COVID-19 Update: Chain, Chain, Chain, Supply Chain of Fools

October 22, 2021 | Matt Barasch


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Rather than our usual dive into COVID, the market and the economy, we thought we would briefly spend some time this week with the global supply chain (spoiler alert, it is having problems), what is likely to happen and what this is likely to mean for inflation going forward.

Let’s start with the supply chain problem. COVID-19 dealt an unprecedented shock to global supplies. Quite simply, we had never turned a “switch” on and off like we did with COVID back in March of 2020. As the NY Times describes: “the pandemic has disrupted nearly every aspect of the global supply chain — that’s the usually invisible pathway of manufacturing, transportation and logistics that gets goods from where they are manufactured, mined or grown to where they are going.” Much of global production starts in Asia – China, Korea, Vietnam – and these areas were hit first by COVID. Further, much of the second stage of production occurs in Germany, which is a manufacturing powerhouse, and the second wave of COVID, which hit Europe after Asia, led to a rapid shutdown in Germany and the rest of the continent.

This would not have been a problem per se as demand was expected to drop with COVID, but the opposite happened. Sure, no one was going to the gym or to Boca, but demand for things such as at home gyms, comfy office chairs you could put in your basement, and cars so you could do a “staycation” to the local national park as opposed to getting on a plane skyrocketed like never before. In addition, if you are going to be spending a lot of time at home, let’s put some lipstick on it – paint the bedroom, put in a new deck, finish the basement, etc. – and demand for all of this stuff soared too.

Factories, of course, tried to respond. This was not necessarily easy as lots of people were sick from COVID and government restrictions made it hard to operate, but for the most part they tried to respond. This gave light to a new problem – the things we buy and the manufacturing base that makes these products has become highly complex over the past two decades. The new refrigerator you bought in 1995 had a motor that cooled the unit, but this motor was fairly basic, and a light that switched on and off when we opened and closed the door (at least we think it went off when we closed it). A refrigerator bought in 2020 has microchips and smart screens and a complex low energy motor. 75% of the world’s semiconductors come from China as do many other key inputs and as demand surged from consumers, demand surged from factories for the key components that China and emerging Asia supplies and this led to massive demand for shipping to get these key components from Asia to the factories. Global shipping buckled under the surge in demand, while supply of shipping containers dried up – leading to a massive bottleneck in the system in which shipping could not be procured, containers piled up at ports because of a lack of shipping, goods sat in factories because of a lack of containers, and so on. And then there’s trucking too – which suffered from many of the same supply/demand issues and is also intricate to the system.

And because things are more complex these days – all it really takes is one problem to basically throttle your whole system. So, if you have a brand of deck stain that combines 18 different chemicals and you can get 17 of those chemicals, but not the 18th because the supply chain is broken – you have no deck stain.

Okay, so we have a broken supply chain, but now what? It is clear that this problem is not going to be solved in short order – i.e. the next 6-12 months. There are simply too many moving parts as we hopefully captured above. But at some point, we would guess late next year into 2023, it will eventually begin to normalize. Demand has already begun to wane a bit as many businesses panicked ordered goods because they could see the problems that were developing and this essentially represented a pulling forward of demand. But more importantly, there is an old axiom of economics – the best cure for low prices is low prices and the worst thing for high prices is high prices. What this means is that when the price of something is too low to make money on, it will not be mined or manufactured anymore. The supply drops and the lack of supply pushes prices higher. As prices rise, those who stopped mining or manufacturing begin to mine and manufacture again (usually with a lag because you can’t just turn a mine on and off on a dime), as supply slowly comes back. Prices still rise because of the lag, which revives even more supply and eventually we get to oversupply, which, you guessed, starts to weigh on prices and push prices back down and the cycle repeats. We are in the phase right now where prices are soaring (duh) and supply is trying to get restarted, but as mentioned, you can’t just turn it off and on quickly with COVID adding another layer to the turning off and on process.

And there’s even one more wrinkle – the labor market is super tight because many people have been very slow to return to work. Now, this is going to get partly fixed by the ending of government subsidies, which is basically unfolding right now in many parts of the world including North America. So, while the supply chains are getting turned back on, this process is slowed by a lack of labor, but this should get better over the next 12-months.

The bottom line is that we should get there – it may take 6-months (I doubt it), it may take 12-months (possible), it may take 18-months (likely) – but at some point we will be back to a mostly normal functioning supply chain.

So, what does this mean to inflation? Prices have gone up a lot – but for inflation to continue to be a thing, they need to keep going up. In other words, if a head of lettuce was a buck and now it’s two bucks, for there to be inflation a year from now, that lettuce has to be more than two bucks. If it’s still two bucks, while that’s a high price and it will crimp your spending on salad dressing (go PC rather than Newman), it is not inflationary. As the supply chain works out its problems, we are going to stop seeing prices go up. This does not mean we are going to see them come down – lettuce may still be two bucks, but if the supply chain is mostly back to normal, there is no economic reason for lettuce to go three bucks. And if it did, so much lettuce would be produced at three bucks that supply would overwhelm demand and we would end up with a lot of expensive uneaten lettuce.

Now, since it is possible that it takes 12-18 months to fix the supply chain, we could see inflation continue at apace for a while. In other words, we are not making a call that lettuce is going to stay at two dollars over the next year. But, as the supply chain normalizes, prices should begin to stabilize. In fact, there is a strong argument to be made that as the supply chain normalizes, we could go through a period of deflation (falling prices). Because the price of many things is at such a high level relative to historic norms, there is a real risk that miners, manufacturers, etc. will overproduce when the supply chain is fixed and we will see the old economic axiom play out – high prices being the worst thing for high prices.