The Global Supply Chain Part I – What's Wrong?

This transcript has been generated by an AI tool.

00:03 - 00:52

Hi, everybody, and welcome to The Pulse, where we cover trends in the economy, markets, and asset allocation for long-term investors. I'm Matt Palazzolo, Senior Investment Strategist at Bernstein and Head of our Investment Insights Team. The supply chain is a term that is now common to everyone, but not for good reason. Supply chain disruptions have been the culprit for everything from delivery delays to inflation. To help us make sense of where the supply chain stands today. We've invited Mike Mathay onto our show. Mike's a senior research analyst at Bernstein, and he covers a wide range of industrial companies, from GE to FedEx and as such, Mike's got his finger on the pulse of a lot of things, and most recently, he's had to dig in on the supply chain. So we thought it was a great time to have Mike on the show. So, Mike, welcome to The Pulse.

00:53 - 00:55

All right. Thanks for having me, Matt. Glad to be here.

00:55 - 01:11

Good. So, look, Mike, I guess to understand what's going on and what's really going wrong with the supply chain today and over the last six, nine, 12 months, we need to step back to the early days of the pandemic. What happened back then as it relates to the supply chain? What went wrong?

01:12 - 02:11

Yeah, I think it's important we start with some historical concepts. I want to go back a little further than that even. You know, if you think about it, we've really spent the last 30 years or so globalizing manufacturing and by extension, the movement of raw materials, intermediate goods, and finished products around the world. And really, this goes back to the end of the Cold War, when we saw geopolitical stability in a new way and we saw a broadening of trade agreements around the world. Let's say companies do things like leverage labor costs and technology on a global scale, all to drive better outcomes for the consumer. Here in the US, we became more dependent than ever on imports. But it's not just us. You know, I saw a data point recently from the OECD that 90% of global freight volumes now moves by ocean. So there are a lot of things moving around and that's built on a foundation then, that globalization is built on a foundation of reliable and fluid transport.

02:12 - 02:50

Quick example to make that clear. So let's say I'm going to pick up a new couch for my house. You know, years ago that couch might have been manufactured in North Carolina. Today it might be in Indonesia. To get to my house, that couch comes out of a factory, gets put on a truck, goes to a port facility somewhere in Asia where it gets put into a 40-foot shipping container. Then it gets loaded onto a ship with somewhere between 5,000 and 15,000 other containers. Spends three weeks crossing the Pacific Ocean, where it's unloaded at the next port onto a truck, maybe a railroad, gets put on to another truck, gets to the store, and finally gets delivered to my house.

02:50 - 03:13

You know, another example might be a car. These are probably the most globalized supply chains out there. Your car might be built in Ohio, but it comes with parts from all over the world, some of which probably cross the Mexican border several times before the car is finally built. I think of it as kind of like a series of conveyor belts where everything is synchronized. And now coming back to the pandemic,

03:13 - 03:55

the lockdowns that we saw in early 2020 brought that system to a screeching halt. First, we had the factories closing down in Asia, then other regions soon followed, and the shipping companies cut their capacity massively in anticipation of what was expected to be a severe downturn. Now, as we know, that's not exactly what happened because governments sprung into action around the world. What we got instead was a boom in demand for goods. Driven by the stimulus packages, you know, the US perhaps more than most. But also changes in consumer behavior because we were all now working from home. Social distancing. So you weren't going to the theater or restaurants. Instead, you were, you know, you're buying technology, home goods, maybe a bike or a car.

03:56 - 04:19

Mike, before we get into the reopening, I want to ask you a question about that supply chain that built up over three or four decades, I guess. Did it end up being too fragile? Right. We think about it, you know, running a business, you want to be flexible, but you also want to be lean. Are those two concepts in conflict with one another as it relates to the supply chain? And is that where the issue was?

04:20 - 05:05

I think that's a great question, and I think it's a source of some real debate and analysis right now. I mean, this isn't the first time we've had some disruption in the supply chain. If you went back ten years ago, there was an earthquake in Japan which resulted in a tsunami. Right. That then messed up semiconductors, which I know you're going to talk about on another show. But that was a kind of a shot across the bow. And in some cases, the pursuit of relentless efficiency has certainly created a very stretched, and in some cases, fragile machine. And I think we've seen that lately. So there's a lot of activity and maybe we'll come on to this later. But there's a lot of activity focused today on resilience and flexibility, just as you described.

05:05 - 06:03

Yeah, there's a famous chart that works its way around the halls of our office here in New York that shows profitability for corporations over the last 30 or 40 years, those margins that have just climbed really since the early 1980s, and particularly for manufacturing companies, which is a lot of your, the companies that you focus on, it climbs significantly because of these efficiencies that you're talking about. So in the pursuit of profitability, maybe give up some of that flexibility and at some point that presents some challenges. I want to fast forward from the historical context that you were providing to, I don't know, around April, May, June of 2020, the economy starts to open back up. Slowly, people start to order more goods online, renovations are occurring in homes, and a whole host of other economic activity. What were the issues that we ran into as the economy began to open back in the middle of 2020 and the back half of 2020?

06:03 - 06:29

Well, you are right. So what we found was that it's a lot easier to shut down a complex system than it is to restart a highly integrated production system. And this is driven by a few different factors, right? So the shutdown was synchronized, but the restarting wasn't. And so we had different experiences with COVID in different locations around the world. Different countries responded in different ways, and the reopening happened at different times.

06:30 - 07:27

At the same time, you had the shipping networks. So all these container ships that we talked about briefly, they had all been shifted into serving the immediate needs of the pandemic. So cleaning supplies, masks, other PPE that was needed around the world. Now those ships and those containers are in the wrong places. So as we're trying to pivot back to a more normal pattern, the capacity just isn't there. And since then, we've had and continue to have a series of one-off events that, sort of echo shocks to the system, whether it was the storm we had in Texas that knocked out several plants and electricity for weeks, as that ship getting stuck in the Suez Canal. And then we've had ongoing COVID disruptions too, where there was Delta or Omicron, and that's impacting production both locally, but also in sites in Asia and the ports back in Asia. So it's an ongoing challenge as we're trying to get things re-synchronized.

07:27 - 07:45

Right. I think that was an interesting point that you made. It's easier to shut down an economy than it is to open it back up. And particularly when you have ships, maybe you have capacity, but it's not in the right place or it's being utilized for other things like shipping masks when you needed to ship couches out to Mike, where do you live, Mike, New Jersey?

07:45 - 07:46

In New Jersey, yeah.

07:46 - 07:47

Yeah, that's right.

07:49 - 08:07

So we talked a little bit about semiconductors. We're going to have a show on semiconductors. So we're not to spend too much time there. But I know that was one of the most...areas that had the most acute disruptions. What else felt the pain most acutely of the reopening and the supply chain disruptions? What don't we know about as much as we do semis?

08:07 - 08:44

Well, I think most of us experienced this pretty personally. Early on, we saw shortages in some of those cleaning supplies and PPE that we were talking about because everyone went to the store to to stock up, or you couldn't buy toilet paper or paper towels for a while. Then it moved on to other things like bicycles and seemingly seemingly random food items that you just couldn't get. And then as the technology demand boomed to support work from home and remote learning, that's when we saw it really shift to the semiconductors there. And I think we all gained a new appreciation that you'll explore next time about how pervasive they've really become.

08:44 - 09:17

But if you fast forward to today, outside of chips, which is likely to remain an issue for a while, I think it's less about some of these acute shortages and it's more about coping with strong demand and the ongoing issues in the freight networks. I think we can see this most clearly in some of the key bottleneck areas like the West Coast ports. And so I don't know if you know this, but the ports of Los Angeles and Long Beach together account for about 40% of imports into the United States, but we actually can see it in other places, too.

09:17 - 09:45

Some of these disruptions in Asia, some as recently as last week, are back at the front end. So we've got more echos still coming. The backlog of ships that we're seeing at the ports, which is spreading now from Los Angeles to the East Coast ports as companies try and respond. But it's also in places like drivers and chassis to move containers around. It's warehouse operators and delivery drivers. So you're really seeing this struggle to keep up with demand for goods.

09:45 - 10:08

And is it fair to say, Mike, as you walk through this, you know, saying chassis to drivers to this... I mean, there is no one company, one individual, one group that controls everything, right? It's all these disconnected parts that ultimately make up the supply chain. If that's true, does that then make the repairing of the supply chain issues that much more complicated?

10:08 - 10:35

I think that's exactly it. So remember, this is a system of conveyor belts, the way I described that were essentially layered on top of each other over years and years. Now we're trying to re-synchronize those. And if you remember my couch example and all the stops that it makes along the way before it gets to my house, at every point there is equipment and people that need to be in place to move it along the way. And getting all those pieces back in alignment is really the challenge here.

10:35 - 11:12

I mean, just to give you another data point, I saw this data from the Bureau of Economic Analysis. It is really a big problem. Prior to the pandemic, the consumption of goods in the US was about 65% services, 35% goods. Now it's 60/40. So that shift may not sound like a lot, but it's billions and billions of dollars of product, and import levels currently are still running 12-13% over where they were in 2019. So there's a lot of stuff coming into the country at a time when the system really isn't set up to handle it.

11:12 - 11:32

Yeah, that, I guess, mix shift more toward goods relative to where we were pre-pandemic has also been a big driver of inflation. I've seen some numbers that say that shift took us back to where we were roughly ten years ago in terms of the mix between goods, purchases and services, which is just, I think, astounding.

11:32 - 11:49

So Mike, let's move forward to the response that both companies had and consumers had. Once it was clear that we had a supply chain issue and all of these disruptions, what did those two categories, consumers and companies, what did they do in response?

11:49 - 12:36

Yeah, so I think in the short term, a lot of companies have essentially focused on how do I alleviate the constraints and how do I offset the costs from these disruptions. So I'll pick Nike as an example. Nike's shipping time to get a pair of shoes from Vietnam where they're manufactured to the stores here in the United States, stretched out to 80 days. That's about two times the pandemic. So they had some choices to make about how they're going to move things. A lot of companies shifted to faster modes, like maybe they would take some things off the ocean and put them on to planes. For a lot of products, that's just not going to work. For my couch, that's not going to work. I'm not even sure it works for a pair of shoes, you know. For an iPhone, sure. Other companies might have moved to a different port.

12:37 - 13:02

You also saw a lot of companies say, well, how do I redesign products to get around the places where there are constraints or around suppliers who are affected? And I've even heard some saying, look, we're sending our engineers into our suppliers' factories to provide extra manpower to try and alleviate these. And then finally, the most obvious thing, which you've kind of point to, a lot of companies are responding through price, and that's the way they're offsetting some of these things.

13:02 - 13:24

Mike, you mentioned the 80 days versus the 40 days for Nike sneakers. And there's other examples obviously. I'm interested in, you know, where were inventory levels going into the pandemic? Or were they pretty lean at that point in time, meaning companies really couldn't work through what they had in the back, or were inventory levels higher, and so they had a little bit more flexibility than they otherwise would?

13:25 - 14:00

I think the answer is going to vary based on the markets that you're talking about. If I think less about Nike and more about my industrial manufacturing companies, inventories were not high. The manufacturing demand had actually been fairly slow for the prior couple of years coming into the pandemic. And so when things seized up and the demand boomed, any inventory was quickly depleted. And I think you see that today. If, you know, if you're looking for a water heater or a refrigerator or a stove, you just can't get them, and you haven't been able to get them for the whole pandemic. I mean, because the supplies just weren't there. Yeah.

14:00 - 14:39

You mentioned that some companies, for example, and not with every product, obviously, moved from shipping by ship to shipping by air. I have to assume, Mike, that that's, I guess, a benefit of a larger company that has the ability to all of a sudden make that kind of an adjustment. Your average small business, medium-sized business, maybe a smaller cap company that's publicly traded, can't make that adjustment. First of all, is that fair? And then the larger question is, did larger companies have more of an advantage trying to go through and manage through these supply chain disruptions, given their size and scale, etc.?

14:39 - 15:23

So I guess if I separate the two questions, your ability to move to airfreight, as an example, is really going to be based upon the value of the product that you're selling versus the cost of shipping. So, you know, something like a small electronic device or jewelry or certain types of clothing, the shipping cost to move that is very small compared to the price that you're going to sell it for. So in cases like that, a manufacturer might be able to to do it. If it's something bulkier or heavier, it's that much more challenging. That's more the a driver of companies' ability to to shift to airfreight. And keep in mind there's there's not nearly enough airfreight to cover the volume of stuff that's moving on the ocean.

15:23 - 16:02

Now, pivoting to your other question, we did see some really interesting behavior from some of the largest retailers and consumer companies coming through this. And that's that some of them took to chartering their own ships. So we saw Walmart, Target, Home Depot, Costco, even Coke and Dollar Tree chartering their own ships as a way to get around the bottlenecks that would give them the flexibility to not be stuck on a container ship with a bunch of other product from other companies and if necessary, change the location they were going to while en route. So if the ports of L.A. and Long Beach were all backed up, maybe Oakland or maybe Vancouver as an option.

16:02 - 16:23

And when a company and a CEO, CFO were dealing with the higher cost of getting a good from point A to point B, I guess then at that point in time, they have a choice. They can either take that cost hit, which means profitability comes down, or they can raise prices on their products. I know anecdotally a lot of companies have raised prices on their goods.

16:23 - 16:33

What are you seeing from your seat, Mike, as an analyst covering these diversified industrial businesses, are they taking price? How elastic or inelastic is it?

16:33 - 17:00

Yeah. So just to put some some color around it, the cost increases that some of the companies have been dealing with have been dramatic. So the cost of moving a container from Shanghai to Los Angeles pre-pandemic ranged around 1500 dollars for about five years before the pandemic, early in 2021, that had jumped to $4,000 before peaking last September at around

17:00 - 17:08

And that's if you, I don't know, rent the entire ship. Right. And if you were to take half the container, then I guess the price would be 50% of that.

17:09 - 17:12

Yeah. So that's, that's the price of one of the boxes, one of the containers.

17:12 - 17:14

One box. Yep. One

17:14 - 17:58

Yeah. So last week it was still around $10,000 to move it from Shanghai to Los Angeles. So a multiple of times. And that cost then gets put, as you said, into the cost structure of the companies who then have to decide what to do. In my area, in industrials, historically, pricing was about 1 to 2% a year. And if you went back far enough, it was even flat to down as we were going through this period of globalization, and some of those savings were being passed on to the customers. Fortunately for many of the companies, the experience we had a few years ago with dealing with tariffs taught them again how to work through pricing with their own customers. And so among the companies I follow, pricing is probably up about 5 to 6% on average, but the range is very wide.

17:58 - 18:42

If you have more exposure to steel and other commodities as a function of your cost structure, you would have to pass that much more through. Not everyone's been successful at this. On the one hand, I've heard companies saying there's never been a better time to get price because customers are really focused on availability as opposed to cost. On the other hand, there's been some companies who have struggled, some that have a more direct exposure to the raw materials and some who just couldn't get the pricing done. There was one a couple of weeks ago. They make equipment that goes into data centers. The stock was down 50% in response to their failure to be able to get, to get pricing. That's probably the most severe example that I saw in recent months, but they weren't alone.

18:42 - 18:55

Mike, where do we stand today? Meaning, has it gotten any better or have the disruptions slowed? Meaning, is it not getting as bad as it had been six months ago?

18:55 - 19:16

So when we first talked about this a couple of months ago, I had some notes that were pointing me towards some optimism around things improving and some of that was seasonal as we were coming through the holiday season and then into Lunar New Year. At this point, I'm not feeling all that optimistic. There are still a lot of things that have to get re-synchronized for this to work through.

19:16 - 20:02

I saw a data point just the other day, a survey done by the National Association of Manufacturers here in the United States. They survey their members every quarter on a very...variety of topics. One question I ask was, when do you expect the supply chain improvement to be material? And the bulk of the respondents now see the second half of 2022 or the first half of 2023, and that has moved out from prior surveys. And I think that's what people are coming to terms with and companies are accepting that things have changed, that maybe the era of globalization is over and as a result they're investing in longer term changes targeted, like we were saying earlier, at flexibility and resilience.

20:02 - 20:33

Some of those things are, we're going to hold more inventory to the extent that that's possible, to build that flexibility. And we're going to adopt longer term supply agreements to improve both our visibility and the visibility of our suppliers to work with us. And in some cases, you're seeing companies build new capacity in region. So in our case, that might be here in the U.S. or in Mexico or in Canada to reduce the distances that the materials and the goods are traveling. That gives them flexibility to shift things around or just manufacture more locally.

20:33 - 20:53

That's good. And I wanted to ask you about those longer term improvements. But I guess, Mike, in the near term, what is it that we're looking for? Like, what's going to make this better? I'm going to oversimplify this, obviously, but is it just a significant slowdown in demand that is going to ease the pressures on the supply chain in the near term?

20:54 - 21:13

So it's a function of two things. I think one is time and the other then is demand. And as we were talking about earlier, the volumes at the ports are above pre-pandemic levels. And so maybe you get some normalization in consumer behavior that we're going to all travel a bit more, want to go to movie theaters and restaurants and so that.

21:14 - 21:22

Back to services, to get back to that issue that we talked about earlier, the share of goods versus services has shifted. Does it go back to normal? That would ease some of that pressure, you're saying.

21:22 - 21:54

Exactly. So some of the spending shift would ease some of the incremental pressure on the ports and allow them to catch up or not just the ports. But as we talked about, every step, every link in the chain to essentially catch up. That's going to take time. Now, to the extent that we have a...some sort of an economic downturn or a recession or other reasons that slow consumer behavior, that might accelerate the change. But I think that's really what we're looking at here, is time to work through the congestion and any relief that we get from demand.

21:54 - 22:15

Mike, before we let you go, kind of want to finish on a high note. As you look out over the next, I don't know, five, ten years, are there any winners that come out of this? And not individual companies, obviously, but just sectors or areas that we should be aware of, that given the challenges of the last couple of years, this might have worked to their benefit?

22:16 - 22:43

Yeah, I think that's a great way to wrap it up, and I think the answer is yes. There are some companies and sectors that are going to benefit from this. I mean, in the really short term, this disruption in supply is going to trigger some inventory that's in the wrong places or coming in to the stores at the wrong time. And that's going to be beneficial to some of your off-price retailers or some of the outlets that are there to absorb those inventories under normal conditions. And so those companies will benefit in the short term.

22:44 - 23:17

If I stretch to a longer term view and clearly labor is seeing some benefit here, wages are rising around the world and in many different industries. If I look to those shipping companies that are so strained today, they're really getting much better pricing. So some of the shipping rates are up five times on a contract basis over what they were pre-pandemic. And the companies that supply into those, like the shipbuilders, that's a terribly cyclical industry. But now we've got order books that are at a ten year high as companies are looking to augment that capacity on a more sustained basis.

23:17 - 24:03

We're seeing some really interesting innovations, too. I just read an article the other day about collapsible shipping containers that when they're empty, instead of being shipped back empty, they can collapse them down to one-fourth of one-fifth the size and really create some more fluidity. And then finally, if you look at the companies that I follow, I think that what we're going to see is that those companies that are exposed to U.S. capital spending are going to be in a position to benefit here because the solutions really longer term to this issue are to have a more robust and in many cases more regionalized manufacturing and distribution base. So that's going to support spending on new factories, new distribution here in the United States and also on the technology that supports all of that. And so I do think you've got room for a lot of companies to benefit as this sorts itself out.

24:04 - 24:24

Great. You know, I think it's always important when we get into challenging times like this to not only try and understand as much as possible the challenge in the near term, but also look out and see who the winners are if we look beyond the horizon, which I'm glad you're able to do for us. So, Mike, it's a great question to finish on and we appreciate your perspective and all the work you do for our portfolios. Thanks for joining us on The Pulse.

24:25 - 24:26

Thanks, Matt. It's great to be here.

24:26 - 25:09

And so all of you who have listened to our show today, thanks for joining us. We hope you learned a lot from Mike. I certainly did. And if you're interested in hearing more about the ongoing supply chain issues and inflation, you've several more episodes coming up that will dive into how we're seeing it in different sectors. So please stay tuned for that. And as always, we'll continue to monitor the key trends and the risks in the economy and share them with you on The Pulse. If you've enjoyed this podcast, please subscribe and rate us on Apple Podcasts or Google Play or Spotify or wherever you listen to your podcasts and e-mail us with your thoughts and questions and any feedback that you might have to insights@Bernstein.com. And be sure to find us on Instagram and Twitter at BernsteinPWM. Until next time, thanks a lot and be well.