Thematic View: The role of industrial production in economic activity

Market and economic highlights:

South Africa’s government of national unity (GNU) takes shape

The new cabinet appointed by President Cyril Ramaphosa was sworn in in early July, with the President delivering the opening of Parliament address shortly thereafter. The significance of the appointing and swearing-in of the cabinet lies in the formalisation of the government of national unity (GNU). The GNU agreement had the tough task of balancing the interests of the seven parties represented in the cabinet and 10 parties more broadly represented in the GNU.

Inflows into the South African bond market, a rally in the South African equity market and the incrementally stronger currency suggest that the formation of the GNU was well received by market participants. We view this primarily as a function of broader policy continuity and certainty.

The US economy materially surprises to the upside

The US economy grew at an annualised pace of 2.8% in the second quarter of 2024, significantly above the market consensus forecast of 1.9%. The print was mainly supported by a strong rebound in consumption expenditure and private inventories (see chart 1).

Chart 1: US Q2 GDP by segment

Chart 2: US Q2 GDP by segment (trend since September 2021)

Private inventories were particularly strong as a function of corporates building up their inventory in response to global supply chain issues (rising transportation costs due to the Middle East conflict and other climate-related issues in the Suez Canal).

From an economic perspective, rising inventories should provide a disinflationary tailwind in the US.

Irrespective of the robust GDP print, we continue to expect that a potential labour market correction, falling wage growth and lower pricing should impact growth.

SARB keeps rates on hold

The South African Reserve Bank (SARB) monetary policy committee (MPC) met in July and elected to keep interest rates unchanged, a decision which was in-line with the consensus view. The SARB’s inflation forecasts see inflation falling below the midpoint of its target range of 3% to 6% in the fourth quarter of this year. This was captured in the split vote by the MPC, with two members voting for a 25-basis point cut in rates and the other four voting for rates to remain unchanged. This suggests that the direction of interest rates is skewed to the downside.

The SARB’s assessment of inflation risks swung to the upside following the May meeting where the MPC viewed risks to inflation as balanced – the first time we have experienced that assessment in two years. The SARB has done an excellent job in containing inflation and moving ahead of developed market central banks in the wake of the post-Covid economic recovery and subsequent inflation bubble as a function of pent-up demand and supply chain gluts, among others. However, the current level of inflation, inflation expectations and the repo rate have resulted in elevated monetary policy restrictiveness.

There are various risks to the currency in the near term, including the various global elections and geopolitical fragmentation, and the relative attractiveness of our bonds to those in the developed world (the US in particular). The SARB has considered those risks in its assessment. That said, we view a structural upturn in South Africa to be broadly supportive of the rand/dollar exchange rate and a cyclical upturn as a result of lower rates as added support for the currency and the economy. Political volatility appears to be broadly behind us as the GNU has taken shape, the cabinet has formed, and the business of government is getting underway.

Thematic View: The role of industrial production in economic activity

Industrial production has long been considered a barometer of economic activity globally. It measures the industrial output of an economy and is sometimes considered the “backbone of economic output”. Through the industrial production process, goods are developed for consumption, which indicates the absolute level of economic activity and thus the direction of economic growth in specific regions. For context, industrial production in South Africa would have been significantly impacted by energy security challenges in 2023 and would have been a primary reason for the country experiencing a low growth outcome. Because 2024 has seen lower levels of loadshedding, we would expect industrial production to pick up. It's worth noting that the loadshedding impact on industrial production was partly curbed by the importing of solar panels, the installation of alternative sources of energy and the use of diesel generators. The key point is that industrial output is a key component of understanding overall economic activity.

Over the last 25 years or so, manufacturing as a percentage of global GDP has declined (we use manufacturing as a proxy for industrial production in this analysis). This implies that manufacturing has become less important for global economic activity. The potential reasons are varied, but there have been significant increases in trade protectionism and different region-specific issues such as lower wage costs in emerging markets and potentially lower absolute transportation costs. This implies that the value of the manufacturing sector has declined over time, in a relative sense, and that the absolute levels of production have not, particularly in the light of a rising global population.

Chart 3: Manufacturing as a percentage of Global GDP

Out of  a select group emerging and developed economies in the world, over the last 20 years or so industrial production has become less important in China specifically (see chart 4 below) where industrial production previously made up above 30% of GDP in the early 2000s.

Chart 4: Industrial production as a percent of GDP across select countries

Australia, South Africa and India have followed a similar trajectory regarding the quantum of the change in the contribution of industrial production to GDP. However, the entire sample shows that all countries have declined, with only the euro area and Germany standing out as reducing to a lesser extent than the global average change over the period.

Chart 5: Changes in the contribution of industrial production to GDP across select countries

Looking at charts 6 and 7 below, two of the world’s largest economies (China and the US) have grown incrementally from manufacturing-based economies to become more services-based. The relevance of identifying which sectors the broader economy is exposed to is primarily to determine the key drivers or variables of economic activity across countries. It can be argued that services-based economies are more exposed to consumption expenditure and thus more sensitive to macroeconomic phenomena such as the value of the currency, elevated interest rates and high inflation, among others.

Chart 6: China GDP by economic sector

Source: Statistica, 30 July 2024

Chart 7: US GDP by economic sector

Source: Statistica, 25 July 2024

The services economy has similarly grown in traditionally oil-driven economies such as those in the Middle East, although it is worth mentioning that from a nominal GDP perspective, the contribution of services is affected by variables such as oil prices, which impact the nominal GDP contribution of the various sectors in the economy (i.e. higher oil prices typically lead to a greater nominal GDP contribution for the oil sector, which forms as the general industry sector).

Over the last few years, we have seen the industrial production index in the US stall, when compared with the pre-Global Financial Crisis (GFC) trend growth in industrial production. The chart below (Chart 8) illustrates how industrial production in the US has yet to return to pre-crisis levels.

Chart 8: US industrial production index

The relevance is in the link between year-on-year growth in industrial production and year-on-year nominal GDP growth in the US shown in chart 9 below. The slight uptick in industrial production of late should be a positive indicator for nominal GDP growth, however, real GDP growth is likely to be impacted by sticky headline inflation, which is currently hovering at around 3% in the US.

Chart 9: Industrial production and economic growth in the US

Industrial production in the US surprised materially to the upside in the most recent data and surprised to the upside for a second month in a row.

Chart 10: US industrial production versus consensus

Despite robust industrial production data, the S&P Global flash PMI for the US released last week suggests that US manufacturing output worsened in June and recorded its worst performance in seven months. The improvement in the flash composite PMI reading was largely thanks to the flash services PMI, which rose to a 28-month high. This ties in with our earlier point about US economic activity now being more sensitive to service-based output.

Chart 11: S&P Global flash PMI (US)

The significance of the manufacturing PMI data reading is that it is closely tied to earnings growth on the S&P 500. Weak manufacturing PMI data suggest that earnings growth should come under pressure. As mentioned above, industrial production and economic growth are closely correlated, which means that weak industrial production is typically associated with weak economic growth. This supports our view that earnings expectations may be elevated on the S&P 500.

Chart 12: Manufacturing PMIs and earnings growth

Capacity utilisation remains weak in the US although it is trending in the right direction. This is a measure of the relative usage of all available resources (i.e. factors of production). The long-term average is for around 80% of all resources in the US to typically be in use. The current level suggests some under-usage of resources, but not at the depressed levels typically associated with economic deterioration in the US.

Chart 13: US capacity utilisation

Capacity utilisation turned in June (chart 14 below), with the print surprising to the upside. Capacity utilisation has been consistently missing analyst expectations over the last 14 months.

Chart 14: Capacity utilisation trends since 2022

Conclusion: less important, but still important

Industrial production has become less important for global economic activity over time, as proxied by its relative contribution to global GDP. However, industrial production remains an important signal of economic activity given its link with nominal GDP growth. The US economy is typically positively correlated with global economic activity, and that suggests that when the US economy is increasing/declining, then that is typically the experience for the rest of the world. This is no surprise, given that the US economy makes up around 25% of the global economy.

Industrial production growth seems to have stalled in the post-GFC environment. Manufacturing output and industrial production have followed a similar path since 2019, which should be a negative signal for overall economic activity in the US.

Improving capacity utilisation suggests that the US economy is putting greater available resources into use, which should be good for overall economic activity going forward.

That said, there are various variables we remain concerned about regarding overall economic activity in the US:

• Restrictive monetary policy and its subsequent impact on consumption.
• A normalising labour market (excess labour demand continues to fall).
• Decreasing wage growth (and its impact on consumer disposal incomes).
• Falling inflation and its implications for revenue growth in the US (subdued corporate profitability).
• Slowly rising delinquencies.