Industrial products industry outlook
INSIGHT ARTICLE |
Key takeaways from the winter 2020 industrial products industry outlook
- Investment in technology and talent is critical for growth.
- Trade uncertainty remains a headwind.
- Supply chain evolution demands innovation.
- Labor shortages will persist.
- Optimization of process is critical for growth.
MANUFACTURERS FACING HEADWINDS
Manufacturing is in a continual state of transformation, pushed along by rapidly advancing technologies. The last 18 months, in particular, have provided many challenges, including shifting supply chains because of trade tensions, changing customer needs and a shifting competitor landscape. It all leaves manufacturers having to move more aggressively toward investing in technology and talent, as well as partnering with or acquiring businesses to cement themselves as leaders in the Fourth Industrial Revolution. They must do so all while staying focused on profit margins and revenue growth.
As the United States continues its longest economic expansion on record (128 months as of December 2019), U.S. and global manufacturing have recently reversed the growth from the beginning of 2018. Continued uncertainty brought on by the U.S.-China trade war has cast a cloud over the sector and increased the chances of a prolonged global manufacturing slowdown. While the JP Morgan Global Manufacturing PMI showed tentative signs of a recovery in November, registering a positive reading of 50.3 after six straight months of contraction, international trade continued to be a drag on the sector, as new export business decreased for the 15th month in a row.
At the same time, the U.S. November global Purchasing Managers’ Index contracted for the fourth straight month, registering 48.1, while hovering near the 10-year low registered in September. The Institute for Supply Management’s measure of new orders, which are typically tracked as a leading indicator of a downturn, fell to 47.2 from 49.1 in October, matching the year's low reached in August, and again reaching a level not seen since April 2009. Surveys of manufacturers in six major regions suggest that the decelerating trend in sales—which began in the second half of 2018—is likely to continue. The RSM US Manufacturing Outlook Index has been range-bound for the past six months at 0.7 standard deviations below normal levels. That implies that manufacturing sales growth, which was barely positive in the fall, will have difficulty remaining positive into 2020. The composite index is based on surveys of business sentiment conducted by six regional Federal Reserve banks and can be considered representative of the general direction of national manufacturing activity.
The most frequently mentioned constraint cited by manufacturers is the uncertainty over tariffs and trade agreements, with a particular focus on China and the United States-Mexico-Canada Agreement. Costs throughout the manufacturing supply chain, from steel and aluminum to shipping rates, have all seemingly been affected, and that will continue in the near-term. Labor also continues to be a challenge for manufacturers. Nationally, the unemployment rate has held steady at around 3.6%, but we have seen a steady divergence between the job growth in the service sector versus the manufacturing sector. In 2019, the service sector created 1.39 million jobs while the manufacturing sector created 2,000 jobs. Still, manufacturers are struggling to fill critical jobs because they cannot find workers with the right skills. The uncertainty surrounding domestic and global trade policy, as well as the tight labor market, appear likely to continue into 2020, creating challenges for organizations that do not adapt, while providing significant opportunities for the nimblest organizations
Trade uncertainty lingers
Ever since the United States initiated a trade dispute with China, in early 2018, over what it said were unfair practices, manufacturers have had to reduce the impact by evaluating alternative sourcing strategies, creating supply chain efficiencies or implementing new pricing strategies. And there is little sign that these pressures will ease.
It’s not just China that has been the source of trade tension. After a much-hyped signing ceremony last year, the United States-Mexico-Canada Agreement still must be ratified by the legislatures of each country. Mexico has approved the deal, and in the United States, Democrats struck an agreement to support the deal after seeking changes in labor and environmental protections. It appears that Canada has been waiting to see how negotiations in the United States played out.
Then there is the auto industry. In 2018, the Department of Commerce launched a section 232 investigation on passenger vehicles and automotive parts to evaluate “whether such imports are weakening our internal economy and may impair the national security.” In February 2019, the Department of Commerce submitted its report to the president, but a decision on whether to impose tariffs or take alternative actions still looms, leading to significant uncertainty for automakers and their suppliers. Why does this all matter? According to the Center for Automotive Research, consumers could see the price of all new vehicles rise by $455 to $6,875 depending on the tariff level, where the vehicle was assembled and whether the policy provides exemptions for automotive trade with Canada and Mexico. This will affect not only the new vehicle market, but also the used vehicle market as prices may rise because of heightened demand and constricted supply. In addition, higher prices for automotive parts will drive up the cost of maintenance and repair, so even holding on to an existing vehicle will become more expensive for consumers.
While we expect U.S. manufacturers to continue their outperformance related to world growth, they will continue to grapple with the effects of global trade policies and the associated downturn. Resilient organizations focused on building more flexibility into their investment planning and operations will ultimately fare much better than their industry peers.
MIDDLE MARKET INSIGHT It is difficult to make supply chain decisions without adequate data to evaluate. Manufacturers in the middle market need to understand the impact tariffs have on their business and anticipate next steps in an increasingly complex environment.
Supply chain evolution demands innovation
The market is forcing manufacturers to evolve and innovate at a much faster clip, and no place is this more evident than in their supply chains. Whether these changes are spurred by trade tensions or by increasing customer expectations, manufacturers no longer can sit back and play defense. A recent survey of middle market companies by Umpqua Bank found that more than half of the respondents were looking to diversify their supply chains domestically and internationally as a result of current trade policies. The ability to respond quickly in this environment will require manufacturers to look at their supply chains in a different way, focusing on end-to-end visibility to enable realtime decision-making
MIDDLE MARKET INSIGHT Middle market manufacturing supply chains have to be nimble. As circumstances change, it is an ideal time to re-evaluate business structures to challenge the norm.
The decision to shift operations away from China is usually made for the long term because of the time and money invested in setting up new facilities and making new shipping arrangements. The new markets are often other emerging Asian countries, led by Vietnam, India and Thailand, where production costs are considerably lower than in China. Vietnam has especially been a major beneficiary of this supply chain shift. China almost tripled the amount of goods they bought last year from Vietnam compared to 2014, while the United States increased its purchases by $18 billion compared to the same period, according to Bloomberg. In response to the increased demand, Vietnam will have to stay ahead and invest in its infrastructure to ensure that port capacity and customs staff can handle the increased volume.
It is challenging and sometimes costly for companies to reconfigure their supply chain. Many American companies have their own factories in China and have had them for decades; shutting them down would prove costly, and in most cases, would not make financial sense. Others, especially middle market companies, use China as a means to mass produce components and have long-term relationships with suppliers that they don’t want to break. Given the ongoing political uncertainty, we ultimately believe that more companies will explore outside of China, with new hubs in Southeast Asia and Mexico, as well as domestic suppliers benefiting from these shifts.
MIDDLE MARKET INSIGHT To solve supply chain challenges, middle market businesses may need to think critically and creatively. Perhaps an alternative location or new vendor might offer relief in the current environment.
Labor challenges will persist
Manufacturing firms added about 1.4 million jobs in the United States from the low point of the Great Recession. Now growth is slowing. Manufacturing jobs increased by 46,000 in 2019, slowing from a gain of 264,000 in 2018.
Even though job growth has slowed, U.S. manufacturers continue to struggle to find talent with the right skills in today’s tight labor market. With 469,000 open manufacturing positions as of September 2019, there is less than one unemployed person for every job opening. As the manufacturing industry faces significant change because of digitization, employees will need to develop new skills and become more digitally fluent. While training in process automation tools is relatively easy, training in artificial intelligence tools is much more complex. Companies need to think not only about their internal workforce, but also of an external workforce strategy to identify, attract, recruit and retain technology talent. Adding to the challenge is that this talent has typically not been attracted to the manufacturing sector.
A bright spot for manufacturing employees but a rising challenge for employers is that wages continue to remain steady, with growth of around 3%. Given the difficulty of finding qualified workers, employers are unlikely to reduce wages or lay off workers unless there is a significant slowdown in growth. We expect steady wage growth, as well as a tight labor market to continue in 2020
Optimizing manufacturing processes
Industrial production and manufacturing production both rebounded 1.1% in November following the biggest drop in October that we’ve seen in industrial production since May 2016. The increases in each were driven by the sharp reversal in auto production (12.4% increase), as the United Auto Workers ended the strike at General Motors. While these numbers were positive, the ISM’s Purchasing Managers’ Index dropped to 48.1 in November, hovering near the 10- year low of 47.8 registered in September. The manufacturing sector, which makes up about 11% of the U.S. economy, has been weakened by the 17-month trade war between the United States and China, and this has been especially tough on middle market manufacturers.
The customer list of most middle market manufacturers will show that the 80/20 rule applies; that is, 80% of their sales are from 20% of their customers— sometimes just one or two customers. Challenges like these create an environment in which forward-leaning manufacturers must focus on streamlining businesses and realigning around key or new markets or customer segments to drive growth.
Manufacturers will need not only apply digital technologies to existing manufacturing processes, but also create new innovative processes to turn their value chains into ones that create customer stickiness. We expect companies to increasingly turn to digital tools and advanced analytics to bolster productivity and drive growth. While some manufacturers are already using advanced analytics to reduce quality issues and error rates in their manufacturing processes, the future will see manufacturers using digital platforms to enable self-service options for customers and to simplify the purchasing process, moving closer to a consumer-product type experience.
MIDDLE MARKET INSIGHT The customer list of most middle market manufacturers follows the 80/20 rule; that is, 80% of their sales are from 20% of their customers—and sometimes it’s just one or two customers.
THE PATH AHEAD
As the broader economy moves from a product-centric industrial economy to a new economy that is customer-centric and empowered by exponential technologies, manufacturing, too, is evolving with technology-enabled business models. Advanced manufacturing technologies like 3D printing, digital twins, augmented reality, industrial internet of things, advanced analytics and co-bots are increasingly becoming part of mainstream manufacturing operations.
- Additive manufacturing is drastically reducing build time from months to hours, in certain instances, and consequently, expediting time to market.
- Real-time data insights strengthened by machine learning and artificial intelligence are able to predict equipment breakdowns and prevent expensive repair and downtime costs.
- Smart factories and connected supply chains are enabling real-time coordination of production and logistic schedules to be more agile, lean and responsive to fast-changing customer needs.
- Robotic automation may not be new to industrial manufacturing but robots’ increasing cognitive capabilities and ability to work alongside humans are proving to be viable labor solutions.
- Data analytics is critical to evaluate product profitability, inventory rationalization and product segmentation—all involved in driving value from the production and sales process.
Today’s technologies are moving mass production to mass customization and making it possible to quickly deliver tailored solutions direct to the customer. But according to the RSM US Q4 Middle Market Business Index, only about 46% of executives polled say they expect to increase capital spending during the next six months, down from 50% a year ago. With new technology available, both for internal and external efficiency improvements, the challenge for businesses in an industry with so much available new technology may be less about understanding the need for implementation and more about actual adoption. U.S. manufacturers have historically led the world in innovation and efficiency, but that gap is shrinking with China and other countries. A prolonged slowdown in investment may hurt U.S. manufacturers’ innovation.
Invest in talent
While advanced manufacturing increases productivity, improves operational efficiency and enhances customer experience, it needs sufficient capital investment and, more important, talent with the right skill sets to realize these benefits. While manufacturing job openings have been growing at a near historical rate since 2000, and some studies estimate that there may be up to 2.4 million manufacturing jobs unfilled in the next decade, retiring baby boomers and changing skill sets throughout the workforce have caused a shortage of labor. The limited pool of digitally skilled professionals makes it critical for companies to educate and train or retrain employees. The World Economic Forum, in its Future of Jobs Report 2018, estimates that more than half of all employees will require significant reskilling by 2022. Companies need to think creatively to address this issue—internet-enabled training devices and programs, partnerships with educational institutions, multigenerational initiatives to facilitate knowledge sharing, and customized real-time feedbackbased approaches are some methods to retrain employees and address the skills gap.
M&A: Build or buy?
Merger and acquisition activity may pick up in the manufacturing sector in 2020 if the economic downturn causes reduced valuations, making deals more attractive. A desire to strengthen capabilities in their core business could further spur deal activity or investments in joint ventures or startups, especially as they relate to protecting supply chains because of heightened global political tensions. The slowdown in production coupled with any weakness in the economy may create prime opportunities for those manufacturers with the capacity to expand. Large divestitures with a progression toward simplification are the deal trends expected in the coming year. More organizations in the industrial space are targeting technology and software-based acquisitions, as well as adding service to product portfolios, which are all trends we will be watching.
Companies seeking an M&A opportunity should consider the following:
- Partner with an adviser. M&A can be challenging, and it’s difficult to know all of the questions to ask or the potential pitfalls. Whether buy or sell side, manufacturers should have a business adviser familiar with these types of transactions to guide them through the process.
- Optimize and standardize processes. When positioning a business for sale, the seller needs to make the business attractive; maximize marketability and exit value through a readiness assessment.
- Technology advantage. When evaluating potential acquisitions, it’s critical to ensure that targets have current technology in the product, customer-facing and supply chain areas. Leveraging and taking advantage of technology can add immediate value
OPPORTUNITIES FOR 2020
The coming year promises to be a dynamic and transitional one for manufacturers, as they look for growth in an environment with continued volatility in trade policy, workforce challenges, managing input costs and leveraging the impact of technology. While the potential for uncertainty may continue for the foreseeable future, manufacturers will need to continue to evaluate alternative supply chains and evaluate their business models, all while investing in their people and technology. U.S. manufacturers have a long history of resiliency and innovation. But the bar is higher, as we head into 2020, to break out from the competition and invest in the future.
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