Economic conditions will remain challenging for manufacturing firms over the next six to 12 months. Supply disruptions will continue to hinder outputs, but underlying demand for products should remain strong. As a result, activity in the sector should pick up sharply as supply shortages ease.
Supply shortages, surging materials prices and difficulty in hiring qualified staff have stalled the manufacturing sector’s recovery. Indeed, output in the sector hasn’t risen since April.
A shortage of raw materials is a problem across the industry, and the impact is most obvious in the automotive sector, where a lack of semiconductor chips has meant that output is still about 25% lower than it was in February 2020, before the pandemic.
Manufacturers starting to pass on costs
In addition, the manufacturing sector has been hit especially hard by the surging cost of raw materials. Producer input price inflation, which measures how much manufacturers are paying for inputs, has risen from just 1.8% y/y in January to 11.4% in September. It’s likely to continue rising over the next six months as higher energy prices continue to make themselves felt. This could bring input prices inflation worryingly close to the 20% increase in costs that, in our survey with Make UK, the majority of manufacturers said would have serious consequences for their businesses.
However, manufacturers have been able to pass on an increasing portion of these costs. Producer output price inflation, which measures the prices of goods leaving factory gates, has risen from 0.3% y/y in January to 6.4% in September. That suggests that the impact on manufacturing firms’ profitability probably isn’t as bad as the surge in costs implies.
What’s more, the manufacturing sector is ramping up investment in response to the shortages of labour and materials and the changing economy. Investment grew by 8% q/q in Q2 and was 1% higher than before the pandemic. Stronger investment should feed through into higher productivity, which, in turn, should result in more competitiveness and profitability. It is particularly encouraging to see investment above pre-pandemic levels given the cashflow issues being felt by many across the sector.
Global supply chains are likely to be snarled for another year yet – but there are some encouraging signs. The volume of shipping containers traveling from Asia to America and Europe is already either back to pre-pandemic levels or above them, and the prices for many industrial commodities seem to have peaked and are starting to fall back. The initial disruptions from Brexit also seem to have eased, with the proportion of firms saying they are experiencing disruption at UK borders falling to just 10% in October from 35% in January.
The best news, though, is that demand across the UK and wider global economy is strong and will remain so. Admittedly, growth will slow over the winter as consumers grapple with higher energy bills and firms are held back by continuing supply shortages. Once these issues have passed the stage is set for a period of strong growth. The priority for many manufacturing businesses will be to ensure they are ready to make the most of more favourable market conditions when they arrive.
Interest rates will rise, but not by much
Many manufacturing firms have accumulated significant amounts of debt during the pandemic and are concerned about the impact of interest rises on their ability to service that debt and to borrow to invest. Indeed, the Bank of England has strongly hinted that interest rates will rise in the next few months and financial markets are expecting interest rates to rise from 0.1% to 1.0% by the end of 2022.
However, we think interest rates are unlikely to get much above 0.5% next year. This is because inflation is likely to fall back rapidly to 2.0% in the second half of 2022, reducing the need to tighten monetary policy. What’s more, once interest rates reach 0.5% the Bank of England will start shrinking its balance sheet. It will want to be sure of the impact of lower liquidity on the market before it raises rates further.
There are two key points here. The first is that once interest rates do start to rise, they will only do so gradually, and they will remain very low by historical standards. Secondly, and more importantly, real interest rates, which take inflation into account, will remain negative for a long time yet. This will create fertile conditions for manufacturing firms to invest in the productivity-enhancing technology needed to survive and thrive in the ultra-competitive post-pandemic economy.