Nutmegeasyinvest

Supply and demand: the Covid effect

Over the past 30 years, global manufacturing supply chains have become more complex and more integrated as globalisation gathered pace and global trade volumes surged. The western world has become accustomed to sourcing raw materials and finished goods from emerging markets, where cheap labour and low freight costs made offshoring supply chains attractive in a world of increasing cost pressure.  

 

 

The nature of manufacturing supply chains has also changed significantly, with the shift towards lean or just in time processes that focus on efficiencies, offshore sourcing and highly optimised component deliveries. Manufacturers across a wide range of industries have reduced physical inventories, becoming reliant on the fast and efficient delivery of parts, and a supply chain ecosystem that works seamlessly from raw material to finished good. For many manufacturers the combination of more efficient manufacturing processes and lower production costs was too attractive to ignore.   

The result of these shifts in supply chain activity has been truly globalised supply chains that rely on components from across the globe in production processes. It is estimated for example that an Apple iPhone uses components from suppliers in 43 different countries. Supply chains have also become more reliant on key component manufacturers – for example, the world’s largest computer chip manufacturer currently has a market share of 55% 

The emergence of Covid-19 and the associated global disruptions and changes in consumption patterns have represented a significant challenge to supply chains, and one that looks set to shape a change in their future structure. Activity restrictions and shifting demand patterns represented a perfect storm to processes relying on seamless global activity and endangered by bottlenecks. 

Here we highlight how some of those effects continue to persist in the global supply chain and what this means for investors as we track the global recovery.  

Demand Shock

First, the Covid-19 pandemic created an unbalanced mix of aggregate demand in the western world – shifting towards goods, rather than services (given many services sector activities were restricted). Goods demand has therefore surged in the past 18 months, just as activity restrictions began to impact both production and export capability.  

The extent of this shift in demand is visible in the United States, where the Institute for Supply Management reports record high number of manufacturers reporting a back log of orders, while at the same time the lowest inventories since 1997. They also report elevated lead times for production materials, in-line with their global counterparts in purchasing managers surveys, suggesting that rebuilding inventory will take time given the backlog of demand and continued challenges in sourcing input materials.

 

ISM: Business backlog of orders, Customer inventories

[Source: Macrobond]

The changes in consumption activity have also brought about demand shocks in certain sectors more aligned with pandemic trends: the work from home boom for example introduced a cyclical demand for personal technology products that far outstripped supplier expectations. HSBC notes that demand for notebook PCs grew 29% in 2020, while demand for TVs grew 13%, far outpacing estimates based on previous year’s demand growth[1] 

 

Supply Disruption

One area where increased demand is particularly acute is in electrical component supply chains. The rising importance of semiconductor components had placed increasing reliance on a small number of global producers long before Covid emerged.  

Lead times have become extended, and manufacturers reliant on semiconductor supply chains have been forced to make tough decisions. A shortage of certain types of semiconductors has forced manufacturers to shift product mixes to protect profit margins, while several major auto manufacturers have been forced to temporarily pause production in US based plants. A shift to higher margin products has exacerbated supply issues for lower margin ones – if a TV uses the same chip, why create a $300 model when you can create a $700 version? Even the world’s largest technology firms have not been immune – Samsung warned on potential delays to launch its next generation of phones, while Apple has cautioned that the chip shortage could impact third quarter sales.  

A structural shortage of semiconductor components looks likely to persist for some time. Semiconductor fabrication is a complex activity, with long investment cycles and ramp up times for production. The market is dominated by a number of companies with high market share, while long term demand dynamics remain favourable in a world where more products rely on complex electrical components. With current fabrication facilities estimated to have already been running at high capacity-utilisation rates, supply issues are unlikely to be remedied in the near-term. However, the extreme demand effects introduced by the pandemic should fade as western economies normalise and the balance of goods and services consumption rebalances.  

Low emerging market vaccination rates prolong supply challenges 

While the rebalancing of aggregate demand has begun in earnest in the western world as services sectors reopen, lower vaccination rates in many of the emerging markets, in particular in emerging Asia, means global manufacturing supply chains are likely to continue to witness pockets of supply disruption in the coming months as the Delta variant spreads. 

Most recently we see this in Vietnam, where the surge of infections and accompanying social distancing measures has forced production closures in apparel manufacturers, including some of the largest footwear manufacturers globally. So, while demand side effects begin to rebalance, supply side effects will continue to impact supply chains and the businesses associated with them – Adidas recently warning that current supply issues, such as those in Vietnam, could cost as much as €500m in lost sales as supply falls short of demand 

Freight dislocations 

Another issue highlighted by Adidas was that of logistics and freight disruption. A global manufacturing base with lean processes had become reliant on efficient and effective global freight routes, delivering both raw materials and finished goods on time and at low cost. Again, here the global pandemic has introduced disruptions, stretching capacity, pushing freight costs higher and delaying deliveries for just in time processes.  

The extent of the impact on shipping can most visibly be seen in container rates. In the chart below the WCI Composite shows the average cost of shipping a 40ft container across the largest eight East West trade routes, while the Baltic Dry Index provides a benchmark for the price of moving raw materials via three types of dry cargo vessels.  

As the chart demonstrates, the cost of shipping a 40ft container has increased by over 500% since March 2020, with composite shipping rates reaching new all-time highs at the beginning of August. 

 

Baltic Dry Cargo Index, World Composite Shipping Rates (40ft container)

[Source: Macrobond]

A number of interlinking factors has led to this spike in costs. First, the global shipping ecosystem has suffered from a shortage of containers in the past 18 months. As lockdown restrictions slowed the processing of shipping containers in the western world and therefore also their return to Asian manufacturing hubs, the strong demand for goods imports and advanced reopening in Asia ensured a steady flow of containers on East to West trade routes continued. This resulted not only in port congestion at many import hubs but created a shortage of containers in export locations given the longer turnaround times.  

 

Add to this a usual blockage of the Suez canal in March, continued manufacturing disruptions and the temporary closure of the Chinese port of Yantian in May, the third largest container shipping terminal in the world, and the congestion bottlenecks have been amplified. Congestion at ports leads to sailing delays which in turn further disrupts just in time supply chain processes. Data from Sea Intelligence shows only 40% of sailings are arriving on schedule (versus closer to 80% pre Covid), with an average delay of over six days, while HSBC estimate that 4-5% of global container capacity is being held up in current port delays. And the problem does not sit solely in shipping alone: the container ecosystem relies on the seamless connection between ships, port operations and onward distribution. Thus, rail and road freight disruptions have also played their part, as have factors such as a structural shortage of truck drivers in the United States.  

Of course, this freight congestion will also begin to subside as bottlenecks are worked through, and goods demand fades. However, many ports are already operating close to capacity, and so we expect shipping rates to remain elevated for some time to come. How long shipping disruption persists will relate to how quickly demand rebalances between goods and services, and whether global supply chains can avoid further disruptions in key locations.  

Raw materials 

One of the most visible dislocations in the supply of raw materials has been in the US housing market. The symptoms are largely consistent with other dislocations in supply and demand being experienced in the global economy: a shift in consumer demand, a disruption to supply and a temporary reaction in price.  

US Lumber prices soared to all-time highs in May 2021, as low mortgage rates and a desire for greater space drove strong housing and home improvement demand for Lumber products, above that of sawmill production capacity. The resultant effect was a spike in broad US lumber prices, and in particular those used in construction processes.  

While generic lumber prices have normalised somewhat from their May peak, they remain above pre-Covid levels, and construction specific lumber materials such as oriented strand board have cooled only marginally. Further, homebuilders continue to report widespread material shortages and cost increases – a May 2021 survey found that more than 90% of builders reported shortages of appliances, 87% reported a shortage of windows and doors, and more than 50% of builders reported shortages of steel beams, insulation and roofing materials 

Meanwhile, the effect on house prices is clear: the national association of home builders estimates the increased cost of lumber products between April 2020 and July 2021 would add $30k to the price of an average single family home, while US house prices rose 16.6% over a year ago in May according to the S&P Case Shiller House Price index.  

S&P Case Shiller House Price index.

[Source: Macrobond]

What does this mean for the economic recovery?

Supply chain issues are a key focus of policy makers, as they look to sponsor an economic recovery while controlling the risk of inflation. The current supply chain dislocations are certainly a friction on economic growth, yet global trade activity remains strong, and we don’t see these supply chain dislocations endangering the recovery. However, it is clear to see that the current supply and demand dynamics in goods trade, and the effect on goods price levels is inflationary (despite goods accounting for a much smaller portion of the inflation basket than services). The chart below shows the visible increase in goods prices over the previous 12 months, in particular in ‘durable’ (or hard-wearing consumer) goods where price pressures have been negative for some time.  

 

US Goods and Services Prices- 12m % change

[Source: Macrobond]

US and European policy makers remain aligned in the view that these inflationary pressures are transitory. The Bank of England recently noted the growth and extent of supply chain bottlenecks was a key reason for increasing their 2021 inflation expectations. But they also noted a continued belief not just that supply chain issues were temporary, but also signs that bottlenecks were receding.   

 

We share the view that much of the current inflationary pressure will be temporary, given we expect a rebalancing of demand as economies reopen, and the gradual easing of supply chain disruptions and bottlenecks. However, we don’t believe there is room for complacency, and we continue to monitor inflationary dynamics in both goods and services. We also expect that as the services sector reopens, it will encounter bottlenecks of its own, such as the current apparent mismatch between record high job openings and high unemployment.   

For the global trade complex, we believe it is likely that the Covid pandemic engenders structural change in supply chains, but capacity for radical shifts in the near-term is a challenge. Global supply chains have evolved in the past decades to rely on lean processing and just in time mechanics, combined with low freight costs and frictionless movement, leaving little room for error and allowing even the slightest disruptions to have compounding effects. But even the most cautious approaches would not have estimated the demand effects of a once in generation health pandemic.   

It’s likely global manufacturers will materially evolve their supply chain structure in the next decade to avoid disruptions; to achieve greater geographical diversity; as well as leaning more heavily on technology and automation. The pandemic has highlighted some of the shortcomings of offshoring, and the associated complexity of global supply chains. In truth, a consolidation of the global trade system was well under way before Covid struck, prompted by quality control concerns, resource security, environmental pressure and geopolitical friction – particularly between the US and China. Combined with the demand and supply shocks induced by Covid, onshoring is likely to be a key global trade theme in the coming years.