So much for the knowledge economy – industry is back

MAKING things had been thought to have gone out of fashion not that long ago. As the proportion of output and number of jobs devoted to manufacturing and heavy industry in most Western economies seemed to be on a relentless decline, many commentators began talking about “post-industrial societies”, and politicians about “the knowledge economy”.

How times change. While much of the recovery has been immensely fragile, manufacturing has provided a welcome lift near enough everywhere, even, remarkably, in Britain. Governments are counting on the industrial sector to lead economies out of post-recession torpor. Should spread betters have as much confidence?

Certainly, traders who anticipated the recovery a year ago will have done very well. Manufacturers did terribly at the height of the recession as collapsing confidence led retailers to run down inventories without placing new orders.

But that has now reversed, however, and the turning back on of production has reinvigorated many industrial firms, especially those exporting to emerging markets. The Purchasing Managers’ Index (PMI) results for the UK released this week revealed industrial growth to be at its highest level since 1994.

Share prices have followed new orders. The primary British manufacturing index – the FTSE 350 Industrial and Engineering – has risen by 40 per cent since the end of September. David Jones, chief market strategist at IG Index, points out that the best performing firms have been those connected to the oil industry, where demand for components has exploded.

And indeed the best performing stock in the FTSE 100 last year was the Weir group, which manufactures pumps used in the oil industry. The firm saw a 118 per cent leap in its share price in 2010. Similarly positioned firms such as IMI and Melrose also did very well, with IMI registering a share price increase of about 65 per cent.

That sort of performance may yet continue. According to Manoj Ladwa, senior trader at ETX Capital: “Anyone producing stuff seems to be a fair bet at the moment. Manufacturers and engineering firms are mostly cash rich, low debt and now paying reliable dividends”. As the recovery gains further traction, valuations should continue to rise, as will indices in countries with large industrial sectors, such as Germany.

With talk of new currency wars breaking out, many governments in the West are determined to export their way back to prosperity. Manufactured goods tend to be exported much more than services. With world trade rapidly recovering, the enviable performance of last year could very well continue. Given that growth in the service sector is looking less inspiring, perhaps it is time for spread betters to finally embrace the industrial society.

● Why manufacturing is so cyclical
At the height of the recession, it was widely noted how “unfair” it was that countries like Japan and Germany, which had not heavily overleveraged in the boom years, seemed to be bearing the brunt of the collapse. Germany’s economy lost 5.94 per cent of its GDP overall, initially a lot quicker than many economies, while Japan lost 8.67 per cent. In both countries falling output only lasted for four quarters, however, compared to six in the USA and the UK. That was arguably largely the result of those countries’ focus on export driven manufacturing growth. Part of the reason why manufacturing is recovering so dramatically now is because of how much it was depressed during the great recession.

Manufacturing is generally considered by economists to be much more volatile than the service sector. That is largely because of the inventories effect. When confidence and demand in the economy collapses, businesses selling expensive manufactured products like cars often choose to run down inventories instead of manufacturing more goods that they then may end up stuck with. As a result, the start and end of a recession is amplified: initially, production is slashed before demand falls, but then later, as demand recovers, inventories are rapidly rebuilt. That means that countries with large manufacturing sectors tend to experience shorter but more severe recessions than countries with large service sectors.

The effect is heightened further by trends in business investment. Heavy industry is generally very capital intensive – steel mills, car factories, oil rigs and the like are substantial investments. Those investments are said to be “lumpy”, meaning that they can only be bought in large instalments – a company cannot easily choose to buy half a factory. They also have heavy “sunk costs”, since a company buying a car factory will probably not be able to sell it. As a result, when business confidence is very low, firms will be likely to delay planned investment until better times return. As a result, more capital intensive economies tend to suffer more severe downturns than more service oriented economies, but also gratifyingly rapid recoveries. And with such a recovery underway at the moment, industry is a much happier place to be than the service economy.