We are expecting a major inventory cycle in worldwide manufacturing over the next two years, hitting already fragile manufacturing sectors in global economies. Even in normal times, the shape of the current economic cycle would lead to a knock-on inventory cycle, but high interest rates will amplify its shape in 2024 and 2025. This will affect different economies according to their exposure to the sector.

One of the more remarkable features of the global economy since the pandemic is that we have seen a high degree of synchronous developments and trends. From the demand shocks during lockdowns to the inflationary surge in 2021/2022 and now the impacts of tighter monetary policy, developed economies have experienced commonalities more prominently than individual factors.

Currently, all major economies are grappling with lacklustre growth and many are teetering at the edge of recession. However, a closer look reveals that there is a clear sectoral split in terms of economic performance, providing another common theme. Across developed economies, it is the manufacturing sector that is seeing a pronounced slowdown. For example, the G7 nations have all reported manufacturing PMIs in contractionary territory for several months now.

What are the reasons for this synchronous slowdown in manufacturing activity?

The first reason relates to the aftermath of the pandemic. During lockdown, consumers shifted their spending towards goods as expenditure on socialising and travelling was heavily curtailed. Over the past year, behaviour pivoted again as consumers prioritised spending on going out, holidays, and other services that they missed out on during the pandemic period.

Secondly, manufacturers around the globe had high hopes for a consumption boom driven by China’s reopening after Covid restrictions were lifted at the beginning of this year. However, as the latest data have confirmed, the boost from re-opening has disappeared quickly and Chinese policy makers have been forced to assess further stimulus programmes to lift growth.

Lastly, manufacturers are also exposed to the effects of the dramatic monetary policy tightening seen over the past 18 months. Durable goods such as cars and appliances are frequently bought on credit, which means that higher borrowing costs will have a dampening effect on demand.

A prolonged downturn in global manufacturing sectors will invariably have an impact on the global economy as a whole. While the share of manufacturing in overall GDP has been falling steadily across developed economies over the past two decades, the sector still acts as a bellwether for the health of economies. For now, the slump has not led to large scale lay-offs with labour markets only very slowly starting to show some signs of loosening across the Eurozone and in the UK. However, an extended lack of demand will eventually lead to a pick-up in insolvencies and job losses. In Germany, where the share of manufacturing still stands at around 18% of GDP compared to 11% in the US and 8% in the UK, the economy contracted in both Q4 2022 and Q1 2023, entering a technical recession.

Looking ahead, there is likely more pain to come as the inventory cycle turns and global destocking leads to a further slowdown in manufacturing activity. In the UK, we forecast rolling four-quarterly inventories as a share of GDP to bottom in Q1 2024, at -1.0%, down from +1.6% two years earlier, providing a considerable drag on growth.

Our view is that the performance of developed economies will start to diverge again more clearly in 2024. In particular, the recession risk in the UK and Eurozone seems more acute compared to the US, which posted a surprisingly strong Q2 GDP growth rate this week – quarterly growth accelerated to an annualised 2.4% up from 2.0% in Q1. The fact that growth was driven by non-residential fixed investment, which includes investment on structures, equipment and software, further confirms our view from earlier in the month that the US is better placed to achieve a ‘soft landing’ and bring inflation down without falling into recession compared to its European counterparts. This is further aided by the significant impacts of the Biden administration’s Inflation Reduction Act, which has led to a boom in factory construction all over the country. With firms expanding their US activities to benefit from generous tax cuts and subsidies, this bodes well for the recovery of the battered manufacturing sector.

Kay Daniel Neufeld is Director and Head of Forecasting and Thought Leadership at Cebr