Introduction
We find ourselves in very tenuous times because of the global spread of coronavirus. Unfortunately, it is going to inflict a serious financial and emotional pain before it disappears. Hopefully, sooner rather than later, we will be able to flatten the curve and things will start returning to normal. But things on the other side of this pandemic could be very different and I am reasonably confident that it will have a lasting impact on how we function as a society, just how 9/11 attacks and 2008 global financial crisis changed our attitudes.
This article is placed in a time when humanity has conquered COVID-19 and reduced its spread. I would like to discuss following three points regarding that scenario –
How supply chains can get impacted creating immediate shortage of goods
How passive investing can create shortage of risky assets, leading to a sharp rally
How most of the consumer demand is probably deferred but not destroyed
Eventually, I will share my opinion on how the combination of these three factors could lead to a surprise inflation and what could that mean for investors.
Potential Supply Chain Hurdles
Every product goes through its own journey before a consumer can purchase it. In modern times, production processes are often spread across companies and geographies. As an example, one recent analysis found that Toyota relied on 2,192 distinct firms in its production process. Because of COVID-19, countries are increasingly closing borders, manufacturing plants are shutting down, labor shortage is becoming real and worst of all, we are losing lives. As per an article published by Gartner, different ways in which coronavirus can impact supply chain are as follows –
Materials: Supply shortages of materials or finished goods
Labor: White- and blue-collar labor may not be available
Sourcing: Travel may be restricted, limiting the ability to discover alternatives
Logistics: Existing networks may experience limitations in capacity and availability
Consumers: Consumers may change their purchasing habits
Supply Chains as Complex Systems
We have streamlined production globally and are efficient at it but have introduced vulnerabilities in the form of key points of failure. There are choke points that nobody knows about and unfortunately, will only come to light when they fail. If supply chain was an organization, then choke points are key men risk. Nick Vyas, executive director of the Center for Global Supply Chain Management at USC Marshall, in his recent interview states that –
“Today many global supply chain networks are becoming so complicated that they are best thought of as complex systems ... Complex systems tend to exhibit non-linearity, chain reactions, and feedback loops, which make it difficult to predict how changes to any given unit will impact the broader system.”
Global Choke Points
Today our world is significantly different than what it was during the 2003 SARS epidemic. China is now a developed country, accounts for about 20% of world’s GDP, has much better transportation network and is strongly intertwined with the global economy – especially manufacturing industry. After all, that was China’s story of success. What this means is that supply chain disruptions in China are now a global issue. Travel restrictions, closing of borders, shut down of manufacturing plants, shortage of labor and decreased traffic is going to delay production. In financial terms, we put our manufacturing eggs in one basket and chose not to diversify. Now, there is a real risk that this concentration may lead to a supply shock when COVID-19 is behind us.
To make matters worse, COVID-19 has expanded beyond borders of China and we have confirmed cases in more than 140 countries. Italy and Spain recently went into lock-down and other countries may follow suit. Such lock-downs can easily last for months. This will have a cascading effect on global supply chain network. Global production is likely to take a massive hit. Nick Vyas, in the same interview, also adds –
“The topology of global supply chains—their shape, patterns, and connections—will determine how global production responds to the widespread intermittent supply shocks caused by the coronavirus … These hubs can become the choke points of globalization—vital junctures that, when closed off, can severely disrupt economic activity. Identifying exactly where these choke points are, however, is not always obvious ex ante...”
What are Companies Experiencing?
In an Axios article, it states that companies are expecting longer recovery periods. About 80% of the companies in a recent ISM survey expected supply chain disruptions, and most of them expect supply chain shocks to intensify after the first quarter. Not only is there a shortage in the supply of products, but situation is further exacerbated by the shortage of air and ocean freight options. Companies can be expected to pay higher prices to avail priority service. In a recent ISM survey conducted between Feb. 22 and March 5 among 628 respondents that largely represented U.S. organizations, a few things that stood out about Chinese dependence are –
>44% of respondents said they did not have a plan to address supply disruption
62% respondents are experiencing delays in receiving orders
48% are experiencing delays moving goods within China
46% report delays loading goods at Chinese ports
Understandably this is stale information in this environment, but I am inclined to believe that it will take a while before things normalize globally considering the cascading impacts of global shutdowns.
What can Customers Expect?
In another article from Axios, it states that consumers should prepare themselves for shortage of products as soon as in a few weeks. Facebook Oculus Quest is out of stock in the US, Apple has warned of delays in replacement of a few devices, and Coca-Cola warned in late February that products in artificial sweeteners used in diet coke have been delayed. Proctor & Gamble has more than 300 suppliers in China that provide 9,000 different materials for its products. FDA is working with 180 drug companies and 63 medical device manufacturers to evaluate whether their products and components are at risk of shortage. When China’s production starts coming up to speed, South Korean’s supply of memory chips may be impacted, and later it could be Europe followed by US where you can expect further cascading shocks. A few carmakers have shut down US and European plants as they try to fight COVID-19. These examples are anecdotal and the extent to which it will go is uncertain, but we could easily see a supply shock that can last for a few months based on this early data.
Passive Investing
Let’s switch gears from supply chain world to investment world. What is Passive Investing? Passive Investing assumes that all available information is already priced in the market. It advocates that investors should avoid active stock selection and market timing. Instead, it suggests buying and holding the entire market (a bunch of stocks, bonds, etc.) and is available to investors for a much lower fee. In this article, I will briefly discuss why passive investing in equities skews markets towards sharp rallies.
When people invest passively in equities, they are buying publicly tradable stocks. Now, there is only a limited amount of publicly tradable stock available for each company. As share of passive investing increases in the market, supply of publicly tradable stocks is bound to decrease. In recent selling that occurred, data from industry giants such as BlackRock, Vanguard and State Street showed that retail investors were still net buyers of equities (as of 13th March 2020), which means institutions were net sellers and more publicly tradable stocks may have ended up in the passive investing black hole i.e. will not be available to for institutions to buy again, unless passive investors sell.
It matters because once coronavirus is behind us, investor sentiment will start turning positive. I am led to believe that people think coronavirus is what has put the brakes on demand, and nothing is wrong structurally in the economy. With less shares available to buy on the upside, not only could it lead to a shortage of risky assets but also there will be more money (include the enormous fiscal and monetary stimulus) chasing fewer stocks. It can create a violent upswing in the market. This is an exact opposite dynamic of what we are seeing in the market recently, and I shared it in the ‘Liquidity Matters’ article, where too many securities are chasing too few dollars in the system leading to a selloff in practically every asset class. If market reverses losses sharply, passive investors can recoup their paper losses and add more wealth to their portfolio.
Impact of Coronavirus on Demand
Coronavirus has impacted consumer behavior in an unprecedented way. There has been a substantial impact in the immediate demand because of the spread of COVID-19. As a result, we saw companies reduce their profit estimates for the year and stock markets crashed at a historical speed. To combat the economic slowdown, governments have provided record fiscal stimulus to people and businesses. Central banks have flooded markets with dollars to save financial system and corporations. Not only should these stimuli potentially help people and businesses to navigate the rough seas, but also it should provide them with more dollars on the other side of the pandemic.
But if you look deeper, there is still demand for workers at companies like Amazon and at a higher pay (looking to hire 100,000 workers), manufacturing plants are looking for more workers in China and once coronavirus is behind us labor shortage could be a real thing as people may still be nervous to resume operations. Wages for these people can go higher. Also, a lot of white-collar employees have not lost their jobs but are working from home. In this scenario, they continue to receive their income stream while their expenses have reduced. If we accept the argument that passive investing dynamics may lead to a quick recovery in stock prices, then all these people may end up in a better financial situation than they began the crisis with. This may imply that they will be ready to consume almost everything that businesses could offer. Hence, I state that most of the consumer demand is deferred but not destroyed.
Inflation
Simply put, inflation occurs when people are willing to pay higher prices for goods and service than what they paid before. When shortage in supply of goods and services because of broken supply chain network will encounter hungry consumers whose nominal wealth has increased because of stock market rally (skewed by passive investing), fiscal and monetary stimulus, I believe a lot of consumers will be willing to bid higher for same products than they did before. Severity of supply shock and recovery of markets would determine the speed and magnitude of inflation, but it could be very high considering the amount of stimulus that has gone in the economy and will only worsen if coronavirus exhibits seasonality.
An argument against inflation could be made by saying that oil prices are near record lows. Oil is a raw material in production of almost everything, so why would there be any inflation. It sure has merit and reduces the chances of inflation, but because we do not have grasp over the severity of supply shock that can occur, it is not a fool proof argument. On top of it, if Saudi Arabia and Russia resolve their issues with or without American intervention, you may see a rally in oil markets. Will that happen is another story, but it is a risk that could further exacerbate the inflationary scenario discussed above.
Surprise inflation could be very risky. Globally, countries have trillions of dollars outstanding in debt and deficits. Also, recent demand shock for dollar has made global currencies (especially emerging markets FX) very vulnerable. On top of it, add the record fiscal and monetary stimulus provided by governments in the world right now. All that debt needs servicing and your currency needs to be stable. If surprise inflation occurs, long term yields are going to rise very quickly and will burden the countries with interest costs. It could cascade into sovereign defaults in a bad case. Bonds can sell off. Global currencies will come under immense pressure. Unless supply chain shocks are resolved, equities may or may not be the right place to park the cash. Investors may seek refuge in non-sovereign scarce assets at that point.
Conclusion
Because of the spread of coronavirus and actions taken by governments around the world to stop the spread, existing supply chain network is bound to come under significant pressure and it could lead to a failure of choke points, thereby leading to an unexpected shortage of products. Once coronavirus is behind us, investor sentiment should start turning positive, but because of increasing share of passive investing, there will be fewer stocks to chase on the upside and markets may recover much faster than it seems right now. Also, governments and central banks across the world have provided record fiscal and monetary stimuli to global economy. Stock market rally and these stimuli may put more nominal wealth in hands of consumers who are likely to be hungry to spend it. And, if there is shortage of products at that time, it could lead to inflation, which could lead to a rise in bond yields and increase pressure on governments to service their debt, and in several cases, situation could deteriorate into sovereign defaults. In such a world, investors may seek refuge in non-sovereign scarce assets.
Disclaimer: I am not a supply chain expert/professional and most of the related information is a product of my frantic internet search on this topic lately. Also, this article is talking about a scenario when we have controlled the spread of coronavirus. Last, but not the least, this is not an investment advice.