Supply Chains, Bottlenecks and Cost Inflation

Supply Chains, Bottlenecks and Cost Inflation

Supply chains are central to the functioning of the world economy. Their importance has been unveiled recently by issues like Brexit, the Pandemic and more recently by disruption to shipping in the Suez Canal.

Supply Chains

At their most efficient, supply chains allocate capital and resources effectively. When optimal, prices of goods fall helping fuel prosperous trade.

Getting goods to those in most need, and quickly, was starkly revealed last year when supplies of PPE abroad fell short at a time when demand soared at home. Panic buying was evident for a short period.

As the virus took hold early in 2020, businesses and households also cut demand for goods. This is clearly visible in Chart 1 below – the dark blue bold line dropping sharply. Fortunately, this demand shock was followed by a rapid recovery as economies started to emerge from lockdown, helped along by policymakers safeguarding incomes and businesses. PPE supplies also normalised.

As demand recovers the benchmark Baltic Dry Index (BDI)– the light blue dotted line – is responding positively too. It has started to pick up. The BDI is a proxy for freight rates (cost of transporting) and a good indicator of trade activity.

 

Chart 1 – World Trade Volumes and the Baltic Dry Index

Source: CPB and Bloomberg, 29th March 2021

Bottlenecks

More recently the issue of supply chains has been amplified by the world’s largest container ship, Ever Given, managing to get itself wedged in the Suez Canal. Since March 23rd it has chocked off trade but thankfully it is now floating free.

The Suez Canal is a key shipping lane linking Europe to Asia. Last year 19,000 vessels passed through this maritime shortcut. In context 12% of global trade by volume and 10% of the world’s oil follows this route. Naturally, when something like this happens a reaction is inevitable. We know that by blocking other vessels, delays have pushed some costs higher.  Most noticeably was the cost of oil, up 6% (Brent Crude) shortly thereafter.

However, a shortage of containers and slower handling speeds pushed up freight costs. It now costs $8,000 to ship a 40-foot container from China to Europe, almost quadruple the figure a year ago.

Cost Inflation

With economies in recovery mode businesses are now facing new cost pressures. Air and freight costs are higher as are key commodities oil and iron ore.

Input price pressures are showing up in the cost of producing and manufacturing US capital goods – Chart 2 US Purchasing Managers Index (PMI).  The Manufacturing Goods Price PMI (orange dotted line) has risen by 76% since April 2020. Increases have been broad based; encompassing metals, energy and semiconductors (discussed in our article “The world needs Chips”).

Chart 2: US Manufacturing Input Price Index and US Inflation (PCE)

Source: FactSet, 30th March 2021

As prices increase downstream the prices of finished goods are expected to rise. This is one of the reasons why the US Federal Reserve revised their inflation expectations above their 2% average target.

Central Bankers and investors expect inflation to accelerate as the recovery takes hold, but whether this is transitory or embedded is hotly debated right now. Unfortunately, inflation is difficult to predict at the best of times.

In Chart 2 we show a different, broad, measure for inflation. One based on consumer spending – Personal Consumer Expenditure (PCE). This index covers goods and services too, and it indicates an uptick in US inflation is already underway.

Here in the UK input cost price pressure are also evident. According to the Office of National Statistics (ONS), UK producer price inflation increased 0.6% over the month in February, after increasing 0.8% in January.

What lies ahead?

Next month US companies will be releasing their latest company results for the first quarter of 2021. This provides another opportunity to review input and output costs, and how they have evolved. Investors will be looking to see if business profit margins are holding up and where the pressure points are. If margins hold, or expand, investors will be more sanguine about assigning higher valuation, particularly for those businesses that display greater pricing power over competitors.

Make no mistake, disruption across supply chains and higher input costs represent a real challenge. Ironically, this is what drives innovation, with technology and science offering solutions. Successful businesses grab opportunities and, in the process, become resilient and ultimately prosper. This is another lesson learned from the recent past, and one that rarely changes.

Global Markets