Back to the drawing board: risk versus reward in post-pandemic supply chains

Panjiva Research is taking part in the Portfolio Construction Forum's "Markets Summit 2021 – Back to the Drawing Board" event on March 3. This report forms the basis of our presentation at the event and will be updated with links to the recording and materials.

Supply chain decision-makers, ranging from buyers to investors, must continue to focus on mitigating risk rather than maximizing growth in 2021 as the world emerges from the COVID-19 pandemic. Logistics disruptions, cost inflation, competition for components and viral mutations overshadow the first half. Further ahead, political risks outbalance opportunities as China flexes its power in Asia, the Biden administration applies what still amounts to an "America First" approach, carbon and digital taxes abound, and new trade deals lead to stronger competition across manufacturing industries.

Seven ways risk has usurped reward — how did we get here?

The classic economic value added, or EVA, equation provides two routes to adding shareholder value: raise returns (rewards) or cut capital costs. The latter depends critically on reducing both systemic and company-specific risks. In the period after the global financial crisis of 2007-2008, a decline in the cost of capital may have led many companies to focus more on boosting returns and less on managing risk within the cost of capital.

Events of the past three years have punished such positioning. The rise of economic populism and in particular former U.S. President Donald Trump's trade wars with China and others have added uncertainty and additional costs — in the form of tariffs — to corporate supply chains. The COVID-19 pandemic, meanwhile, has revealed four phases of varying risk environments for corporate supply chains that are continuing today, as discussed in Panjiva's 2021 Outlook.

The first phase, coinciding with the outbreak in China, was an early interruption of supply chains in specific product areas. That led to rapid factory closures in just-in-time sectors, including autos, but had a minimal effect on the economy at large. Indeed, global export activity in February 2020 dipped just 0.8% year over year when excluding China, Panjiva's data shows.

The second stage of widespread destruction ran from initial waves of residential and industrial lockdowns from March 2020 through July 2020. At its worst, global exports fell 23.5% year over year in May 2020, or 28.0% excluding China, which was already well into its recovery at that point. Few industries' supply chains were untouched outside of those necessary for the treatment of the pandemic, including healthcare and home/personal care.

The third stage of reopening is continuing and has proven to be far from smooth, with interconnected supply chains struggling to restart as the pandemic tightens or loosens its grip. The lag in the recovery of exports from the Americas, which were still down 0.5% year over year in December 2020 even though Asia had returned to growth from August 2020, in part reflects the faltering restart of industrial operations between the U.S. and Mexico, as well as the earlier decline in energy commodity prices.

As we will discuss below, the fourth stage, focused on resilience-building in supply chains including government policy action, is barely getting underway. It is worth noting that one challenge in the coming months will be "COVID-19-adjusting" seasonal data — comparisons to prior years may be applicable instead.

Cheap shipping becomes congested containers

Corporate supply chain operators have taken cheap shipping as a given for several years. The shipping bust of 2016 and the bankruptcy of Hanjin Shipping Co. Ltd. highlighted the dangers of a commoditized product — container shipping — and a lack of pricing discipline among the large shipping companies.

The past year has seen a very different picture. The container lines showed clear restraint in "blanking" shipping routes when demand was insufficient, before diligently passing through surcharges as ports and equipment systems became congested during the economic recovery period.

The latter has been driven by a surge in demand for stay-at-home consumer goods during the pandemic in Western consumer markets, shown by a 73.4% year-over-year increase in U.S. seaborne imports of home appliances in the fourth quarter of 2020 compared to a year earlier, Panjiva's data shows. That has continued in the first quarter, with imports through Feb. 14 rising a further 69.3% year over year.

The congested ports have delayed deliveries by weeks or even months. with dozens of ships moored offshore Southern California waiting for unloading as port operations are disrupted by staff falling sick or having to care for family members.

The costs have been widespread. Panjiva's analysis of Shanghai Shipping Exchange data shows that as of Feb. 19, rates for shipping from China have risen 135.7% since the start of 2020 and by 24.9% since the start of 2021, leading them to their highest on record. Shipping from China to the U.S. West Coast has risen 96.0% since the start of 2020, while rates to Europe and Australia have increased 221.3% and 111.2%, respectively.

The annual shipping contract round ongoing currently will likely rake in higher costs for beneficial cargo owners for the coming year. It may also drive a change in behavior, with beneficial cargo owners likely to want fixed-price, all-in fixed-term contracts rather than the more flexible contracts of the past. In that regard, higher costs will have to be traded off against lower risk.

Relief may be some way off. While there has been a surge in new vessel orders so far in 2021, most will not be delivered until 2023. Further, the shipping industry is starting to react to the need to reduce greenhouse gas emissions. That will likely lead to higher but uncertain costs, with freight forwarders including Deutsche Post AG starting to offer carbon-pricing packages.

Dead inflation becomes corporate cost increases

Combining S&P Global Platts container rates with Panjiva's shipping data shows that the hypothetical cost of importing goods to the U.S. by sea rose to $6.36 billion in January from $2.46 billion a year earlier. In the fourth quarter of 2020, the cost rose to $15.8 billion from $6.29 billion, a $9.53 billion increase. In January alone, the cost increase reached $3.90 billion (reaching $6.36 billion from $2.46 billion a year earlier) for one month alone. Indeed, freight costs exceeded the cost of customs duties for the first time.

Commodity cost inflation, including oil, metals and timber, is also increasing. That, combined with the shipping cost increase, is leading an increasing number of corporations to highlight inflation in their earnings reports since the start of 2021.

Panjiva's analysis of S&P Capital IQ transcript data shows 24.9% of calls mentioned "freight" in January compared to 15.0% a year earlier. The greatest uptick in mentions of "freight" was among technology hardware companies (35.3% of calls mentioned the word in the three months to Jan. 31 from zero a year earlier). Meanwhile, the sector discussing the issue most frequently was household durables (55.2% in the past three months from 21.2% a year earlier). While companies are facing higher costs, few have yet discussed how they will mitigate the costs or manage their exposures going forward.

Cutting the fat becomes competition for components

Short-term supply chain management in the auto industry during the pandemic has provided a classic example of why risk management now matters more than pursuing higher returns. Indeed, it illustrates a broader challenge where companies have underestimated the degree to which they do not just compete with peers in their own industries for components; they often have to compete with other industries. That raises the importance of a risk-first mentality with regard to supply chain management.

A shortage of semiconductors for the automotive sector has led to widespread manufacturing closures. General Motors Co. will close four plants through mid-March; Ford Motor Co. is expected to warn that 10% to 20% of output could be lost in the first quarter; Nissan Motor Co. Ltd. will cut its output target for fiscal 2021 by 3.6%; and Honda Motor Co., Ltd. will reduce its production targets by 2.2% for the fiscal year.

The shortfall was caused by the automakers rapidly cutting orders for semiconductors earlier in the pandemic, apparently not counting on chipmakers reorienting production — which has a six-month lead time — toward consumer electronics.

It will take some time to recover. Nissan COO Ashwani Gupta has said, "[W]e do believe that in May or June we should be out of this crisis." Meanwhile, Toyota CFO Kenta Kon is less concerned, previously saying that they "do not see any decrease in [their] production volume" by using high-frequency communications with suppliers to reduce the risk of supply chain interruptions.

Aside from increased supply chain visibility, another solution could be to increase inventories in the future. Daimler AG Chairman Ola Källenius has said, "[I]t makes sense in the future to go into more levels of safety stock," according to the Financial Times (London).

The importance of the automotive sector to the wider economy has also drawn in government intervention, which can be both a blessing and a curse. President Biden has signed the long-awaited executive order regarding critical supply chain security, which will be executed in two stages.

In the first stage, the executive order aims to address "production shortages, trade disruptions, natural disasters and potential actions by foreign competitors" for four key sectors: pharmaceutical APIs, critical minerals, semiconductors and large-capacity batteries. A 100-day review ending April 6 will "identify near-term steps" for executive and congressional action "to address vulnerabilities." There will then be a similar, one-year review to address the defense, public health, ICT, energy, transportation and goods sectors that will also include agency actions more broadly.

Continued plant closures will inevitably have a knock-on effect on parts purchases of other items, particularly those within automotive electrical systems that are closely integrated with semiconductors. Panjiva's data shows that Mexican exports of automotive electrical components climbed 15.6% year over year in December 2020, accelerating from a 10.2% increase in November.

Exporters who have been expanding the fastest may have the most to lose from a sudden grinding to a halt of what had, in prior years, been stable customers. Imports linked to Robert Bosch Stiftung Gmbh climbed 106.9% year over year in December 2020 while those linked to Lear Corp. and Valeo SE rose 69.8% and 31.6%, respectively.

Recovery rebound becomes rebuild requirements

The rollout of vaccines worldwide is a cause for celebration and optimism that a return to normal economic conditions is possible. However, the timing and structure of the recovery will have significant implications for supply chain planning.

From a timing perspective, the reopening of the service economy later in the year may divert consumer spending from goods during the peak planning, manufacturing and shipping period from June onwards. That will leave considerable inventory uncertainties for retailers in particular. Panjiva's data for U.S. seaborne imports shows the distortions caused in 2018 and 2019 by tariffs linked to the U.S.-China trade war.

The need to maintain existing sanitary standards in manufacturing and logistics, which have cut productive capacity, is likely to persist even in the absence of further mutations of SARS-CoV-2, already seen in the U.K. and South Africa.

In that regard, personal protective equipment supply chains have provided a number of cautionary points. A persistent level of medical export protectionism has continued even a year down the line from the pandemic, with 121 restrictions globally compared to a peak of 177, not allowing for the EU's vaccine export scheme.

The emplacement and exemption of tariffs on face masks — as well as a potential exemption lapse, according to Bloomberg News —  has created cost risks for buyers. There have also been short-term disruptions to supply chains in rubber gloves due to forced labor accusations linked to supplies from Top Glove Corp. Bhd. Panjiva's data shows U.S. seaborne imports of rubber gloves linked to Top Glove dropped 83.1% in September 2020 versus their July 2020 peak, with the result that total U.S. seaborne imports over the same period rose only 2.3%. That was due to a 39.4% rise in shipments linked to Hartalega Holdings Bhd. and a 26.5% increase in shipments associated with Sri Trang Gloves (Thailand) Public Co. Ltd. 

China growth engine becomes newly muscular China

Historically, China has provided both a source of low-cost manufactured goods and a market for commodities and other specialty products. More recently, though — whether with Australia over the origins of the coronavirus or with Canada over Huawei Technologies Co. Ltd. — China has taken a more muscular approach toward foreign relations, with a potential impact on the exports from and supply chain activity in those countries.

Australia's exports in the aggregate have expanded 13.0% year over year in January including a 13.2% increase in shipments to China, Panjiva's analysis of official figures shows. That would suggest a limited impact from China's trade actions, although that has been covered in large part by a surge in Australian exports of iron ore and cereals, which rose 53.5% and 67.9%, respectively. There has been a notable drop among products that have been specifically targeted, with exports of beverages and fish down 38.8% and 58.9%, respectively.

A push by the Biden administration to pursue a more multilateral approach to geopolitics with China further increases the risk that the political and economic spheres will clash. U.K. government actions in regard to 5G telecoms and the designation of alleged human rights abuses within trade deals are a potential source of future conflict.

There is no shortage of other trade policy brushfires for supply chain decision-makers to navigate even if the opportunities presented through new trade deals, such as the Regional Comprehensive Economic Partnership and an expanded Comprehensive and Progressive Agreement for Trans-Pacific Partnership, are significant.

"America First" unilateralism becomes "America First" multilateralism

Cost minimization has been the central mantra of supply chain construction throughout the past three decades. That was accelerated by China's accession to the World Trade Organization in 2001 and by a steady shift to low-labor-cost countries for basic assembled products (furniture and apparel) and centralization with economies of scale in more complex areas (telecoms products, consumer electronics).

The implementation of tariff-led trade policies by the Trump administration upended many of these plans. It also led companies serving the U.S. market with the need to offset tariffs through methods ranging from price increases to burden-sharing through supply chain restructuring and legal actions. 

The tariffs have certainly proven effective in cutting U.S. imports of afflicted products from China. Panjiva's analysis shows that imports of list 1 and list 2 products (tariffs applied at a 25% rate since July 2018 and August 2018, respectively, under the section 301 program) that are central to supply chains fell 29.5% in 2019 compared to 2017. Subsequent improvements have largely reflected increased purchasing of COVID-19-related products, as well as exemptions granted where companies cannot avoid tariffs. Imports of list 1 and list 2 products were nonetheless 31.7% lower in the fourth quarter of 2020 versus the same quarter in 2017.

The advent of the Biden administration may have brought a change in tactics, but the broad brush aims of focusing on U.S. employment levels and supply chain security are unchanged. Biden is also in no rush to remove tariffs either on imports from China or other products such as steel, aluminum, solar panels and even washing machines, where the Trump administration used tariffs.

When combined with the administration's new executive order regarding six critical industries, there remain considerable risks around the right way to construct supply chains to serve U.S. commercial and industrial demand. Options range from onshoring to "friendshoring," or locating in closely politically allied countries, to simply diversifying to reduce risk.

Maximizing returns and reacting to risk becomes managing risk and optimizing returns

There has been the emergence of risks beyond the pandemic that raise real concerns for supply chain operations and challenge ongoing assumptions about the right level of risk in at least three areas: environmental risk, political risk and logistical risk.

From an environmental perspective, there has been ample evidence of the effect of extreme weather on supply chains from the recent cold weather afflicting the southern U.S. While not demonstrably caused by climate change, they do shine a light on the effect of a lack of preparedness and focus on short-term cost minimization. Industries as varied as LNG exports, automotive assembly, furniture construction and steel production all faced several days of closures as a result of the Texas storms.

Spending on greenhouse gas reductions will also scale up with uncertain rates and distribution. The steel industry is particularly exposed in terms of carbon border taxes in the EU, the implementation of the Biden administration's environmental policies and global decarbonization commitments that may come to head at the 2021 United Nations Climate Change Conference to be held in the U.K. in November. The EU, U.S. and China accounted for 48.1% of global steel imports in 2019 and will drive the direction and speed of travel for greenhouse gas emission reductions.

Political risk also remains elevated and can only be effectively mitigated by incurring additional costs through diversifying sourcing. The recent coup in Myanmar has compromised apparel and luggage supply chains for companies including adidas AG and Samsonite International SA. Both had increased U.S seaborne imports from Myanmar, with growth of 33.0% and 84.5% year over year, respectively, in the fourth quarter of 2020 before cutting shipments in January. H & M Hennes & Mauritz AB (publ), meanwhile, has been steadily cutting back already. Even putting aside reputational issues, the current protests have disrupted economic operations in the country. Hapag-Lloyd AG has decided to "temporarily suspend any import bookings into Myanmar" due to port congestion linked to the disruptions caused by "continuous daily protests."

Even if political and policy risks can be managed, there are still underlying logistics risks with operating extensive, cheap but fragile supply chains. Those have been brought home in 2020 and 2021 with a series of cybersecurity attacks — including those against CMA CGM SA and Forward Air Corp., which halted their operations — and more recently a spate of container losses-at-sea that have beset Ocean Network Express Pte. Ltd., Evergreen Marine Corp. (Taiwan) Ltd. and A.P. Møller - Mærsk A/S (twice), among others. While accidents happen, their impact can be mitigated through the use of robust, visible supply chains — even if that comes at the cost of reduced profitability in the near-term.

Christopher Rogers is a senior researcher at Panjiva, which is a business line of S&P Global Market Intelligence, a division of S&P Global Inc. This content does not constitute investment advice, and the views and opinions expressed in this piece are those of the author and do not necessarily represent the views of S&P Global Market Intelligence. Links are current at the time of publication. S&P Global Market Intelligence is not responsible if those links are unavailable later.

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