The potential shifting of trade policies toward de-globalization could pose new hurdles for global supply chains that have long-lasting effects and ultimately pressure the bottom lines--and thus the credit quality--of import-reliant firms.
Ultimately, S&P Global Ratings believes a broad or rapid disruption of, and rise in costs related to, supply chain efficiencies--through either trade-agreement revisions or the equivalent of increased tariffs--would affect a variety of industries on different levels. Given the continued uncertainty associated with trade and tax reform, it's premature to discuss potential credit implications for individual companies. But high-profile industries that could be materially affected include autos, retail, transportation, consumer products, and technology.
While previous disruptions in supply chains--such as the 2011 earthquake in Japan, which damaged a key factory of semiconductor manufacturer Renesas Electronics Corp.--have been severe, they've also been short-lived. S&P Global Ratings believes that de-globalization could change the way multinational corporations manufacture and distribute goods--not just in the near term but for decades to come.
The vote by Britons to leave the EU was perhaps the first jolt to any complacency about the continued march of globalization. Any lingering doubts that a new nationalistic focus was sweeping through the Western World were quickly quashed by the election of Donald Trump as the 45th president of the U.S., whose promises to tear up the North American Free Trade Agreement (NAFTA) and vehement opposition to the Trans-Pacific Partnership (TPP) appealed to American voters disillusioned with an economy mired in a period of historically slow growth.
Emmanuel Macron's decisive victory over Marine Le Pen, the leader of France's far-right National Front Party, in the second round of presidential elections in France, as well as the earlier defeat of Geert Wilders for the post of Prime Minister of the Netherlands, show that a shift toward de-globalization faces stiff opposition in the EU. Yet it remains to be seen whether anti-globalist sentiment has peaked or whether the setback is temporary.
We think skepticism of globalization partly reflects discontent among a significant portion of the population that hasn't shared in promised economic prosperity. In many advanced economies, the Great Recession resulted in the widespread loss of jobs and, in the U.S., homes--a key source of wealth for many in the middle classes. This heightened the focus on increasing income inequality, jobs lost to low-wage countries, and a sense that the economic future will be dim for all but those at the higher end of the wealth spectrum. In addition, fears of terrorism, a sense that countries have lost control of their borders, and questions about national identity have all contributed to the success of candidates promising to bring back local autonomy--as well as manufacturing jobs.
As a consequence, political risk appears to have the potential to disrupt existing U.S. supply chains significantly. President Trump's pledge to put America first has found expression in his tax-reform plan, which would reduce the top statutory tax rate on corporations to 15% from 35%. House Republicans have a similar proposal to reduce the rate to 20%. To offset the loss of tax revenue, both plans have suggested initiatives such as tariffs and border taxes on imports. There is also talk of a reciprocal tax that mirrors the tariffs U.S. products face with each nation into which it exports. Moreover, the Administration might renegotiate NAFTA. If, for example, the rules of origin were to be tightened and require products to have a higher amount of local content to qualify for duty-free access, this would raise the trading costs, making it more likely that trade would decrease and supply chains be disrupted.
Clearly, the imposition of significantly higher import taxes--whether a border adjustment tax, a reciprocal tax, or some other variant--would raise the cost of doing business for import-heavy industries in the U.S. Such a move could also bring on retaliation from other countries, forcing firms to adjust their supply-chain strategies until there's a new equilibrium.
To be sure, this wouldn't be the first time companies would need to adjust to such shifting supply-chain dynamics. By the late 19th Century, the sourcing of raw materials and trade in goods had become a global affair. By telegraph, a company in London could order a shipment of goods from Germany, India, or any number of outposts around the world. Unfortunately, this newfound interconnectedness didn't prevent international conflict, and World War I put an end to the benefits that the easier flow of goods conferred. It wasn't until after World War II that the seeds of the modern economic order were sown.
Now there are a number of sources of supply-chain risk (see table). In 2011, for example, nature was the culprit, when Renesas suffered earthquake damage at one of its major factories, 70 miles northeast of Tokyo. The company supplied 40% of the microcontrollers for the auto industry, and the affected facility accounted for about 25% of Renesas's global microcontroller capacity. The company worked around the clock to supply the needed chips. And while the disruption to the auto supply chain was severe, it proved temporary.
Sources Of Supply Chain Risk
|Political risks||These span several categories: legislative, legal, regulatory, and security. Legislative threats tariffs and quotas. Legal threats include lawsuits, violation of intellectual property rights, and criminal acts by employees. Regulatory risk involves penalties for failure to comply with labor, environmental, and safety rules. Security threats include high crime rates, terrorist acts, nationalization, civil unrest, and political instability.|
|Environment risk||This includes the impact of climate, weather, and geography on centers of production or on the utility and transportation infrastructure that supports the supply chain. Specific threats include hurricanes, typhoons, floods, earthquakes, tornados, tsunamis, wildfires, and extreme heat and cold.|
|Financial threats||These involve the loss of lines of credit because of a banking crisis (something that occurred frequently in 2007 to 2009), currency devaluation, major market fluctuations, or the failure of a financial institution or even economic collapse of a country. In addition, prior government incentives--such as tax subsidies or favorable financing terms--could end or phase out.|
|Energy threats||These include the effects of rising energy costs on production and transportation expenses. Customers may also be more inclined to substitute a new or existing product for one whose price is increasing with rising energy costs. Other sources of energy are unlikely to ease demand for fossil fuels in the next few years. Given the meltdown at Japan's Fukushima power plant, several governments have raised concerns about the safety and long-term economic viability of nuclear energy as a carbon-free fuel. In addition, we believe renewable sources of energy (such as wind and solar) will provide only a small percentage of worldwide energy use for the foreseeable future.|
|Health threats||These include the impact of sickness and quarantine on a workforce because of epidemics such as the avian flu or SARs. It also encompasses unsafe labor conditions--such as exposure to dangerous levels of emissions, toxic waste, water and soil contamination, fire and explosions, and building and mine collapses.|
|Demographic risk||This indicates the shrinking supply, especially in the developed world, of qualified workers and rising health care and pension obligations because of an aging workforce. It also refers to changes in the consumption and investment patterns of nations as populations age.|
|Information risk||This category covers inadequate information systems that do not support the business mission because they are not designed well or are prone to failure. It can also involve the disruption of information systems by hackers and security breaches of valuable customer information.|
Re-Engineering The Supply Chain
Against this backdrop, American companies would, in our view, shift at least some production back to the U.S. to deal with the imposition of significantly higher import taxes. Those with returns on invested capital (ROIC) that would decline as the result of an import tax would naturally seek out new efficiencies to cut costs. Therefore, because the supply chain determines how a company captures and delivers value to its customers, we expect firms would go back to the drawing board and re-engineer them to try to restore margins to previous levels.
Delivering value can be achieved by lower costs or providing customers with better products or services. Supply chains, for instance, can help firms reduce costs by being more responsive to customer demand and carry less inventory. But optimizing supply chains isn't just about cost reduction. Competitive advantages can also be achieved through faster order fulfillment and customized services. For instance, when a product is out of stock, shoppers will switch and purchase other brands 25% of the time. Supply chains that result in fewer stock depletions increase sales and can ultimately boost margins, with lower fixed costs as a percentage of sales.
Re-engineering supply chains typically involves a series of often-lengthy steps. First, a company must understand the strengths and vulnerabilities of its supply chain--from procurement to production to shipment. Beyond these internal operations, companies must also be able to assess the health of their direct--and even indirect--suppliers (so-called Tier-2 and Tier-3 suppliers) to know if support is needed.
Unless a supply chain is purely demand-driven (a so-called pull versus a push chain), suppliers must forecast future customer demand to plan production and schedule distribution. In that case, it's important to generate the most accurate forecasts, avoiding making predictions by detailed product categories or particular items, and accounting for market conditions. In addition to input from all relevant parts of an organization--sales, marketing, procurement, etc.--it helps to reach out to customers for information about end-market demand.
The next step is to identify the critical points of failure in supply networks, which map the flows of goods, financing, and information among suppliers and customers. Points of vulnerability can include long lead times, sole sourcing of supply, and overdependence on key personnel and technology.
All of this gives a company the tools it needs to re-engineer its supply chain, which often involves reducing unnecessary complexities. This can be done, for example, by consolidating manufacturing facilities or warehouses. (At the same time, too much concentration can reduce the flexibility of a supply chain to adapt to changing customer demand.) Reducing variability, too, can improve a supply chain. Bottlenecks can be eased by increasing production capacity or holding more inventory, though this could raise costs.
At any rate, even the best-designed supply chain will fail at some point, and so it's important that companies dedicate staff from different areas to dealing with emergencies. In the best cases, teams will have performed scenario analyses to come up with a range of contingency plans. Finally, it's important that firms collaborate with suppliers and customers to create even more realistic and robust responses to network failures.
Supply Chains Today Are Optimized For An Open World
Efficient supply chains help companies increase profits, manage costs, and better compete in domestic and foreign markets--all while allowing for more flexibility. For example, research shows that companies turn to outsourcing and offshoring after economic recessions as a way to increase production without adding much to capacity and hiring. (Clearly, there are negative effects to this, most notably the loss of manufacturing jobs in a country.)
Global trade has expanded rapidly in the past few decades--not only in final products but in intermediate inputs as well, reflecting the growth of global supply chains. For example, in the electronics industry, perhaps the most globally integrated, the value of trade in intermediate goods has caught up with the value of trade in final goods (see Chart 1). After a growth spurt since the mid-2000s, the global trade in electronics has been leveling off (and decreased sharply last year) as supply chains reach a more mature phase.
Global trade now accounts for about 20% of the world economy, up from 14% in 1990 (see Chart 2). Among the U.S.'s NAFTA partners, the share of imports in Mexico's economy has climbed steadily after eclipsing that of Canada's in the mid-2000s. Even in the U.S., which is characterized as domestic-focused because of its large services sector, imports are significant. The percentage of foreign content in U.S. purchases ranges from 52% for autos to 84% for apparel, which--in addition to computer and electronics--are among the sectors which we think are most vulnerable to supply chain disruptions (see Chart 3). It's worth noting that industries that export more, such as machinery and chemicals, also have significant import content.
To be sure, advances in technology, transportation, and logistics have all boosted the growth in global supply chains. But as important to this dynamic are open and stable political conditions in emerging markets, and a generally trade-friendly global environment, which we believe is now more uncertain (see "Borrowers In The U.S. And Canada Are Enjoying Favorable Conditions, But Risks Are Growing," April 4, 2017.)
Assessing The Effects On Credit
Ultimately, we think there could eventually be some credit implications in several industries, including autos, retail, transportation, and technology. For U.S. borrowers that import a high percentage of intermediary and final goods, after-tax earnings will likely suffer, absent the use of tax assets and other firm-specific mitigating factors.
We believe the automotive supply chain would be disrupted if the new administration follows through on a tax for imported vehicles and auto parts. A border adjustment or reciprocal tax of 20% or more would lead to a significant shift in production back to the U.S. It is estimated that U.S. automakers and suppliers import 50% of their vehicles and parts from Mexico, Japan, China, and South Korea. Although the impact of the import taxes on individual automakers and suppliers will depend on their exposure to production outside the U.S., we would expect the overall after-tax earnings of the industry to fall materially.
We believe companies will try to offset import-tax-related ROIC declines by realizing new efficiencies and thereby decreasing costs. This could be accomplished by firms re-engineering their supply chains to optimize value creation.
Retail and consumer goods
U.S. retailers generally carry merchandise from a number of vendors, which mitigates the effects of supply-chain interruptions. In this light, threats to the supply chain haven't been a major concern for borrowers in the sector, and many large retailers have been able to survive serious, but temporary, disruptions without incurring significant damage to their bottom lines or creditworthiness. However, we now believe potential disruptions pose a more significant risk. Given the trend toward increasing isolationism, well-established supply chains could soon have to adapt, becoming more local or at least regional. This would be a complex undertaking, carrying some operational risks, and it would likely raise costs and pressure margins.
This comes as many retailers' revenues and margins are already under pressure given a supply network that is increasingly outdated in light of consumer shifting preferences. Inbound sourcing and supply logistics are slow to react to such shifts, and outbound logistics (including store footprints) were built at great cost for a different era and can't be repurposed easily. We believe that for certain sectors--in particular, department stores and apparel retailers--the failure to make supply chains faster, less costly, and more nimble will eventually weigh on credit quality. Given persistent sales declines for some retailers, it arguably already has. Competition from online and unrated retailers is forcing department stores and apparel sellers to re-examine their speed from merchandise planning to store shelf. For a wide range of retailers, speed of delivery has become a major competitive consideration. In this light, well-established supply chains (both inbound and outbound) don't represent the competitive advantage for large retailers that they once did.
On the other hand, we don't see increasing de-globalization as having a material direct effect on the consumer products sector. Most consumer products companies aren't large importers, and so protectionism in the form of a border tax would likely have a minimal impact. Food companies that sell or use produce such as coffee, tea, spices, and bananas could have to raise prices if an import tax is implemented because these items can't be produced in viable quantities in the U.S. But these aren't big-ticket purchase, and we beleive companies would have to increase prices only modestly. That said, if retailers' costs were to rise significantly and they were unable to pass these costs onto consumers, they could look to consumer products companies to absorb some of the costs, thus putting pressure on margins for borrowers in the sector.
The direct risk of de-globalization varies significantly for transportation and logistics companies (a partly overlapping term for companies that move inputs and inventory from suppliers to producers, warehouses, and customers). Trucking companies have an overwhelmingly domestic focus and would likely be least affected, particularly if trade relations with Canada change less than those with Mexico (which has more-limited cross-border truck traffic). Still, given that the final delivery of imported goods is usually done by truck, the sector would suffer to some extent from reduced international trade. Certain railroads are somewhat more at risk, as they carry international goods from ports into the U.S. interior or on transcontinental journeys. Another transportation sector that could suffer disproportionately from rising trade barriers is large package express companies, which are closely involved in many manufacturers' supply chains because they can provide rapid, reliable, and closely tracked movements of mostly high-value goods.
Any protectionist stance that raises barriers to international trade, unwinds cost efficiencies from global supply chains, or imposes significant tariffs or taxes on imports would have moderate effects on the U.S. capital goods sector. And in some cases, those effects could be beneficial. Because many of the borrowers we rate in the sector are net exporters, a border adjustment tax could have some positive effects. However, this doesn't remove the uncertainty of whether increasingly isolationist policies would ignite a trade war, what the impact would be on suppliers (which may be significant importers), or what revenue pressures customers outside the U.S. would feel. At any rate, the capital goods sector--which includes manufacturers of heavy and light industrial equipment, machinery, and industrial components--operates day-to-day in large part because of a far-flung supply chain organized to provide raw materials and other components as needed. The frequent need to manufacture products geographically close to their sales markets, particularly when inputs are produced elsewhere, highlights the importance of a reliable supply chain. Because the borrowers we rate have established relatively efficient supply networks, we would expect limited shifting of production to the U.S. in response to protectionist policies.
With the supply chain of technology companies becoming increasingly complex and global, any failures or disruptions could significantly weigh on the operating performance of semiconductor vendors and original equipment manufacturers (OEMs). Most of these companies, including those in the U.S., have outsourced production and assembly for many years. As semiconductor makers develop more-sophisticated designs, we expect they will continue to outsource most of their manufacturing to Asia, benefiting from foundry size, technological advancement, and low labor costs. Similarly, for OEMs, focusing more on product development and marketing by outsourcing manufacturing and assembly to lower-cost regions has led to the creation and prevalence of the electronics manufacturing services (EMS) sector. We expect OEMs will continue to avoid supplier concentration when possible. At the same time, a too-extensive supplier network could become difficult to manage and constrain OEMs' ability to extract better contact terms. The quality of an outsourcing partner is one of the most important factors in supplier selection, as it can have a significant impact on an OEM's competitive position, especially in such a rapidly evolving industry. The loss of a supplier's competitive edge--even for a short time--can pose big obstacles for an OEM. As such, we still find them sole-sourcing certain components as the technological advantage and operating scale and efficiency outweigh concentration risk in many instances.
Streamlining Cost Structures
All told, we believe that rising de-globalization could disrupt global supply chains. The ramifications of this could have long-lasting effects that ultimately pressure manufacturers' bottom lines and thus their creditworthiness.
In this light, we expect companies to streamline their cost structures if after-tax earnings are hurt by such things as tariffs and border taxes. We believe companies could achieve this by re-engineering their supply chains to optimize their financial performance. And those borrowers that quickly and intelligently adapt to these changing political realities may have the chance to improve their competitive position vis-à-vis their less-responsive peers.