Industrial America is Resurgent and What That Means for Asian Businesses

While many in the investment community have been focused on generative AI in recent months, the chart below showing manufacturing capex in the United States caught my attention. The chart shows that industrial America is resurgent and forms the clearest evidence I have seen yet on the reshoring of supply chains. The spending is primarily driven by announced investments in semiconductor fabs ($206bn), battery factories ($53bn), auto/EV plants ($33bn) and clean energy ($14bn). The increase in manufacturing capex is corroborated by the increase in U.S. manufacturing jobs. The data carries deep ramifications for businesses globally, especially for those in Asia, given Asia accounts for 54% of the world’s manufacturing output.

Historically, China and the rest of East Asia have been the powerhouse of global manufacturing (see chart below, source: World Bank). Total global manufacturing output was $16 trillion in 2021, of which, China was $4.9 trillion (c. 30%), U.S. was $2.5 trillion (c. 16%), Japan & Korea were $1.5 trillion (c. 9%) and Germany was $800bn (c. 5%). In terms of regions, Asia accounted for 54% of the world’s manufacturing output, followed by Europe at 22% and North America at 18%. However, the resurgence of manufacturing capex in the United States may upend the status quo of Asian dominance in manufacturing.

So what’s driving the resurgence of industrial America?

I believe there are four key factors:

COVID-19 pandemic laid bare the fragility of modern supply chains: The pandemic created a situation of excess demand and constrained supply due to disruptions in supply chain (see chart below). The companies which did well during the pandemic were those which had diversified supplier bases, had digitised their supply chain operations and could be nimble in moving production between geographies in response to changing pandemic situations on the ground. In the aftermath of COVID-19, companies have learnt that they don’t just need to solve for the cheapest cost of production but also manage supply chain risk.

U.S. and China geopolitical tensions: Many multinational corporations watched their decades-long investments in Russia marked down to zero in the aftermath of the Ukraine war. While U.S. — China geopolitical tensions and resulting contingency planning started in earnest following the election of Trump as President, the Russia-Ukraine war resulted in a new sense of urgency as executives watched China and U.S. exchange vitriolic rhetoric over Taiwan. This has further prompted companies to reduce their dependence on China in serving global markets such as the U.S. For example, Apple currently supplies over 90% of iPhones from China and media reports have mentioned that it is reportedly planning to produce 25% of iPhones in India by 2025, up from 7% today (which is already up 3x yoy).

U.S. incentives, in particular, CHIPS Act and Inflation Reduction Act: Responding to pandemic-exposed supply chain vulnerabilities and geopolitical considerations, the U.S. has unleashed a range of incentives to bring high value-added manufacturing back to the United States. The CHIPS & Science Act of 2022 provides $53bn of funding to bolster U.S. semiconductor capacity and catalyse R&D. The Inflation Reduction Act of 2022 provides clean energy production incentives with a total value of over $400bn. The U.S. government resolve is best expressed by the White House statement below:

“For the longer term, the Administration proposes a variety of actions to strengthen our industrial base, increasing resilience and reducing lead times to respond to crises. It vows to reverse long-time policies that have prioritised low costs over security, sustainability and resilience. Because these policies ignored the costs of being unprepared for risk, the United States has ended up with brittle supply chains that are, adjusted for the costs associated with this risk, also quite expensive. The Administration proposes to reverse this damage by investing in research, production, workers, and communities that will rebuild sustainable manufacturing capacity across the country…Because it does not make sense to produce everything at home, and because U.S. security also depends on the security of our allies, the United States must work with its international partners on collective approaches to supply chain resilience, rather than being dependent on geopolitical competitors for key products”

The White House, July 2021

Industrial automation makes manufacturing in developed economies more competitive: Lastly, the higher costs in developed economies is often cited as the leading cause for offshoring production. However, higher labour cost in China and increasing automation in production processes makes the cost arbitrage less appealing. China had a massive boom in industrial automation in the preceding decade and currently has higher robot density than the U.S. on a per capita basis (see chart below), a surprising outcome given the U.S. GDP per capita is 5x more than China’s. Recent robot shipment trends indicate that U.S. manufacturers are catching-up and the country is seeing a new boom in industrial automation (see FANUC’s earning call snapshot below).

One of the key questions that emerges from the above discussion is whether the resurgence in industrial America is at the expense of China?

My view is that yes, China will see a lower share of global manufacturing capex and slower manufacturing output growth than it has seen historically. However, it is important to note that companies are not abandoning their factories in China, rather, the incremental capacity to serve overseas markets is going to other destinations such as the U.S., Southeast Asia and India. China will remain an important and growing manufacturing hub driven by:

1. A large and skilled manufacturing labour force available at competitive cost
2. A strong and improving logistics infrastructure as expressed by World Bank’s Logistics Performance Index (see chart below)
3. A large domestic and regional consumption market that would continue to be served out of China — Morgan Stanley estimates c. 77% of China manufacturing serves the domestic Chinese market

So how should we expect global supply chains to evolve?

I hypothesize that in the following decade, we’ll see the secular trend of companies modifying their current supply chains in the following manner depending on their industry:

• Companies in industries that benefit from government incentives and have sufficient demand in a region will endeavour to “near-shore” their supply chains by moving production sites closer to end-consumption. This strategy is best illustrated by Tesla which benefits from U.S. and EU incentives for battery and EV production, and has sufficient regional demand for its cars to have economies of scale in local production. As a result, Tesla has constructed giga-factories in the U.S., Germany and China to meet domestic demand, and is planning future capacity in Mexico and potentially India. Foxconn, a Tier-1 supplier to Apple also falls in this category:

Looking at 2023 capex, while already factoring in normal maintenance and automation spending, China will still account for the largest proportion of the total. This is capex in terms of new business expansion needs. Expansion will also be needed in Vietnam, India, the United States and Mexico in response to customers and supply chain adjustments. In terms of revenue, the current ratio between China and overseas regions is about 7-to-3. Going forward, the proportion of overseas regions will continue to increase. This strengthens supply chain resiliency…The build, operate, localize model being deployed in overseas regions will result in regional-specific development of products.

Young Liu, Chairman & CEO of Foxconn

• Companies in industries that do not have the scale (niche manufacturers), economics (Tier 2/3 suppliers to OEMs) or production process flexibility (specialized manufacturers such as ASML) may move to a “China + 1” strategy or “friend-shoring” strategy where they will have an alternative to China with a substantial minority production capacity to have a hedge against the geopolitical risk.
• Lastly, companies producing low value-add consumer goods such as furniture, footwear, apparel and luggage are already moving from China to cheaper destinations such as Vietnam and India, and setting up export facilities in those countries (see chart below).

Next question I’d like to delve on is the implications for Asian companies given the forthcoming upheaval in supply chains. Below I lay out the beneficiaries and the losers:

Japanese factory automation companies (Beneficiaries)

Several Japanese and global factory automation companies have been facing a highly competitive environment in China. Buffeted by the Chinese government’s Made in China 2025 targets, Zhuan Jing Te Xin subsidies and the import substitution drive, many local industrial players have been gaining market share in China at the expense of foreign players (see chart below). The market share of the foreign players in China is materially different from that outside China. For example, FANUC (TSE:6954), a Japanese industrial robots manufacturer, has almost 50% market share in industrial robots in the U.S. but only 21% in China. Similarly, Universal Robots (subsidiary of Teradyne, NASDAQ:TER), a manufacturer of collaborative robots, has 48% global market share but only 32% market share in China due to stiff competition from local players such as Aubo (unlisted), Siasun (SHE:300024) and JAKA (unlisted). Increasing manufacturing capex outside of China will allow foreign manufacturers to gain incremental share more easily than they would have in China. Players such as FANUC (TSE:6954), Nabtesco (TSE:6268), Yaskawa (TSE:6506), Harmonic Drive (TSE:6324), Omron (TSE:6645) and others should benefit.

Semiconductor OEMs (Neutral to Marginally Negative)

Taiwan Semiconductor Manufacturing (“TSMC”, TPE:2330) has 59% market share in the chip foundry market and over 90% of its production still happens in the geopolitically sensitive area of Taiwan. Driven by pressure from its U.S. fabless customers as well as CHIPS Act incentives, TSMC has planned a $40bn chip plant investment in Arizona, U.S. that will commence production in 2024 using 5nm technology. In moving part of its capacity to the U.S., TSMC loses the ecosystem benefits of manufacturing semiconductors in Taiwan and substantial execution risk is introduced in its operations. Also, the production in the U.S. will be at a higher cost than that in Taiwan — for example, building a chip facility in the U.S. is estimated to be at least 2.5–3.0x more expensive than constructing one in Taiwan. Nonetheless, CHIPS Act incentives will lower the effective cost of production in the U.S. and TSMC retains strong pricing power to manage its gross margins. Other semiconductor OEMs such as Tokyo Electron (TSE:8035) and ASML (NASDAQ:ASML), with production facilities in Japan and Netherlands respectively, will likely not need to re-shore production given the political alignment of those countries with the U.S. However, they may have potential negative revenue impacts as both Japan and Netherlands are sympathetic to U.S. demands of reducing/banning exports of advanced semiconductor technology to China, a key consumer.

Greater Chinese suppliers to OEMs (Losers)

The Tier-1, 2 and 3 suppliers to OEMs in China stand to lose from reshoring of supply chains towards the U.S., Southeast Asia and India. These suppliers are often commoditized, work on razor-thin margins and have low pricing power — there is a risk that many may get replaced by domestic suppliers in those countries or be forced to invest in new capacity in those countries in order to keep market share — neither of which are preferable options. For example, Apple Inc.’s suppliers, Foxconn (TPE:2317), Wistron (TPE:3231), Pegatron (TPE:4938) and Luxshare (SHE:002475) have all announced plans to invest in new capacity in India totaling over $900m in commitments. The higher capital costs along with investments in developing a manufacturing ecosystem in India will potentially squeeze returns on invested capital for these players.

Southeast Asian and India suppliers to OEMs (Beneficiaries)

As a corollary to #3 above, domestic suppliers in Southeast Asia and India will benefit. Not all Greater China Tier-2 and 3 suppliers will be able to set-up domestic manufacturing units in these countries, benefiting local suppliers who could potentially have better pricing due to government incentives, such as the Production-linked Incentive (“PLI”) scheme in India that provides tax and other incentives for domestic manufacturing and totals to US$33bn across fourteen sectors. For example, Indian manufacturers, Dixon Technologies (NSE:DIXON) and Optiemus (NSE:OPTIEMUS) are working with Xiaomi to produce smartphones and wireless audio products in India respectively. I expect India to see a manufacturing boom coming off a low base as India shakes off its historical underperformance in good exports (see chart below) driven by supply chain reshoring tailwinds, government incentives, supply side reforms and infrastructure investments.

Chinese factory automation companies (Neutral)

Given my thesis that China will continue to be an important and growing manufacturing hub serving its large domestic market as well as broader Asian markets, I believe that the impact on Chinese factory automation companies will be minimal. Chinese factory automation players benefit from closing the technology gap versus their foreign peers (see example of Estun vs. FANUC in the chart below) as well the import substitution drive promoted by the Chinese government. I hypothesise that Chinese factory automation players will continue to gain market share in China at the expense of foreign players, and the partial movement of supply chains away from China will not take away the long-term tailwinds for these companies. Beneficiaries include CAXA (unlisted), Baosight Software (SHA:600845), Hikvision (SHE:002415), Estun (SHE:002747), Inovance (SHE:300124), Shuanghuan (SHE:002472), Raycus (SHE:300747), Friendess (SHA:688188) Siasun (SHE:300024), Aubo (unlisted), JAKA (unlisted) and others.

Logistics and Supply Chain Software (Beneficiaries)

While reshoring supply chains will make them more resilient to geopolitics and other shocks, the level of complexity will also go up. Companies will need to manage many suppliers in multiple countries, comply with local regulations and manage cross-border logistics. While supply chain software was already important, the increasingly complexity of supply chains may tip enterprises in favour of best-of-breed third-party software rather than using their internal applications or generics from an ERP companies. Software vendors such as the Australia-based WiseTech (ASX:WTC) will benefit (see stock price performance chart below).

In conclusion, industrial America is resurgent and incremental manufacturing capex is finding its way to the U.S, Southeast Asia, India and Mexico versus being heavily concentrated in China as was the case over the past two decades. Considerations around geopolitics and supply chain resilience are causing companies to move away from the model of supplying from China to the world, rather adopt strategies such as “near-shoring” or “China + 1” depending on their end-industry. However, given China’s domestic consumption scale and supply-side advantages, there is no wholesale migration out of China rather incremental capacity being added elsewhere. These changes will result in winners and losers in each of the geographies involved.

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