Mon. Dec 6th, 2021

The author is co-founder of Absolute Strategy Research

The world is probably experiencing the biggest shock for supply chains since British logistics consultant Keith Oliver presumably coined the term in 1982.

As companies respond by raising inventory levels to ensure they have sufficient inventory material, we need to start preparing ourselves for more volatile business cycles.

Some argue that we are close to “peak” stress in the supply chain. The U.S. consumer’s demand for goods may soon begin to return to its pre-Covid-19 trend, as spending gradually rebalances goods to services.

In addition, global business survey indicators on suppliers’ delivery times and component shortages are already at extremes. At such levels, these indicators typically return to average (often rapidly). In Asia, stocks in countries such as Japan and Korea have grown faster than shipments over the past three months.

The more demand and supply move in balance again, the more price pressure should decrease, and inflation rates should fall. In any case, now is not the time for central banks to get caught up in premature rate hikes.

This sanguine view is plausible, assuming the post-Covid inventory imbroglio is only temporary.

But the current level of supply chain stress is on a different scale than the normal, cyclical experiences of the past 20 years. Recent data from the European Commission for the eurozone, for example, show the highest percentage of companies reporting shortages of equipment, raw materials and labor in forty years.

Line chart of factors that limit production in the manufacturing industry (% of firms name each factor) showing that companies in the eurozone are facing an increase in supply constraints

Interestingly enough – and also for the first time in almost forty years – the percentage of companies calling “shortages” has exceeded the number experiencing “insufficient demand”. This is just as important as it is unusual: supply constraints currently exceed demand constraints.

Most policymakers only knew a world where demand was limited and supply was elastic. Whatever the question, China was ready and willing to comply with it as the world’s provider of last resort.

The policy response to the pandemic has upset that balance. High levels of austerity and government transfers during constraints underscored a dramatic recovery in global demand but could not prepare supply, creating a bull-whip effect. Now it is supply that is apparently limited and “inelastic”.

This is a very different policy environment – one where the restoration of global equilibrium in the goods market becomes more difficult; where national output gaps gain more significance; and where ensuring adequate local inventory of goods is of greater importance to both countries and corporations.

The longer the supply chain crisis persists, the more likely companies will be to reconsider their business models. They may decide to invest more to relocate production; they can integrate vertically to take back control of their supply chains; they may start to over-order and carry larger inventory as they switch from a just-in-time to a just-in-case model.

Adapting to these challenges will place additional demands on businesses’ free cash flow and balance sheets. And they can have macroeconomic consequences. Inventory build-up and depletion is a key driver of the economic cycle. The longer inventory levels increase, the more volatile they can become – as can the business cycle.

This supply stress occurs at a time when hyperglobalization is on the back foot, either from tensions between the US and China or from the pursuit of strategic autonomy as nations shift from social to economic distance. There is also pressure from climate transition policies to localize supply and labor markets also remain extremely tight.

Optimists argue that the just-in-time supply chain model with flying flags came through the coronavirus crisis. As nominal demand moderates, as economies rebalance goods to services and as new supply enters into force, concerns about inflation can disappear as quickly as they have come.

The risks, however, are that the scope and duration of the Covid stress test has already begun to challenge the old model. Supply chains have proven to be vulnerable – even if caused by excess demand and underinvestment. Supply chain disruption and increased inventory volatility may not be just a temporary flaw. In which case, if nominal demand continues to grow faster than supply, inflation is likely to remain high and spread to the labor market. The interests of policymakers cannot be greater.

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