Economic Transformation

Much has been made about the weakening manufacturing sector of the U.S. economy. While the most recently available data shows that manufacturing grew in the first quarter, an important forward-looking reading, the ISM Manufacturing Index, was recently below 50, reflecting the view from purchasing managers that manufacturing will be contracting. In this week’s Sight|Lines, we would like to review the implications of a slowing manufacturing sector on the overall U.S. economy.

A History of Manufacturing

Figure 1 shows the weight of the manufacturing sector as a component of U.S. gross domestic product (GDP) going back to 1947, post-World War II. During the war, the U.S. ramped up its manufacturing capacity to support the military. Then, after the war, manufacturing capacity transitioned from military to civilian production. This benefited sectors like aerospace and infrastructure , for example. This transition can also be seen in the data. In 1953, manufacturing represented more than 28% of GDP. So back then, had we heard that manufacturing was slowing or contracting, we would have been worried about a full recession given the size of the manufacturing sector in the overall economy.

But today, manufacturing makes up 11%-12% of U.S. GDP. When we think about this change, we may recognize that the economy really has gone through a transformation. We’ve shifted further away from a manufacturing economy, driven by the production of goods, and more towards a services-based economy. So areas like education, healthcare, entertainment, and financial services, have become a much bigger part of our economy. And these days, innovation, especially in technology, plays a big role. Advances in technology allow people to start businesses that deliver services and drive profitability much faster than in years past.

The Shape of the Workforce

Corresponding to manufacturing’s declining role in GDP, we see a similar trend in the employment data. In 1946, about 33% of U.S. jobs, or one out of every three, were in manufacturing. And this is consistent with our history, as the manufacturing focus during and after World War II was very important to our economy and our workforce. Today, only 8.5% of jobs are in manufacturing, or about one in 12. This is due to a combination of factors. Today, U.S. manufacturers can produce more goods with less labor due to advances in technology and productivity. In addition, many manufacturing jobs have been outsourced to countries where labor is cheaper. Manufacturing is still a sizeable component of GDP for other developed and emerging economies. For example, manufacturing is about 21% of Germany’s economy, 21% of Japan’s economy, and 29% of China’s economy.

Is Worry About Manufacturing Weakness Signaling a Recession?

Figure 3 shows the ISM Manufacturing Index over time and includes shaded periods of recession. The chart shows that periodic dips below 50 do not always immediately precede a recession. For example, this index fell below 50 five times during the 1990s, spread out over much of the decade, before a recession occurred.

Conclusion

Our solid economic growth has been slowing. And there is concern about more slowing in manufacturing, especially outside the U.S. This, in part, is what led the Fed to lower rates in July and September. These concerns are amplified by uncertainty about things like U.S.-China trade, the impeachment inquiry, Middle East tensions, Brexit, and monetary policy. Despite the potential for weakening manufacturing, the economy remains solid. Employment remains strong, with low jobless claims numbers, firm job creation, and the lowest unemployment figures in 50 years. The consensus forecast for 2020 GDP growth is 1.7%. Few economists are forecasting a recession over the next year.

So, should we be concerned that a possibly slowing manufacturing sector may cause a recession? Given the reduced role of manufacturing overall and the strength in other areas, we think not. However, we are mindful of the slowing manufacturing activity outside the U.S. and the possible spillover effects this would have on animal spirits and on the U.S. economy.

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