Supply Chain Blues

As a young research analyst in the early 1990’s, I learned all about Japan’s manufacturing competitive advantages which were based on a concept known as “Just-In-Time Processing”. Shortened to the acronym JIT, it’s based on Toyota’s approach to manufacturing which calls for close relationships with suppliers where you can trust that the supplier will deliver the necessary parts on time with few defects. This allowed companies to carry much less inventory thereby making them more profitable. Later, this concept was adopted around the world and like most useful trends, it was taken to the level of absurdity.

Today, much of the world’s supply chain flows through China, a country that has proven to be both unreliable and untrustworthy. It’s also on the other side of the world which means the global supply chain depends on stable ocean travel and relatively benign geopolitical relationships, particularly at choke points like the Suez Canal and Panama Canal.

Recall the giant cargo ship Ever Given getting stuck in the Suez Canal, forcing ocean traffic to back up with no alternate route. Keep in mind that in 1973, the canal was closed to traffic when the Egyptians and the Israeli’s squared off in the Yom Kippur war. Fortunately, back then global manufacturers did not employ JIT; otherwise it would have turned into a world war.

JIT also known as lean manufacturing is a great strategy for maintaining an efficient supply system only it works best when suppliers are relatively close. Every mile of increased distance between suppliers adds to the risk of a breakdown of the system as we are presently experiencing. Add a Communist Dictatorship finally showing its true colors to the equation and the risk multiplies.

The Global Supply Chain

The cost of shipping freight around the world has sky rocketed. The chart below of the Baltic Dry Index has jumped by 300% since the beginning of this year. The absurd part of this jump is the fact that shipping capacity has actually grown 2% since 2019 while unit volume is down 3%. Normally a decline in volume with a rise in capacity is a recipe for declining freight costs. Why the spike in costs?

The problem is timing. In the past, shipping companies could depend on highly forecastable seasonal patterns but not since Covid struck. Not only was much of the world’s manufacturing shut down to fight the virus, the US Congress sent fairly big checks to all of us when we had nothing else to spend it on except imported goods. This created the mother of all timing problems for the global economy as US demand jumped 4% since 2019 even as the rest of the world languishes.

The result is more than 100 ships waiting off various US ports including more than 70 ships waiting to berth at our busiest port, the Port of Long Beach. With the generous supplemental employment benefits being paid to the jobless, they have little incentive to work moving goods. The same can be said for truck drivers. The roads are full of trucks but not enough to keep up with the supply that his hit all at once.

In our last quarterly newsletter, I wrote that it’s now the US Treasury that creates inflation, not the Federal Reserve. We’ve never had a time when the Federal Government sends out checks to taxpayers like today. This is why additional spending packages being floated in Congress may prove dangerous. If we put more money in people’s pockets while the global supply chain is still wrecked, the impact on inflation could be disastrous for our economy.

China Factor

In the US, Covid is largely under control. If you’ve been vaccinated, the Delta variant seems to pose only a small risk – much like the flu. But China doesn’t have effective vaccines; they’re still experiencing bad outbreaks, resulting in cities or parts of cities being locked down.

Perhaps the worst thing about China right now is the rolling blackouts they’re experiencing in their electric grid. Electric grids are like a tub of water that needs to remain at a constant level despite water coming in and going out at the same time. Any declines in water coming into the tub needs to be met with a similar decline in water leaving.

China’s electric grid gets 63% of its electricity from coal-fired plants. Recently, China decided to stop the importation of Australian goods after the Australian government called for an international body to investigate the origins of Covid at the Wuhan Institute of Health. China retaliated by slashing coal imports from Australia along with other goods.

This is significant because Australia produces very high quality coal, unlike Chinese coal and the coal from other trade partners. In fact, much of China’s vaunted export industries lie in regions where until now, Australian coal was used exclusively.

The result has been rolling blackouts, particularly in regions such as Guangdong Province which is responsible for 10% of China’s GDP. The result has been a disaster for the Chinese economy while adding further pressure to the global supply chain. China’s Premier, Xi Jinping, finally got the message last week and told his electric utilities to buy fuel “at any price”.

But this brings up another problem in China and that is profitability at their electric utilities, or should I say, level of losses. In 2020, China’s electric utilities lost money because the government set retail prices below China’s break-even price. Since then, the price of coal and natural gas has skyrocketed – that’s a 500% increase in the chart below. This means that for every increase in unit of electricity, Chinese electric utilities lose even more money. They’re going to need a bailout before much longer.

Notice I’ve yet to discuss the elephant in the room in regards to China – Evergrande. Some of you may recall that we anticipated the 2008 financial crisis ahead of time by focusing on the egregious lending practices taking place in our domestic real estate market. China’s real estate market is infinitely worse.

China is an integral part of the global supply chain and they’re experiencing a demographic crisis, a water crisis, a real estate crisis, a financial crisis, an energy crisis, and a pandemic all at once.


The Federal Reserve has been printing money for the past 12 years yet prices have remained benign until just recently. Perhaps it’s not the Fed after all, as I pointed out in our last newsletter. Instead, it’s a combination of the US Treasury putting a lot of money in people’s pockets during the worst of the pandemic combined with difficulties in the supply chain.

So why are oil prices up when vehicle miles driven still hasn’t recovered to pre-pandemic levels? The answer is hoarding. People believe inflation is coming despite it no longer being correlated to the Federal Reserve’s balance sheet.

So if inflation is going to run rampant, why isn’t the price of copper soaring? Why is the dollar getting stronger in world markets?

Instead of inflation, we believe the past “efficiencies” garnered by moving the supply chain to low cost countries like China are presently being unwound due to the inherent weaknesses in a supply chain that wraps around the entire world. Corporations chose to follow strategies that were never meant to be used with a long distance supply chain and now we get to pay the price. This is why I don’t believe that we’re going to get a “structural inflation”. Instead, I believe that many of the temporary efficiencies of running the global supply chain through China are over.

Corporate Profitability

The demise of China marks the end of a cycle where US corporations were able to “farm out” many of the least profitable parts of their financial models. Whether it’s the inability to get product or paying more for the inputs to their value chains, US corporations are going to have a difficult time maintaining current profit levels. In effect, we may experience an unwinding of all the virtuous elements of the past 25 years where outsourcers were able to bounce from low cost to low cost locales with comparatively few barriers to exit.

Nations such as Vietnam and India will pick up manufacturing market share but I’m not sure it will be the same, particularly as logistic managers re-examine assumptions about the ease of moving inputs across the globe on a timely basis. As I wrote earlier, JIT is about trusting your suppliers.

If nothing else, they’ll want to keep additional inventory on-hand, which brings up risk of spoilage or obsolescence. The stock market continues to price in perfection but if it follows the Y2K analog, we should be able to obtain the stocks we want to own for the next cycle at opportunistic prices.

The GeoVest Approach

If prices continue to rise, the Federal Reserve may be forced to stop injecting excess liquidity into the markets. This is because I believe they’ll want to maintain the illusion that they can still impact the economy. If this happens, stock market returns may become VERY volatile.

The good news is that successful investing will likely return to identifying emerging trends and determining who has the competitive advantages to profit from those trends. This is where we excel as a firm.

Specialty chip production, cyber security, banking with blockchain technology and upgrades to our electric grid appear to have long term prospects irrespective of the global economy. A shakeout much like the year 2000 is likely which should allow us to execute our future purchases with discipline and insight.

We’re long term investors. The past two years have been dominated by wild trading strategies much like the year 1999 but it appears that game is over. Thank you and it’s our continued pleasure to serve you.

Philip M. Byrne, CFA
Chief Investment Officer