What The Hell Happened To The Supply Chain?

Out Of The Frying Pan Into The Fire

Let’s talk about lumber. During the past year, Covid restrictions kept labor at home and temporarily throttled the production capacity of US and Canada sawmills. But, demand remained strong or grew as people working from home pursued improvement projects. The sawmill downtime depleted wholesale and retail inventories and, with demand spiking, mills are now unable to keep pace with demand. Industry developments such as lean manufacturing and sawmill consolidation over the past decades have created a bottleneck, limiting the capacity of finished goods timbers, all while the price of planted timber has continued to fall. 

As a result of these discordant conditions, finished timber prices have soared 400%, while houses are up 15% on average. Those issues are compounded with shortages of every material and appliance that goes into a new home. Record demand for housing and limited inventory caused home builders to reach near-record starts in March 2021, only to plummet in April as home builders are unwilling to undertake new builds with such high prices for raw materials in the midst of market uncertainty.  

Some lumber mills are slowly adding capacity that is expected to come online sometime next year. Yet, many others are keeping capacity as is, betting the current demand spike will be short-lived as the pandemic ends and homeowners put their homes on the market. This creates a situation of engineered stagflation: a self-fulfilling prophecy where lack of investment in additional capacity leads to higher prices until products become unaffordable and consumers drop out of the market. 

Across the economy, producers of many raw materials have not increased capacity during this turbulent time. When and if they do decide to add capacity, it will take 18-24 months to come online. Copper, iron, steel, aluminum cans, lumber, semiconductors, plastic, cardboard, corn, coffee, wheat, beef, chicken, and soybeans are now all in short supply. Forecasts predict these shortages to last at least 6-12 months, if not longer.

Producers are playing a most dangerous game. Allowing prices to remain elevated for extended periods encourages buyers to seek alternatives that, once adopted, will lead to a permanent loss in market share. If lumber prices stay high, we could see companies expand investment in modular home construction, concrete 3D printed homes or some other disruptive construction technique. Similar stories could play out across different sectors. 

Economists believe it will take 2-3 years for the $2.6 Trillion in pent-up savings to work its way through the economy. At the same time, societal changes that include hybrid/permanent work from home, immigration across state lines, population growth, urbanization, and millennials becoming homeowners faster than baby boomers are leaving theirs, are all trends that will keep demand elevated over the next decade. 

Bottom line, we are facing an uphill climb due to a combination of constraints that will limit our ability to recover. Simultaneous production capacity limits, labor constraints, and logistics pressures are creating a real risk of an extended inflationary period.

Production Capacity 

Panic buying is usually associated with emotional consumers. Now companies are overbuying raw materials as they fear they won’t be able to get the materials they need to meet customer demand. Increased order volumes and decreased capacity have resulted in the lowest inventory-to-sales ratio on record. You can’t build safety stock if there isn’t any inventory available to build.

Process Constraints 

Over the past several decades consolidation across industries has drained excess production capacity around the world in an effort to improve efficiency. Lean production combined with globalization has created a fragile production environment that cannot respond to rapid changes in demand and disruption. 

With a surge in demand and static capacity, supply chain disruptions create rapid increases in prices or even extended periods of stock-outs.

Multi-application products like semiconductors will see disruptions reverberate throughout the entire system. First, the semiconductor shortage hit the automobile industry due to their own follies of canceling orders during the pandemic. Now, the shortage is beginning to spread to consumer electronics like cell phones and other smart devices. 

Labor Shortages 

The current labor shortage is expected to worsen through the summer before turning the corner in the fall. The primary driver of labor shortages has been the 7 million Americans unable to return to work due to child care constraints. Many of those people will only return to the workforce when schools and daycares reopen. 

The second-largest cohort in the labor shortage has been the 4 million Americans not returning to work due to fears of getting and spreading COVID to vulnerable family members. They will return to the workforce as vaccination rates increase and the country approaches herd immunity. 

Lastly, there is a small but observable cohort who earn more on enhanced unemployment benefits. They are already returning to the workforce as various employers voluntarily increase wages, and certain states cancel federal unemployment benefits. The workforce fills in with the highest paying jobs returning first and the lowest paying, highest stress jobs like restaurant workers returning last.   

Logistics 

Container vessels are now operating at max capacity and clogging ports in the process. Only 40% of global shipments arrived on time in March, leading to multiple week delays on goods delivery. What used to be a 14-day trip from China to California now takes 33-days as ships sit idle waiting to dock in port. This has resulted in Maersk losing 20% of their Asia to West Coast capacity. Maersk’s order cancellations are at the same level as they were in March 2020 when US import demand bottomed out. 

This is occurring while shipping rates skyrocket, with some paying 2-3x more compared to the same time last year. 60-70% of global shipping costs are managed by yearly contracts that were renewed in April and May, with those costs just beginning to reach consumers.

Shipping containers are plunging into the sea at the highest rate in seven years under conditions that are increasingly demanding. Bigger ships allow containers to be stacked higher than before. The overworked crew may not secure the load correctly and inaccurate weight logs may result in top-heavy loads. These ships are also driving through increasingly unpredictable weather in an attempt to take a quicker, more direct route and avoid the time it takes to divert around these obstacles.

Correspondingly, demand for shipping containers is at an all-time high. 80% of all shipping containers are produced in China. While production has increased in the past year, manufacturers see no reason to flood the market with containers after struggling through years of low prices. 

The trucking industry faces an ongoing labor shortage as well as an equipment shortage. Lack of semiconductors limits OEM’s capacity to build Class 8 trucks. While the industry struggles with its aging workforce and the difficulty recruiting new drivers from a labor pool that reads articles daily about autonomous vehicles that are going to put drivers out of work - a self-reinforcing cycle. This has led to 20-25% of all tank trucks that supply the nation with gasoline to be sitting idle waiting for drivers. As summertime demand comes online, continued price hikes and shortages due to these factors are likely. 

Warehouses and distribution centers are facing a shortage of pallets along with their own equipment constraints and labor shortages, adding further delays. Products that used to get to market in 30 days are now taking 90+ days on average. One major bicycle manufacturer went from a 30 day cycle time to 300 days with no end in sight. 

Inflation

Inflation is being driven by significant increases in consumer demand and rising costs of commodities, transportation, and labor, which are exacerbated by the unprecedented shocks to the system. Major storms, historic droughts and rain, ships stuck in the Suez, hackers taking down critical infrastructure, crumbling bridges, train derailments, and shipping containers falling overboard each create little shocks. The regularity of these kinds of shocks in a system that is already struggling to meet demand means pricing power for producers.

The Fed is correct to assume that inflation will be transitory if you simply look at government intervention programs. What the Fed fails to account for in their statements are the unforeseen downstream effects of supply chain disruptions. A case in point: April’s CPI numbers increased 4x expectations due to increases in used car prices caused by the semiconductor shortage. 

This is only going to get worse over the summer as normal seasonality amplifies the demand curve. We’re heading into peak season for construction, shipping, travel, and gasoline usage. If expectations change from inflation being short-lived and transient to significant and longer-term, a runaway inflation scenario becomes possible.

What Companies Can Do Now To Survive

Businesses are between a rock and a hard place. The choice is between pulling back as prices rise and potentially not having enough raw materials to service your customers while overhead costs slowly kill the business. Or take a risk and accumulate excess inventory at 50%-400%+ surcharge, eating some of that and passing the rest off to consumers, who may stop buying at any moment. Below are some strategies to consider to help your business survive: 

• Communicate early and often. Let your customers know prices will be increasing and plan with them accordingly. See if they plan on cutting back or if they want to put in a massive order to build safety stock.
• Segment your markets and test pricing power with some customers before pushing higher prices on your best customers.
• If need be, use your POs, AR, and Inventory to get additional working capital
• The single biggest metric to track is your variable margin. Do a break-even analysis and determine exactly how much margin compression you can tolerate before you start to lose money servicing your customers. 
• Raise prices sooner rather than later. If possible, create expectations with customers on how often you’ll be reviewing materials costs and when they will be notified.
• Use the language of a shared burden when discussing price hikes with customers. The business environment is at fault, you're doing your best to absorb as much cost as possible, but can’t do this all alone and need your customers to share that burden with you as well. 
• Keep an eye on cash flow and make sure inventory builds aren’t going to do you in. 
• Do not sign long-term contracts without some sort of materials hedge. 
• Buying safety stock isn’t panic buying, it’s being prepared for what is to come. Anticipate what might be in short supply in 6 months from now and load up on those as well. 
• Lock in domestic second source suppliers with minimal international trade risk. 
• Prepare now for interest rate hikes. If you have loans coming due, don’t take for granted the banks will automatically renew. 
• If you took out government loans during the pandemic, do what you can to get the government off your balance sheet as soon as possible. 

Originally Published at: https://meadowlarkadvisors.com/2021/06/05/what-the-hell-happened-to-the-supply-chain/