Wait, so what’s happening in the manufacturing sector?
What manufacturers should do to get the house in order in 2020
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CanadianManufacturing.com recently spoke with Craig Alexander, chief economist at Deloitte Canada, to find out how manufacturers can build resiliency in 2020.
Alexander has served as chief economist at TD Bank Financial Group, vice president Economic Analysis at C.D. Howe Institute and as senior vice-president and chief economist at The Conference Board of Canada, was indefatigable.
During our conversation, which has been edited for length and clarity, we discussed the impact of protectionism, what it will take to bolster business strategies, why manufacturers should double down, and why Canadian businesses are weak at commercialization.
Where are we now and what’s going to happen in the manufacturing sector in 2020?
Craig Alexander: If we think about 2019, as we finish off this year and head into next year, the Canadian manufacturing sector is heavily influenced by what is happening globally. The dominant economic story is that the global economy has experienced quite a pronounced slowdown. Global growth has gone from 4% to around 3%. We’ve lost about a quarter of the rate of overall economic growth, and the source of the slowdown has actually been in global manufacturing.
If you look at indicators such as the Purchasing Manager’s Index – some of the most high-frequency manufacturing data we get – Asia and Europe have been experiencing a contraction in manufacturing activity since last spring. And over the last quarter, U.S. manufacturing has also started to decline. If we look at the Canadian performance, what we can see is that Canadian manufacturing has been weakening as well.
But, if anything, in 2019 it didn’t weaken as much as you’d expect given the economic climate. In fact, earlier on in the year – January through May – Canadian manufacturers were doing okay. And it’s only since May that we’ve actually seen manufacturing conditions really soften. I do find it interesting that manufacturing in Canada has continued to host pretty solid job gains. By the time we got to August, Canadian manufacturing wasn’t growing but employment was still rising. And I think this reflects the fact that while economic conditions have weakened, a lot of Canadian markets are actually quite tight. Look at Quebec, for example. When I talk to businesses in Quebec, all they want to talk about is labour shortages. In Ontario and B.C., labour markets are very tight. In Alberta the story is different because the Alberta economy has struggled, so there’s more slack in the labour market. Overall the Canadian manufacturing growth has slowed. Employment remains solid, but varies regionally.
When we look at 2020, I think that the dominant economic story is going to be that we continue to have a soft pace of global economic growth and I think we’re going to see a bit more weakness in the Canadian manufacturing system. In other words, while we were resilient in 2019, I think through global supply chains we will see a bit more weakness in the Canadian manufacturing system. And it’s going to reflect that the U.S. economy, which is our biggest market, is going to grow at a slower pace, and is going to reflect the fallout of the global trade wars that have really disrupted global manufacturing.
How will protectionism impact Canada?
CA: To understand how protectionism is having an impact: We don’t have U.S. tariffs on Canadian products or Chinese tariffs on Canadian products. But when the U.S. and China have a trade war… what happens when the U.S. applies a tariff on a Chinese factory and you weaken the growth of that Chinese factory, then it supplies less equipment for Japan and that Japanese company buys less parts from Germany. And through global supply chains you quickly weaken global economic growth. So, as China applies tariffs on U.S. products, and it impacts U.S. manufacturing, then its Canadian manufacturers that supply parts to U.S. companies that are getting indirectly impacted by the trade war.
I don’t think we’re going to see a recession in North America, but I do think we’re going to see softer economic growth. And I think it’s going to create lingering weakness in the manufacturing system.
What should manufacturers be looking at as they try to bolster trade?
CA: There’s a number of things that businesses need to think about. The first thing they need to think about is how they’re impacted by economic conditions, and think about scenarios.
Throughout 2019 we often had talks about recessions. Markets at different points in time were pricing a recession. And businesses need to think about if there was a recession, how would they respond? Because it’s not easier to plan what your game plan would be to a change in economic conditions outside of a crisis than during one. Equally, the risks would diminish and we can actually see an improvement in manufacturing in Canada.
And are businesses poised to take advantage of those opportunities? One of the things we can see in the data is that businesses are being very defensive. They’re not investing in new machinery and equipment. They’re actually delaying investments because of the risks in the economy. You can’t let the risks paralyze you – you still need to make investments.
And so one of the very great sources of disappointment has been very weak business investment. If you look at how businesses responded to the last business cycle, during the last downturn, one of the leading responses after cutting expenses was to make investments in new technology. So, we need businesses to think about how to become more competitive through capital deepening. And understand labour markets are going to remain tight. With aging population – labour leaving the workforce – the manufacturing system in Canada is going to have to become more capital intensive than it already is. And when it comes to new technologies, it’s about increasing the amount of machinery and equipment per worker. But it’s also about buying advanced technology and taking advantage of things like digital. Using AI, using big data analytics to help improve your business model or your strategic thinking.
The common response from SMEs is: “Technology is expensive. We’re a small business, we can’t afford it.” This is a challenge for them.
CA: I know. I’m very sympathetic to the challenge that businesses have – that investment in technology comes with a big price tag. And while the weak Canadian dollar is actually improving our competitiveness. In point of fact, an awful lot of equipment that manufacturers buy is actually priced in U.S. dollars. It’s not just the fact that the price tag is high, it’s often the fact that the weak Canadian dollar is making it more expensive. And I expect the Canadian dollar to remain close to current levels. I think it’s going to average around 76 cents. I think it’s going to move a cent or two higher or a cent or two lower, but it’s going to average around 76 cents. Businesses are going to have to cope with that.
One thing that does make it more attractive to invest in machinery and equipment is that the federal government did increase the allowance of writing off more depreciation of equipment that’s bought. That was actually how they responded to the U.S. tax cuts. The federal government allowed for an acceleration on new equipment bought, and that actually reduces the cost. So there is a government initiative to try and help encourage businesses to invest in more equipment and technology.
The other thing to keep in mind is that the world is changing rapidly. If Canadian manufacturers don’t invest in latest technology and their competitors do, those Canadian companies are going to run into a lot of difficulty. It’s harsh words, but it’s the reality. We’re living in a hyper-competitive global marketplace and Canadian investment in machinery and equipment has been incredibly weak over the past 10 years.
I was just looking at a chart; the value of machinery and equipment per worker in Canada has been on a declining path ever since 2007. In 2007 we used about $6,000 worth of equipment per worker. And in 2019, we’re using $4,700 of equipment per worker. Now this is during a technological revolution, right? This is during a period when we’re having a tech boom. And, if anything, we should be seeing rising equipment per worker. But in point of fact, since 2007 we’ve seen it steadily decline.
Why is this happening? Can you elaborate on that?
CA: The level of business in machinery and equipment has been flat for many years. In fact, in 2015 to 2016 the rate of investment was below the rate of depreciation. The capital stock in countries is actually getting smaller. So how could this be the case? I think the reality is in recent years there’s been a lot of concerns about the economic prospects. We’ve been in a world where three years ago Trump was elected and he promised to rip up NAFTA. The U.S. is our major export market for manufacturing goods. So, if I’m a company and being told that NAFTA could be ripped up, am I going to make large-scale investments until I know what the trade arrangement is? The answer is, yeah, I’m probably going to wait. So, I think the renegotiation of NAFTA delayed business investment for a lot of U.S.-leveraged companies.
Then we had the trade war with China. And the news has been filled with negative economic stories, chatter and talk about recession. We’ve had an environment where many businesses delayed investments because they want to see what’s going to happen before they make investments.
I think a lot of what’s been happening is that companies have made profits. And I’m not really talking about small- or medium-size businesses. I’m actually talking about large businesses – large corporations that have been seeing their profits rise – that haven’t been investing at a strong pace. And more of the profits have been going into dividends and into share buy-backs. So, they haven’t been using the money productively to make investments; they’ve been giving it back to shareholders. And that’s good for pension funds and shareholders, but from an economic point of view, we’re under-investing.
Then, I also think there’s an issue that it did become more expensive to buy equipment due to the Canadian dollar. If we go back a few years, it was up near 82 – 83 cents, then it fell to 76 cents. And that made it more expensive to buy equipment. There’s been a lot of factors weighing on business psychology. Business confidence has not been strong and as a consequence business investment has been weaker.
And where we have seen business investment has been in places like Quebec where labour shortages became acute. We have seen a pickup in investment in equipment and machinery in Quebec. But nationally we haven’t seen it.
This has been a major source of disappointment from the point of view of the Bank of Canada. Governor Poloz refers at one point to business investment as being a “serial disappointment.” This is one of the serious challenges. We really need businesses to overcome their risk aversion.
Think about it this way: Last December we had the worst correction in the equity market ever in a December. We had the worst performance in December for equities in 2018. And the reason for this is that last year we were convinced that we were going to have a recession. Okay, so what actually happened? The global economy slowed down but it didn’t have a recession, and the stock market in 2019 is up. Depending on which index you’re looking at, it’s up 19% to 24%. So, if you basically said, “I’m worried about a recession,” and you didn’t make investments in the equity market, you actually missed a stunningly good year for stocks. Similarly, if businesses became so defensive about the risk of a recession, they stopped making important investments. A year later, their fears didn’t come true, but that means they’ve under-invested.
You’ve commented that Canada isn’t doing enough investment in R&D? Are we not doing enough to support industry through investment from the government level, for example, through superclusters?
CA: The government investment in superclusters is basically the government trying to identify where Canada’s greatest comparative advantage is. Which industries do we think Canada has an edge on? So, they’re trying to foster an environment that allows those sectors to perform better. And there’s a lot of economic analysis that highlights the strength of a cluster approach. But having said that, Canada still does very little research and development relative to our international peers – even when you adjust for the size of the economy. And we don’t produce as many patents as other countries. And so, the government initiatives around superclusters isn’t really about R&D and patents as much as it is about reducing regulatory burdens for those sectors to help facilitate their growth, or helping to attract capital. It’s an industrial growth strategy that the government is running. But if you just think about innovation, it comes from things like R&D, it comes from things like patents. Canada is weak on those things. It would be okay if Canada was good at R&D and patents, and if we were good at taking what other countries innovate and are exceptionally good at those new advances. But we’re not very good at commercialization.
And I actually think [commercialization] is the bigger one. America does a lot of R&D-related work and there are a lot of patents created in the U.S. But if Canada was good at commercializing new opportunities that’s coming out of research and development and technologies, if we were good at commercializing those opportunities, our economy would perform dramatically better. We’re actually weak at commercialization.
One of the reasons we’re weak on innovation is that in America the bulk of R&D-type work is done by businesses. A U.S. business says, “Wouldn’t it be great if we had a product that does this?” And then they go out and do the research to see if they can create that product. In Canada, the bulk of our R&D is actually done by universities… If R&D is done on a commercial basis by a company, you’re very quickly going to turn it into new products and services. Whereas, if your innovation is being created by your universities, it’s going to take a lot longer to then figure out what the business application is and then take advantage of the opportunity. So Canada is weak on commercialization.
How do we turn this around? How do we get to the point where we can commercialize faster?
CA: There are a variety of different approaches you can take. But I think there’s a very strong case that we actually need more companies to be engaged with universities when they’re doing R&D-type work. And there are examples of this. There’s been some awareness of this issue for some time. I think you can find more examples of where you have research centres that are being run by universities partnered with companies or have company engagement.