10/21/20: Market Update by Jack Ablin, Chief Investment Officer at Cresset
The global pandemic laid bare the vulnerabilities created by producing goods offshore. Shortages of personal protective equipment and other essential medical supplies during the early stages of the pandemic were a reminder that corporate managers’ obsession with production efficiency and cost-cutting at the expense of diversification and resiliency left the American economy susceptible. The Wall Street Journal reported in April that large quantities of critical protective gear and other medical goods manufactured in China by American firms 3M and PerkinElmer were stranded in warehouses there unable to obtain the necessary clearances from Beijing for their export to the US. The shortages caused price spikes for critical medical supplies. A recent study by McKinsey Global Institute (MGI) found that China accounts for at least 70 per cent of exports of 180 products across a wide swath of global supply chains.
US corporations spent the last 40 years perfecting and optimizing the global supply chain. Beginning in the 1980s, US manufacturing relocated to countries with lower labor costs, lax or no environmental standards, government incentives and cheaper currencies, helping companies control costs and expand profit margins. Imports ballooned as a result, particularly from China. US companies have directly invested about $260 billion in Chinese operations since the early 1990s, according to Barron’s. Since 2000, the value of global trade of intermediate goods has tripled to $10 trillion annually, according to MGI.
Even though domestic manufacturers produced $6 trillion of goods in the US in 2019, America’s manufacturing sector has not grown in real terms in over 20 years, as labor-intensive industries like textile and apparel manufacturing relocated to low labor cost locations, like Bangladesh. Even technologically advanced industries, like electronics, have shrunk as well. The annual US trade deficit in manufactured goods now exceeds $1 trillion annually – representing about 4.5 per cent of GDP – according to non-partisan think tank Coalition for a Prosperous America.
Reversing the outsourcing trend by bringing manufacturing back home, will require rethinking production. Domestic reshoring must also include automation, including robotics, artificial intelligence and other software. That doesn’t mean human beings won’t be working in these facilities. In fact, advanced manufacturing requires skilled labor, but there’s a shortage of this type of talent in the US. “National security-related” industries, like defense, semiconductors and pharmaceuticals, would be a good place to start, as an increasing share of defense procurement is derived offshore.
Though US firms design their chips at home, the manufacture of semiconductors is concentrated at foundries in South Korea and Taiwan. Asia accounts for 95 per cent of outsourced semiconductor assembly, according to McKinsey. Relocating a semiconductor plant would cost upwards of $10 billion and require highly specialized engineers. While geopolitics and trade tensions tilt toward domestic production, the bar is high and the costs to resuscitate US-based chip production are great.
The aggressive shift in pharmaceutical offshoring was driven less by operating efficiencies than it was by loopholes in the US tax code. Higher US corporate tax rates encouraged domestic pharmaceutical companies to shift their intellectual property offshore, channeling profits through tax haven countries. To level the corporate tax playing field, President Trump introduced the 2017 Tax Cuts and Jobs Act – but it contained a loophole that enables the expansion of physical pharmaceutical assets in offshore tax havens. Since the end of 2016, the industry has seen 70 per cent of the growth in output of pharmaceuticals and other medicines derived from tax haven countries, like Belgium, Ireland, Netherlands, Singapore and Switzerland. Senators Elizabeth Warren and Marco Rubio have cooperated on bills to reduce American’s dependence on pharmaceuticals produced in China. Reshoring pharma production will also be a challenge: constructing a biopharmaceutical facility can take 5-10 years and cost of $2 billion.
Offshoring not only left America with eight million fewer manufacturing jobs, but it also depleted our nation’s network of suppliers and researchers. At the same time, the interconnected nature of established value chains limits the economic case for making wholesale changes in physical location. Despite the impediments, MGI estimates that of roughly 16-26 per cent of global production, worth $2.9-4.6 trillion, could move across borders in the medium term. This could involve some combination of reshoring, nearshoring or shifting to other offshore locations.
Despite the challenges, there is optimism. A May/June survey of manufacturers by Thomas Report found that 69 per cent of manufacturing companies are looking to bring production back to North America, up from 54 per cent in February. Economics pushed domestic manufacturing abroad, but unfortunately, economics alone aren’t compelling enough to justify reshoring because the imbedded commitments are so huge. President Trump has talked since 2016 about bringing manufacturing investment back home to the US, but little progress has been made for various reasons including the strong US dollar. It will take a coordinated effort of the public and private sectors to bring manufacturing back to the United States on a large scale. Progress will require government incentives, and some foreign governments are beginning to recognize that. In April, the Japanese government rolled out a $2 billion program of reshoring subsidies. The European Union is assessing supply chain vulnerabilities to determine which strategic sectors to target for reshoring. Vice President Biden has promised to roll out an expansion of “Buy American” domestic procurement and bring production of sensitive products home from China.
Reshoring costs will likely be borne by shareholders, consumers and the government. Domestic manufacturing will incur higher labor costs, due to a shortage of skilled labor and a relatively more expensive labor market. Consumers will face higher prices and companies will endure margin pressure. The tug-of-war between wages and profits already shifted in favor of wages five years ago. That trend will continue, leading to upward pressure on prices fueled by stronger domestic spending. Industrial real estate is another critical component of the global supply chain that keeps the world’s goods moving from makers to markets. America’s manufacturing reshoring, combined with e-commerce growth, will undoubtedly increase the demand for industrial real estate, serving manufacturers, warehousing and fulfillment centers. Jones Lang LaSalle, a global real estate investment firm, believes e-commerce sales could hit $1.5 trillion by 2025 — which would increase the demand for industrial real estate to an additional 1 billion square feet. Whichever path reshoring trends take, we believe there will be profitable opportunities investing in and developing industrial real estate.
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