honda plans to shift more production from gas-powered Civics, which the Swindon plant produced, to electric vehicles. In other words, this is a long-term strategic move dictated by Honda’s expectations for shifting consumer demand, not a statement about economic weakness in the here and now. Therefore, it seems like a stretch to argue Honda is a bellwether for scores of factories in other industries.

Then again, even if it were—and even if all this manufacturing weakness didn’t appear temporary—we rather doubt it would make a huge dent in global economic growth. Developed-world economies are predominantly services-driven. UK GDP is about 80% services and only 15% manufacturing.^[i] Only 11.2% of US GDP in 2017 (the latest year on record, still) came from manufacturing.^[ii] Even Germany, Europe’s industrial powerhouse, is 68.2% services and only 25.8% heavy industry (excluding construction).^[iii] In services-based economies, if the service sector is fine while heavy industry shrinks, the economy overall can still grow. This is similar to how Australia and Canada have weathered commodity slumps in recent years. Though mining (Australia) and oil (Canada) are important parts of their economies, causing pain when they hit rough patches, their larger services sectors pulled the rest of the country along. This also happened in the US, when manufacturing contracted for several months in late 2015 and early 2016—service sector growth kept GDP on an upswing.

Funnily, today’s widely derided eurozone flash PMIs suggested this is what is happening. While German manufacturing contracted, services accelerated. The eurozone’s composite PMI did the same. If the broad economy is growing while manufacturing shrinks, that is a testament to services’ strength and the entire country’s resilience, not a sign of weakness.

Forward-looking markets are good at seeing through stuff like this. They price the fears as well as the likely reality over the next 3 – 30 months or so. Or, more simply, they weigh the foreseeable future against today’s expectations. When the data suggest fears are false, that is generally a recipe for stocks doing a-ok.