China’s had its day and manufacturing is coming home

Trenton Makes The World Takes.' Coined in 1910 and later spelled out in nine-foot-high letters on New Jersey's Trenton Bridge, the slogan wasn't just an expression of America's confidence it was a statement of fact.

Yet by the end of the 20th century, with the neighbouring factories long closed, it was practically a museum piece, a poignant reminder of America's manufacturing decline. In both America and Britain, manufacturing fell as a share of GDP from the early 1970s onwards. Indeed, production figures from 2011 show that China has officially replaced America as the workshop of the world'.

Yet the decline is not unstoppable. The financial crisis has caused a shift in global trade patterns and both countries are now on the brink of a manufacturing renaissance that will see factories reopening in the West. Britain and America won't start making everything again, but investors in some industries will do very well out of this comeback.

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The allure of the China price'

So what drove the decline? As the British and American economies matured, they were always going to shed manufacturing jobs. As societies get richer, past a certain point, they start to spend more on services than on manufactured goods.

Yet manufacturing declined far more quickly in Britain and America than in other Western economies. The fall was most pronounced in Britain, where manufacturing's share of GDP fell from 30% in the early 1970s to 11% in 2009. In America it went from 22% to 12% over the same period. In countries such as France and Germany, it also declined, but by a much smaller proportion.

Another, well-documented, reason was the increase in competition from Asia. "China's economic miracle began in 1978, when the Communist party launched market-oriented reforms granting farmers limited property rights and permission to sell anything they produced in excess of state quotas," says Jamil Anderlini in the Financial Times. "This led to soaring agricultural productivity and rural incomes. It was followed by reforms encouraging mass migration, industrialisation and investment in a manufacturing sector that became known as the workshop for the world."

Soon, "the unbeatable China price'" was drawing in investors and buyers from across the globe. It was "predicated on an endless supply of cheap, pliant labour; virtually free land; cheap and easy credit from state-owned banks; and heavily suppressed costs for inputs, such as power and water".

Outsourcing and the domino effect

But British and American manufacturers can't blame their decline solely on vicious competition from Chinese firms. They themselves contributed to the trend by outsourcing. As more and more of the global supply chain moved to China, a domino effect kicked in, says The Economist. "After some level of Asian development and integration, it became more attractive for manufacturers to locate there", so that eventually, locating a plant in America didn't make much economic sense: it was just "too distant from Asia".

By 20022003, about a quarter to half of the manufacturing firms in Western Europe were involved in offshore production. By 2008, more than 50% of American companies had a corporate offshoring strategy.

As a former Apple executive explained to The New York Times: "The entire supply chain is in China now. You need a thousand rubber gaskets? That's the factory next door. You need a million screws? That factory is a block away. You need that screw made a little bit different? It will take three hours."

For their part the British and American governments did little to prevent outsourcing. They paid lip service to local industry, but the loss of manufacturing jobs in the 1980s, 1990s and 2000s was compensated for by a boom in service industries. It was seen as more of a political issue than an economic challenge. Indeed, in 2003, George W Bush's administration's solution to the problem was to suggest that fast-food jobs be counted as manufacturing roles in the official statistics.

A return to things'

But the financial crisis changed everything. Services, especially financial ones, became a toxic industry as politicians fell over themselves to champion the virtues of making real things'. The collapse in the financial sector meant that politicians began to look to manufacturing to lead the recovery from recession. Widening trade deficits also made making things attractive. As a result, Britain and America have introduced a slew of manufacturing-friendly policies.

And it's not just the politicians. There are signs that Western manufacturing firms are growing tired of the outsourcing experiment and moving factories and equipment back home. Why? Because, for many firms, moving to China hasn't been all it was cracked up to be.

Intellectual property has been a big issue. Western firms, such as high-speed train maker Siemens, were only allowed to bid for local contracts on the condition that they worked in a technology transfer' with local partners. This allowed Chinese train makers to develop far faster than had been imagined possible, and they're now competing with their former teachers for contracts around the world.

Foreign firms also claim they are unfairly targeted by local authorities. In a rare outburst last year, General Electric boss, Jeffrey Immelt, complained about Beijing's treatment of foreign business. "I am not sure that in the end they want any of us to win or any of us to be successful." Foreign firms have also become focal points for industrial unrest and tend to be more affected by strike action than their domestic rivals.

Like all trends, there's evidence that offshoring became something of a fad, says Yves Smith of the Naked Capitalism blog. "I've had some executives in different lines of business tell me their company decided to outsource/offshore despite the fact that the business case was not compelling."

John Kent, founder of UK-based electronic key company, Traka, told MoneyWeek that after careful consideration he had decided not to manufacture in China. "I would lose control of my products. If there was a problem with quality it would be difficult for me to sort it out trusting someone on the other side of the world requires a big leap of faith."

This anecdotal evidence is backed up by a General Electric survey, which found that British manufacturers are increasing their purchases of locally made supplies. They have also been given an extra boost by the weakness of the pound in the years following the financial crisis.

The rise of reshoring'

Even service industries are coming back. Last year a spate of high-profile firms, including Santander, Accenture and United Utilities, relocated call centres from emerging markets to Britain. The move was down to emerging-market wage inflation, combined with improved staff retention rates in Britain as a result of high unemployment.

That leads us to the main reason for the reshoring' trend: money. China is becoming less competitive as its industrial policy becomes a victim of its own success. Land and labour costs are rising, undermining its ability to offer the China price'. Wages are rising at a rate of 17% a year often much more for skilled workers. Staff turnover is also high as workers keep moving to better opportunities. That's great for workers, but it drives up costs.

Rising expectations when it comes to living standards have also resulted in more stringent environmental and planning rules. Pollution is a hot political issue and caused China's largest protests both online and physical last year. The cost of land in prime industrial areas has also shot up. Incredibly, it's now more expensive to rent an office in Beijing than in New York (despite growing signs of a property slump in China).

So, on the one hand, the gap between US and Chinese wages is narrowing, say business analysts the Boston Consulting Group. Yet on the other hand, "flexible work rules and a host of government incentives are making many [US] states including Mississippi, South Carolina, and Alabama increasingly competitive as low-cost bases for supplying the US market". Increasingly, unions are prepared to cut deals that will bring back work to America, while high unemployment means there is a large pool of skilled and unskilled workers.

"After adjustments are made to account for American workers' relatively higher productivity, wage rates in Chinese cities such as Shanghai and Tianjin are expected to be about only 30% cheaper than rates in low-cost US states," says Boston Consulting.

Since wage rates only account for a chunk of a product's total cost, that means manufacturing in China will be only 10% to 15% cheaper than in America. That's before you add in inventory and shipping costs. "After those, the total cost advantage will drop to single digits or be erased entirely."

A boon from nervous consumers

Bizarrely, the hit to consumer confidence on both sides of the Atlantic has also helped Western manufacturers. The slump in demand during the financial crisis left many retailers with huge inventories, which were impossible to shift. Many retailers went bust under the weight of debt and mountains of unsold goods. Those who survived are now much more cautious about placing large orders.

Instead, they want to keep inventories small and flexible to changes in demand. That means they need local suppliers who can react more quickly and get goods into the shops fast. A study by two US-based Chinese economists, Xiaole Wu and Fuqiang Zhang, found that onshore suppliers performed better in recessions.

Of course, not everything can be made in Britain or America. Both countries have leant so heavily on international supply chains that some industries will never return. Labour-intensive goods produced in high volumes, such as clothes and electronic goods, will still be made in low-cost centres overseas.

However, for products that require less labour and are turned out in more modest volumes such as household appliances, machinery, furniture and construction equipment it often makes more sense to produce close to the market. This also gives firms the chance to position themselves as good patriots in the eyes of customers.

As a result, several multinationals are now moving their products back home. ATM maker NCR Corporation, toy manufacturer Wham-O and General Electric have all brought production back to the US from China. Others, such as Caterpillar and Ford have also chosen to build new factories in America rather than elsewhere.

It's a trend that has even been acknowledged by China's Ministry of Commerce. American investment in China fell by 18.13% year-on-year between January and October 2011, which Ministry spokesman Shen Danyang blamed on reshoring'.

Since late 2009, manufacturing output in Britain and America has boomed, proving to be the bright spots in otherwise fragile recoveries. American manufacturing has grown for ten quarters in a row, while the latest figures for January showed that output from Britain's factories is also on the up. We look at some of the best ways to profit below.

Manufacturing plays to tuck away

One likely beneficiary from the uptick in American and British manufacturing is US industrial conglomerate Emerson Electric Co (NYSE: EMR). The $40bn firm makes just about everything that manufacturers need to increase production.

It also offers consulting and bespoke services as part of a solutions' package. Its process management division, which accounts for almost 30% of sales, makes measuring devices and controls for power stations and petrochemical firms. Both these sectors are currently reinvesting in new technology to meet new demand from increased American manufacturing.

In a recent 300-page report on Emerson, JP Morgan analyst Stephen Tusa points out that the firm is "the undeniable industry leader" in these markets. "Indeed, the major sectors for this business, tied to capital spending in areas such as oil and gas, refining, chemicals and power continue to grow."

Industrial automation is the next biggest segment, accounting for 20% of sales. This business supplies factories with everything from specialised ball bearings to complex automated systems, and sales are growing as industrial demand picks up.

Almost equal in size is the network power division. This sells gadgets that support manufacturer's telecoms and internet infrastructure. On a forward p/e of 13, Emerson looks well-placed to profit from the Western manufacturing comeback.

At the other end of the industrial scale is £120m market cap Castings (Aim: CGS), which makes metal castings that are machined into components such as steering knuckles for trucks, tractors and cars. About 60% of its sales come from exports to firms such as Scania and BMW.

But UK car manufacturing grew by 5.8% last year, despite disruptions to supply chains caused by the Japanese earthquake. Carmakers have made significant investments in UK production facilities and analysts expect total output to increase to 1.4 million cars from 1.3 million in 2011. That means Castings should benefit from a pick up in its British business.

It's a "financial fortress", says Richard Beddard in Interactive Investor, it stayed "profitable through the recession and emerged stronger". Offering a prospective yield of 3.8% and trading on a p/e of 9.8, it looks decent value.

A more prominent British manufacturing success story is engineering conglomerate Melrose (Aim: MRO).

It makes generators, heavy lifting equipment and industrial components. More than half of its sales comes from North America and Britain. The firm has grown rapidly by buying underperforming rivals, improving results and then selling them on.

Last year it sold component manufacturer Dynacast for £360m, and gave the proceeds to shareholders as a 70p per share payout. Despite a strong recovery since 2009, the stock remains attractive on a prospective yield of 3.69% and a forward p/e of 11.

If you don't fancy taking a punt on any particular company and want to invest in the sector as a whole, then we'd recommend Vanguard Industrials ETF (US: VIS). The US fund tracks the performance of the MSCI US Investable Market Industrials Index. The index covers pretty much every type and size of listed US firm involved in providing industrial goods or services.