Industrial products industry outlook
Headwinds for global manufacturing suggest challenges ahead
INSIGHT ARTICLE |
Key takeaways from the fall 2019 industrial products industry outlook
- The RSM US Manufacturing Outlook Index suggests a continued slowdown in U.S. manufacturing activity.
- The trade war between the United States and China is exacerbating an industry slowdown, creating headwinds on multiple fronts.
- Automakers and logistics providers face a number of challenges, including trade policy uncertainties, stagnant sales growth and workforce issues.
- Some manufacturers consider mergers or acquisitions to achieve their long-term strategic goals.
As the tail end of a decadelong period of economic expansion approaches, global purchasing managers index activity is hovering near or in contraction territory, indicating a continued slowdown in global manufacturing expected to continue into the first half of 2020. Further deceleration will be fueled by slow economic growth and lingering uncertainty about global trade, driven by the prolonged U.S.-China trade war.
Among the G-20 countries—which represent approximately 74% of global gross domestic product—as of September, over 50% have a PMI registering below 50, the benchmark for expansion. Europe, which after Canada and Mexico is the largest regional market for the U.S. industrial sector, remains compromised by weakness in German manufacturing.
This data is consistent with the performance of the RSM US Manufacturing Outlook Index (see below chart), which has been declining for 14 months since its peak in June 2018, and has been negative since December 2018. Performance of the new measure suggests the potential for a decline in U.S. manufacturing sales in the months ahead.
Industrial companies are struggling through extremely uncertain times amid the volatile global geopolitical and macroeconomic climates. Most U.S. manufacturers were able to absorb or pass on the costs of tariffs on Chinese goods that began in July 2018, but the ensuing slowdown in economic activity may ultimately harm them even more than the new duties. In July, the inventories-to-sales ratio for durable goods hit its highest level since the recession, and points to U.S. manufacturing likely experiencing ongoing pressure in the near-term.
MIDDLE MARKET INSIGHT Industrial organizations should prepare for a new environment in which trade tensions and higher input costs are here to stay.
AUTO SALES REMAIN FLAT, AT BEST
U.S. automakers are facing significant headwinds, as noted in their most-recent earnings reports. On a year-to-date basis, sales have averaged a seasonally adjusted annual rate of 16.9 million units according to automotive research site Wards, down roughly 1.3% relative to this time last year, but hovering very close to what analysts would consider trend sales growth (around 16.8 million units). This rate reflects concern that new car demand may have peaked and could be moving into decline, creating additional pressure on the automotive ecosystem.
The reduction in profits will force automakers to reevaluate their investments, and their decisions will be felt throughout the entire supply chain. With light trucks—the most popular vehicles—facing tougher competition, softening demand and historically high prices, automakers will look to drive efficiencies in their global supply chains.
In addition, the industry is still awaiting the Trump administration’s decision on whether or not proposed tariffs on vehicles and parts tied to section 232 of the Commerce Department’s national security report will take effect in November. Meanwhile, a strike at General Motors’ U.S. plants by the United Auto Workers, estimated to cost the automaker $77 million per day, creates additional profit risk during a time when data suggests that sales growth has flatlined. (See figure below).
LOGISTICS COSTS RISE
The Council of Supply Chain Management Professionals’ 2019 State of Logistics Report noted that logistics costs in the United States are increasing. They rose 11.4% to reach $1.64 trillion, or 8% of GDP, over the past year. The report cites continued growth in e-commerce, which was up 14.2%, as a primary driver. In addition, a tight U.S. labor market pushed wages for truck drivers and warehouse workers higher, and led to changes in hours-of-service regulations to improve worker safety. Meanwhile, continued uncertainty over tariffs has caused companies to build inventory levels, contributing to the rise in costs. We expect these trends to continue into 2020, as organizations grapple with the fallout of the U.S.-China trade war.
SHIPPING AND TRUCKING CHALLENGES
According to Bloomberg LP, the U.S.-China trade war drove Asia-North America’s container shipping volume down 44.5% in 2019 so far, compared to 8.8% growth in 2018. Escalating trade tensions and higher inventory levels are creating significant volatility in shipping rates, with spot rates rallying just before tariffs became effective in 2018, and subsequently settling down (see figure below).
Manufacturers entering into longer-term contracts based on higher spot rates may be locked in for an even longer term at these prices. Additionally, beginning in January 2020, the International Maritime Organization will enforce new emissions standards designed to significantly curb pollution from the world’s ships. Under the new rules, vessels must switch from high-sulfur, sludge-like fuels (with a sulfur content of up to 3.5%) to lower-sulfur ones (containing 0.5% or lower), or find an alternative technological solution. While there is no clarity yet on the costs for compliant fuels, it is likely that these fuels will become more expensive, potentially causing a ripple effect that will increase costs for other modes of freight transportation.
MIDDLE MARKET INSIGHT Manufacturers should consider incorporating into their shipping contracts the ability to renegotiate prices more frequently in order to manage trade uncertainties and the volatility in spot and contract pricing.
OPPORTUNITIES AND CHALLENGES FOR TRUCKING
In a recent poll of industry professionals conducted by Kuebix, a transportation management system company, the shortage of drivers was identified as a major challenge for supply chains. The tight labor market, however, may serve to balance the impact of the economic slowdown on trucking rates and provide trucking companies with the ability to increase contractual rates for their customers, albeit in the low single-digit percentages.
Despite softening conditions in 2019, driver availability and retention remain among the biggest challenges for the North American trucking industry through 2020. Relatively low pay, demanding working conditions and increasing drug-and-safety regulations make it difficult to attract talent. Boosting driver compensation, often required to stay competitive, will pressure 2019 margins unless carriers can pass these costs on through increased contractual rates. Manufacturers, already facing the impact of tariff wars and weaker demand, may push back against higher trucking costs, which add to their own margin pressures.
MIDDLE MARKET INSIGHT: Trucking companies must consider nonpay-related measures to combat labor challenges, such as diversifying their workforce to include women, adopting technology solutions, creating better and safer working conditions, managing regulatory compliance, and positioning themselves to attract younger workers.
BROADER LABOR CHALLENGES
Labor challenges will continue as manufacturers deal with sustained levels of low U.S. unemployment and struggle to find and retain skilled workers; job vacancies in the sector are at multiyear highs.
At the same time, manufacturers must sustain profitability and could soon have to make difficult decisions regarding their existing workforce. Signs the trade war’s impact and economic slowdown showed up in recent U.S. jobs data: For the first time in three years, manufacturing activity shrank in August; factory hiring added only 3,000 jobs in the month. Average weekly hours fell in July to their lowest level since 2011 before rebounding in August.
Manufacturers continue to search for ways to address worker shortages, including engaging staffing agencies, retaining potential retirees, offering flexible work arrangements and introducing apprenticeship programs. Some organizations have even started offering employees transportation to manufacturing sites. Other solutions include the use of automation and virtual reality. For instance, Hitachi has introduced virtual-reality training to simulate welding that provides real-time feedback to help employees develop new skills.
If the downward economic trend continues, it would suggest that layoffs could be around the corner, while at the same time presenting an opportunity for nimble organizations to acquire talent that otherwise might not be available to them.
HEIGHTENED MERGER ACTIVITY MAY BE ON THE HORIZON
Historically, a period of contraction in the manufacturing sector results in consolidation among manufacturers. Corporate margins are affected by many factors, such as higher input costs, specifically for raw materials and wages. This may force some manufacturers to consider restructuring, selling part of their business, closing their doors or purchasing another manufacturer to achieve their long-term growth targets.
At the same time, expectations for slower economic growth and declining profitability could make the valuation process more challenging, tempering overall deal prices and activity, which has been strong so far this year, in the months ahead (see the next figure).
More organizations in the industrial space are targeting technology and software-based acquisitions, which tend to be smaller and more expensive than traditional acquisitions in the space. As highlighted in the RSM Q2 2019 Industrial Products Spotlight on M&A trends and private equity deal activity, a significant amount of capital is pursuing fewer quality IP targets. Competition remains stiff, with some investors seeking new assets, and ultimately, reporting an inability to spend their allocated funds.
MIDDLE MARKET INSIGHT Companies should expect M&A transactions to require multiple phases, with more parties at the table, resulting in longer due diligence and protracted closing schedules.
Given that most economic models point to continued moderation in economic growth, the industrial space may have reached its cyclical peak. Manufacturing growth will continue to be challenged by significant uncertainty surrounding ongoing trade negotiations with China, and some companies will hold off new investments due to the lack of clarity created by the dispute. This was evident in July when U.S. imports of capital goods fell to their lowest level since 2017, along with new orders for capital goods, which posted their first year-over-year decline in three years.
The RSM US Middle Market Business Index has shown that through this last business cycle, middle market companies have been slow to increase capital expenditures. These organizations need to be ever wary of sitting idle and waiting for things to calm down. Industry 4.0 will continue to offer traditional manufacturing innovative technology and connectivity, with opportunities for increased automation and improved communication and monitoring, along with self-diagnosis applications and new levels of analysis.
Middle market industrial products companies need to continue to prepare themselves for these changes or risk being left behind.