For manufacturers, the past several months have produced seismic shifts in the global economic landscape. Four major macroeconomic factors are at work: the relative value of the dollar, the new U.S. tax law, NAFTA renegotiations, and proposals for a more punitive regime of U.S. tariffs for a range of imports, including steel and aluminum products.
In today's global environment, each of these events has ripple effects for manufacturers due to the complexities of supplier relationships. Indeed, 86% of corporate spending is now directed to external suppliers, a major increase over the past 20 years, and each event has unexpected implications. Following is more perspective as we all fasten our seatbelts and prepare for the shifts still to come.
The Strength of the Dollar
U.S. manufacturers continue to benefit from currency valuations that make U.S. exports more competitive in overseas markets. Over the past 12 months, the U.S. dollar has declined about 7% relative to a basket of 16 foreign currencies that account for the vast majority of global trade. This “discount” makes U.S.-priced exports more attractive compared to competing products denominated in non-U.S. currency.
Yet two countervailing factors could disturb the current equilibrium. Expectations that the Fed will raise short-term interest rates as many as three more times in 2018 could put upward pressure on the dollar (rising interest rates in the U.S. tend to attract foreign investment, resulting in higher demand for U.S. currency and a strengthening dollar).
However, U.S. fiscal policy may undermine the impact of rising interest rates. The combination of tax cuts enacted in December and a federal budget compromise that increased spending levels for both defense and non-defense programs will likely lead to increasing annual budget deficits. Economists debate the near-term impact of federal budget deficits on the strength of the dollar, but generally agree that rising levels of U.S. debt (the “supply” of debt) can outpace demand, lowering the value of the dollar. This may be more so the case than in the past, as foreign central banks, especially China, have stopped increasing their investments in U.S. Treasuries, weakening demand for U.S. debt even as the U.S. issues higher levels of debt to close the spending gap.
Whatever the future holds, the data in ISM’s Report On Business (ROB) is definitive on the current state of U.S. manufacturing.
The March 2018 ROB (the most recent data at this writing) showed a robust manufacturing sector, in its 19th straight month of growth. This was especially evident in the ROB’s New Export Orders Index, which registered 58.7% in March, indicating growth in new export orders for the 25th consecutive month. Expanded export activity was reported by 11 major industry sectors during this period, including Electrical Equipment, Appliances & Components; Fabricated Metal Products; and Chemical Products. Many survey respondents commented on the currency advantage as an influence on exports remaining strong.
The New Tax Code
The Tax Cuts and Jobs Act (TCJA), passed in December 2017, provides manufacturers with a significant economic opportunity, as it lowers tax rates, in part through a new provision: Global Intangible Low-Taxed Income, or GILTI. The provision levels the playing field between the United States and low-tax jurisdictions. Before the TCJA, it made sense for ownership of critical intellectual property assets to transfer to foreign-based subsidiaries, where income was taxed at much lower rates.
For manufacturers, GILTI means that rather than taking advantage of low-tax jurisdictions abroad to improve tax efficiency, it is just as attractive for firms to keep intellectual property in the U.S. (The new effective tax rate in the U.S. for such arrangements is 13.125%, significantly lower than the nominal U.S. corporate rate and competitive with rates in Luxembourg, Ireland and other low-tax jurisdictions.) Lower tax bills combined with best-in-class technology (such as robotics and automation) and a highly skilled workforce are creating real incentive for businesses to manufacture here, and sell their products both domestically and overseas. GILTI also aligns well with the strategy of establishing regional supplier networks in the U.S.
Over and above these tax changes, the economic environment is very good for expanding capacity, as seen in planned levels of capital expenditure spending running higher now than in the last few years. Per the Semi-Annual Forecast ROB, issued in December 2017: capital expenditures, a major driver in the U.S. economy, are expected to increase by 2.7% in the manufacturing sector and increase by 3.8% in the non-manufacturing sector. Some of the planned expansion is attributable to the still relatively low cost of capital, and a need to expand production capacity to meet higher levels of demand.
North American Free Trade Agreement (NAFTA)
As I write this, NAFTA has entered round eight of renegotiations, with some saying a deal would be reached in May, and others noting that Mexico and Canada may want to hold off until after the U.S. midterm elections in November. The level of impact this deal will have on businesses depends largely on the industry. In manufacturing, the implications are strongest in the automotive industry, as currently, approximately 95% of parts for automotive manufacturing come in from our NAFTA partners. To put this in perspective, it has been estimated that the pharmaceutical industry in the U.S. receives just one 1% of its inputs from Canada or Mexico.
There is one significant area of debate for manufacturers regarding NAFTA: Under the current agreement, costs are lowered by preferable tariff treatment. However, this is accompanied by a need to meet local content requirements, which come with imposed costs that potentially offset or at least dilute the reduced tariffs. If NAFTA is dissolved (or requirements changed), these local content requirements are as well, leaving manufacturers and their suppliers at liberty to do what makes the most economic sense for their businesses. Potentially this could shift some production back to the U.S.
Tariffs for Aluminum and Steel Imports
In March 2018, the U.S. formally ordered import tariffs of 25% on steel and 10% for aluminum from all countries except Canada and Mexico. While major automakers and other consumers of steel may be hurt by this decision, an argument has been made that U.S. aluminum and steel providers are being hurt by alleged dumping by other countries in the U.S. market.
Despite the strong rhetoric accompanying this issue, the fact is that for manufacturers, most supplier relationships are contractual and of long duration, meaning that the industry is not quite as volatile as the political discussion. Manufacturers will also make decisions based on overall savings, which the tariffs will barely dent in many circumstances. In one U.S.-based infrastructure project I am aware of, the project required 70,000 metric tonnes of steel. Sourcing the steel from China, including the cost of transportation, yielded a $70 million cost savings for the project. Subject to a 25% tariff, the cost savings would have been reduced to $52.5 million, but would not likely have changed the sourcing decision.
There are questions about whether the tariff discussion is meant to exert pressure to get to negotiations on other issues, such as the overcapacity globally from China, due to the subsidies that the Chinese government makes available. The end game, some say, is about opening up markets.
Meanwhile, the supply chain perspective on tariffs is straightforward: U.S. manufacturers work in global markets and will source wherever they can get the best price. You can’t put the genie back in the bottle—China is here to stay.
Stepping Up to the Challenge
All of these “seismic shifts” add up to 2018 as a pivotal point for the U.S. economy, particularly regarding manufacturing. From a supply management professional point of view, it is an exciting time, an opportunity to “step up” to the challenge.
I encourage manufacturers to look to their supply management teams’ expertise in helping them navigate the rapidly changing economic landscape. I have every confidence that the resiliency of the manufacturing supply chain, the resiliency of the American economy, and above all, the American spirit, will guide this country through tumultuous times to a successful future.
Thomas W. Derry is CEO of the Institute for Supply Management (ISM), a not-for-profit, independent, unbiased resource for the global supply management profession, with more than 50,000 members worldwide. ISM delivers market intelligence, education, certification, tools, events, discussions and publications for the global market of procurement and supply chain management professionals.