From ‘Just in Time’ to ‘Just You Wait’

Why supply chain disruptions are reminiscent of the financial system breakdown in the Global Financial Crisis

Supply chain woes have swamped the news recently. This is not surprising. The complex machine that is the globalized supply chain has had the equivalent of a large wrench thrown into it by the pandemic. As with any complex system, a breakdown in one part quickly reverberates throughout, often in ways that are hard to predict and even harder to resolve. Supply chain disruptions are the pandemic era equivalent of the financial system breakdown in 2008. There is a market failure. Behavior that may be rational for one company or country—snatching up inventory, over-ordering, hoarding—feeds on itself, triggering more shortages and more disruption. 
S&P 500 earnings surprises  Source: Bloomberg

Luckily, a disruption in goods markets does not threaten the functioning of the whole economy. It is much less dangerous than a financial market breakdown in the supply of liquidity and credit. But while central banks can surge liquidity and direct support to keep financial markets functioning in a crisis, there is no easy fix for supply chains. That does not seem to bother investors. After a dismal September, equities powered higher this month, helped by an earnings bonanza from early reports. But can this rally continue with growing inflation concerns and some worries about economic growth? Fed Chair Jerome Powell’s acknowledgement of continued supply chain pressures sent shares lower on Oct. 22.  


Inflation economics 101?

Supply bottlenecks are a major reason for today’s higher than expected inflation, and for the growing doubts about just how “transitory”—to use the Federal Reserve’s initial terminology—the 2021 surge in price increases will prove to be. By now, it is clear that inflation will stay higher for longer than the Fed and most others expected earlier this year – in the US, but also to some degree across other developed markets. Financial markets are now moving to price in both higher inflation and earlier interest rate increases, although the feared “tantrum” has not materialized.  

Interestingly, financial market participants and economists are far from unanimous about the lessons for policymakers. In a recent meeting, the CEOs of major global financial institutions put inflation at the top of their lists of concerns. Economists present were mostly more sanguine – expecting inflation to turn back down towards the Fed’s 2 percent target in time, while agreeing that today’s levels were unexpectedly high. The key is in the definition of transitory – and the view of what turns a transitory phenomenon into a persistent one. One common meaning of transitory is “of brief duration”. No doubt this is what the Fed meant when it first characterized inflation this way in the spring. But another meaning is “not permanent”, and the more upbeat economists believe there is a good chance that today’s high inflation rates will turn out to be temporary, rather than triggering a spiral of rising wages, costs, and prices.

There are a few reasons for this view. The first is that the underlying reason for the supply shortages—pandemic era lockdowns—is itself likely temporary. Even if Covid is here for the long term, as seems increasingly likely, governments appear less willing to resort to widespread, drastic lockdowns to curb the spread of the disease. Secondly, there are moves to build more resilience into global supply chains. Some of these may not work for the long term or be cost effective. But a diversity of suppliers will help. It is all part of building resilience, as well as efficiency, as Princeton economist Markus Brunnemeir argues in his new book on the lessons of the pandemic.

If you believe in markets, and we do, then you expect prices to drive the forces of demand and supply into equilibrium in time. The question is at what cost. Today’s surging prices for goods and transportation should translate into more production and supply in the coming months, absent a renewed supply shock. Some of the initial price surges are fading now, from airline tickets to rental cars and used cars. As shipping costs have soared and delays lengthened, some companies have joined together to contract ships outside the stranglehold of the 10 major shipping businesses that control 82 percent of global shipping. Governments are also on the case. President Biden has called on the private sector to speed up its reaction, helping to broker an agreement for the Port of Los Angeles to work 24/7 to cope with the backlog of as many as 65 ships floating offshore, full of containers that are in turn full of goods that companies and consumers are waiting for. You might wonder why market forces have not been enough to make that happen anyway. Some processes are more flexible than others, and some executives are quicker to jump on solutions than others and to persuade their workers that it is also in their interests. The big unknown for inflation is whether the price increases needed to smooth out supply bottlenecks will trigger a spiral of other price and wage rises. Many CEOs are warning that they expect cost pressures to continue, at least for at a while.


Will consumers keep on spending?

Demand is, of course, the other side of the inflation coin. Americans have much more cash coming out of this recession than usual, thanks to the huge fiscal packages signed into law by both President Trump and President Biden in 2020 and 2021. Governments around the world have also pushed up consumers’ ability to spend. With demand for services curtailed by health concerns, the pent-up demand for spending has gone into home improvements and goods. The federal government is no longer helping boost the economy. Indeed, its impact on the economy in the second half of this year and into next will be to depress demand. Even if Congress passes some version of the President’s two big spending bills, these will not offset the switch to contraction now underway, as one-off stimulus and unemployment benefits run out. 

Looking further ahead, many point to the fundamental structural forces of demographics, technology, and trade that kept inflation low for the past 20 years as a reason to expect inflation to remain contained. These forces may re-exert themselves once the pandemic-induced frictions are smoothed out and governments and central banks withdraw the extraordinary stimulus of 2020 and 2021. Much will depend on what happens to labor and wages.

Will corporates share the pie with their workers?

Most stories of an inflationary surge include a wage-price spiral. So far, that is not what we have seen, although both wages and prices are rising more rapidly than consistent with the Fed’s average 2 percent target. The labor market is tight, many businesses are reporting difficulties in hiring workers, and there have been a number of strikes called this month. Some wonder whether companies are holding back on increasing wages and perhaps reducing quality where labor is short to limit costs: more restaurants and hotels are asking customers to be patient for service or perhaps even make do with, for example, less frequent housekeeping.  

It is not that earnings have not gone up: average hourly earnings rose by 4.6 percent in the 12 months to September. But this is below the 5.4 percent increase in headline inflation over the year. The implications of these data are hard to tease out, as average earnings are affected by changes in the composition of the labor force. This was particularly important during the pandemic, as lower paid service workers lost their jobs at a faster pace than better paid manufacturing and office workers. It is also too soon to know whether the productivity gains that come with a recovery in growth will prove long lasting. The rising living standards that American families used to be able to take for granted requires either or both of the following: a shift from corporate profits to labor and productivity gains.

Vaccines a year on: no silver bullet but still the gold standard

It is almost a year since we had the marvelous news of a vaccine with greater than 90 percent efficacy in protecting against Covid-19. It is fair to say that the experience since then has been chastening. It turns out that public health policy is a lot more complicated than most expected. The sad death last Monday of Colin Powell illustrated the risks that are posed for everyone, even the vaccinated, as long as there remains a deep pool of infected people who can transmit this deadly disease. Last week, the US averaged greater than 73,000 Covid cases and more than 1,500 deaths each day, an extraordinarily high toll. Only 66 percent of those eligible for vaccines have gotten at least one dose, and 57 percent are fully vaccinated. And in the UK, where the Delta variant spread early, infections have begun to increase again. So far, Prime Minister Boris Johnson has resisted a return to lockdowns, or even mask mandates. Those dignitaries and climate activists flocking to Glasgow for November’s COP26 summit (on which, more next week) may want to be extra careful. President Xi Jinping of China is not taking any risks. In keeping with his policy of staying home, he has said he will miss the summit, no doubt part for geopolitical reasons, as well as pandemic prudence.

Coda: What were they thinking – and can Jay Powell survive it?

The longer the White House has delayed the reappointment of Jerome Powell as Fed chair, the more the odds of this happening smoothly—or even at all—seem to have diminished. It appears that the White House has been waiting for a good time to make a move that progressives won’t like – they object to Powell’s background and views on banking regulations. Revelations of—legal—stock trading by Fed Regional Presidents Kaplan and Rosengren have already cost them their positions. The Federal Reserve last week issued strict new guidelines for senior officials in market actions.  

It may appear strange to many that such guidelines were not already in place. Powell himself has had to defend more recent sales of funds. As some have pointed out, his transactions were similar to the kind that Senator Elizabeth Warren, one of his fiercest critics, carried out in the same time period. Will that be enough to stiffen the president’s spine? In many ways, Powell is his kind of guy. Recent research into the way that the Fed communicates noted that Powell’s comments are clearer and simpler than those of his two predecessors. 
Observations and takeaways for investors:
Show me the money: earnings vs. headwinds 

Recent market actions appear to reflect a tug-of-war between macroeconomic headwinds and strong corporate earnings. For the most part, earnings won out in investors’ minds last week. The S&P 500 and NASDAQ Composite ended the week 1.6 percent and 1.3 percent higher, respectively. Both major indexes posted their third weekly gain in a row. With earnings season well under way, investors are keenly focused on the supply chain issues, rising costs, and reactions from corporates. Companies, such as Tesla and Johnson & Johnson, demonstrated resilience to the backlog in the supply chain, while others passed on higher costs to customers.
 
We noted in our third quarter letter how remarkably low stock price correlations have been, and that continued to be the case. Under the surface, there have been sizable price moves based on company-specific news. Snapchat was a prime example, with its shares plummeting more than 26 percent on Friday after the company announced lower-than-expected revenues and highlighted challenges brought on by Apple’s recent privacy-related changes and companies’ willingness to advertise products that are likely to be in short supply.
 
Europe was somewhat softer with the Stoxx Europe 600 rising just 0.5 percent for the week. Markets saw a rotation towards defensive names and away from more cyclical sectors. Mining stocks, which have a large exposure to China, were negatively impacted by Evergrande’s unfolding situation. SAP, Europe’s most valuable tech company, reported a solid profit, but traded 3 percent lower due to weak 2022 guidance.

Emerging Markets: All eyes on Asia

In a reversal of recent trends, North Asia led positive returns at the expense of other emerging markets last week. Chinese technology names continued to regain lost ground, though they remain far off their peaks. Authorities in Beijing have provided subtle signals that the likes of Alibaba, Tencent, and Meituan will not go the way of the country’s private education companies; investors have reacted accordingly and scooped up the country’s tech champions at attractive valuations. 

After months of China de-risking, emerging markets investors are at their lowest underweight to China in five years. Does this mean we should expect a return to the good old days for China’s consumer technology sector? We doubt it. The rules of the game have changed, and the pecking order of decision making has re-established Beijing as the final arbiter of corporate strategy decisions of significance. China’s technology companies will likely remain profitable but will probably not return to the growth rates of yester-year. The good news is that Chinese markets are very deep and provide investors with multiple opportunities. We remain cautiously optimistic on selective opportunities across medical services, green energy, and biotech segments to name a few.

The new darling of Emerging Markets, Indian markets, took a breather last week as domestic investors, (the main drivers of this year’s rally in India), engaged in profit taking. Opportunities in India are anything but drying up. Foreign investors have yet to make significant investments in public markets, having focused much of their attention on private and venture capital investments in India this year. We expect a public market focus for foreign buyers to appear in the coming months. The IPO market in 2022 is expected to be even more fruitful than this year’s record 72 IPO’s and $10 billion of capital raised. Over one billion people have already been vaccinated, the country’s FX reserves are at record levels, and the economy has shown lower sensitivity to rising energy prices – all tailwinds that bode well for the country’s future growth prospects. From a sector perspective, financials, healthcare, and consumer staples, where embedded IRRs are very attractive, still have a long way to run.

 
 
Muted returns in India paled in comparison to last week’s rout in Brazilian stocks. Equity investors were already reeling from inflationary pressures and the Brazilian Central Bank’s rapid interest rate hikes, when news broke that President Bolsonaro’s administration would seek to expand social spending in violation of the country’s constitutionally mandated fiscal spending cap. A slew of important members of the country’s ministry of the economy resigned in protest at the news, and it remains unclear if Finance Minister Paulo Guedes can keep his team together. Meanwhile, inflation remains stubbornly high, and the central bank is expected to hike rates by 150 bps just this week. Considering next year’s Presidential elections, we do not see a reversal of the government’s spending plans. Short of record commodity export sales (and the hard currency that comes with it), we expect Brazil to enter a period of low growth, persistent inflation, and high interest rates, thereby penalizing the country’s traditional domestic growth sectors.

Team RockCreek 

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