Supply Chain Crisis: Disruption Should Lead to Greater Diversification
We believe the impact of supply chain disruptions on businesses and households is likely to remain significant in the first half of 2022. While the second half could bring some relief if China relaxes its zero-COVID and power-rationing policies and U.S. labor shortages wane, Russia’s war in Ukraine and the sanction responses have led to further disruptions. Although the Russia-Ukraine conflict is likely to have a limited near-term impact on the tech supply chain in Asia Pacific, with sufficient inventory of key raw materials (such as neon gas and palladium) for the coming four to six months, any prolonged disruption to the global supply chain could drive up computer chip prices and further delay shipments. As we noted in our recent Cyclical Outlook, “Anti-Goldilocks”, even after a conclusion to the war in Ukraine, sanctions would likely remain in place for a long time, hampering the flow of trade and capital and exacerbating supply chain issues.
In the longer term, we expect recent disruptions will prompt companies to further diversify their supply chains, reducing China’s role. Other countries in Asia could benefit.
U.S. companies have been hit hard by supply chain disruption
Global supply chain bottlenecks have made headlines the past couple of years amid the COVID-19 pandemic and geopolitical tensions. Initially, the pandemic reduced global demand. However, fiscal stimulus and consumption of goods in place of services have helped to re-stimulate demand. This has placed increasing pressure on the supply side and created congestion and a backlog of orders – from auto parts to manufacturing machinery to logistics – with a shortage of truck drivers further exacerbating the problem. Parts shortages and home-bound employees have prompted many U.S. companies to cut their sales guidance or issue profit warnings.
Port congestion continues to be a challenge: The average wait time in New York ports was about five days at the end of 2021 compared with last year’s 1.6-day averageFootnote. As of 21 March, 44 ships were queueing offshore to enter the ports of Los Angeles and Long Beach, still elevated but declining from an all-time high of 109 in January, according to the Marine Exchange of Southern California.
In addition to a shortage of truck drivers, COVID protocols are gumming things up. For example, since 15 January, truckers entering Canada had to show proof of vaccination, a policy which the Canadian Trucking Alliance estimates will lead to a 10%–15% reduction in cross-border truckers. While the week-long protest at the Ambassador Bridge, North America’s busiest land border crossing connecting Ontario and Michigan, has now ended, we could see similar demonstrations in future that impede transportation routes.
U.S. companies have taken multiple measures to address supply chain issues, including chartering freighters, rerouting shipping to smaller ports along the coasts, and relying more on air freight. Companies with more vertically integrated operations or diversified supply chains — such as electronics manufacturers that have over time reduced concentration in certain regions such as China, and spread more of their supply chain across Asia — are dealing with the situation better than their peers. Yet, lead times remain elevated because these actions have only helped on the margin and are generally not scalable. Lasting improvement will require normalized global labor conditions (from factories to ports and other shipping touchpoints) and for the pandemic-driven demand backlog to be fully resolved.
Additionally, negotiations between the International Longshore and Warehouse Union and the Pacific Maritime Association over the expiring West Coast contract bear monitoring. When the current contract was signed in 2015, negotiations were accompanied by four months of slowdowns that affected port activity. Many customers have shifted shipping volumes to East Coast ports where possible ahead of the June 30 expiration.
Longer term, supply chain migration out of China seems inevitable
China has been a key part of global supply chains for decades, but the recent crisis, brought about in part by the pandemic, is leading companies to consider how they can mitigate supply shocks in the future by reducing dependencies on particular countries and diversifying their supplier base.
We believe China’s exports will continue to be supported by the country’s resilient supply chain in the near term. However, in the longer term, as China looks to move up the value chain, some migration of the supply chain out of China is inevitable, in our view. This migration is most visible in the lagging export growth of mobile phones relative to other electronics, with smartphone sales dominated by local brands.
China’s ageing demographics, which lead to a reduction in labor supply, are necessitating higher value-added manufacturing. While we expect this supply chain migration to continue gradually, it could be accelerated by geopolitical tensions and government incentives from countries such as Japan and Vietnam. However, it is likely to result in non-Chinese companies diversifying their supply chains away from China, rather than completely exiting the country, in our view.
We could also see a drop in China’s imports if the country is able to become more self-sufficient in producing semiconductors in the medium to long term. This should offset some of the export reduction.
Over the long term, we expect supply chain disruption to create winners and losers among U.S. companies. When faced with headwinds such as limited capacity, inflation, power shortages, and the zero-COVID policy, Chinese producers could prioritize production for larger U.S. companies, causing further delays for deliveries to smaller U.S. companies. Asian companies could also benefit at the expense of smaller U.S. and European companies given their proximity to Asian supply chains.
Those most likely to perform well include technology companies that have swiftly adapted their supply chains over the past few years, as well as firms that have consolidated and streamlined their supply chain networks to better manage business continuity planning. Sectors with little reliance on imports or exports or customized semiconductor chips should also fare better – including China auto manufacturers and the internet services industry.
In Asia, over the long term we could see countries such as India, Vietnam and Malaysia benefit from the supply chain migration out of China. However, it will take years to ramp up production in these countries and capital expenditure could prove a drag on corporate earnings.
A shortage of empty containers may exert continued pressure on the global supply chain as manufacturing in China picks up following the recent Chinese New Year holiday. Record high shipping rates not only benefit container shipping companies, but also indirectly benefit container ports, which can charge higher container handling tariffs, including greater charges for storage.
For details on our outlook for the global economy and the investment implications, please read our latest Cyclical Outlook, “Anti-Goldilocks”.
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