Crack! Beware the inflation bullwhip

Deutsche with the note on why elevated US activity and inflation are not over yet:

Sorry, we’re out of stock

So far, share markets have been relatively calm about supply chain problems. This could signal investor complacency given that reports of supply chain shortages and price jumps have been hard to avoid. One of the most worrying examples is the global chip shortage. Indeed, the world’s dependence on semiconductor chips has been exposed during the covid pandemic as customers rushed to buy computers, game consoles, televisions, and electronics in general.

Carmakers have been some of the companies worst affected by the chip shortage. Some, including both GMand Ford, temporarily halted production at numerous locations. The worst may be yet to come. A fire at a Renesas chipmaking plant inJapanexacerbated the shortage. The company supplies about two-thirds of chips used by some carmakers. That has left some carmakers likely to cut their production by a third or more this quarter. The problems could easily stretch into next year. In turn, the flow-on effects to auto suppliers will be sharp.

Other industries face similar supply constraints. Restaurants report trouble sourcing pork, chicken, and beef. The high demand for steel and lumber has led to hoarding and sharp price increases. Meanwhile, normally-innocuous goods, such as some resins used in a variety of packaging, have become hard to source.

In short, some factories that curtailed themselves last year as covid destroyed customer demand are now struggling to keep up with orders. The latest ISMsurveys show factory activity is rising at a swift pace. In the US, the reading of 60.7last month indicates strong expansion, while in the eurozone, the Markit manufacturing PMI of 62.9 last month shows that European factories are followinga similar course.

In total, the World Trade Organisation expects an eight per cent increase in global merchandise trade in 2021. That follows a drop of 5.3 per cent last year, which was not as bad as originally feared. Yet, achieving this could be difficult if supply chains are disrupted. The Institute for Supply Management has warned of the difficulties in maintaining delivery rates due to factory labour-safety issues, transportation challenges, and increased demand.

As Western economies begin to experience a surge of demand, suppliers are finding it hard to keep up. Indeed, supply chain issues in China recently contributed to a slight dip in factory activity growth. As a result, the Baltic Dry index has jumped to levels not seen since the aftermath of the financial crisis

The ‘bullwhip’ effect

Covid delivered a brutal lesson in the need for a flexible supply chain. Yet, many businesses have not changed the way they do business. Worse, many of them are playing into the trap of the ‘bullwhip’ or ‘whiplash’ effect.

The bullwhip effect occurs when a drop in customer demand causes retailers to under stock. In turn, wholesalers respond to a lack of retail orders by understocking themselves. That then causes manufacturers to slow production. Eventually the reverse occurs. As customer demand comes back, retailers quickly order more goods, often too much, and wholesalers and factories are caught short. Shortages occur, prices increase. Eventually production ramps up at levels that are far beyond equilibrium levels and this cascades down the chain. These violent swings in availability of goods then continue back and forth until an equilibrium is eventually established.

The beginning of the bullwhip effect can already been seen in the way retailers and wholesalers have managed their inventory levels since the outbreak of covid. As the following chart shows, pre-covid, retailers kept a supply of inventory at a relatively constant level, above that of wholesalers.

As covid hit, supply chains from Asia were cut. That caused a fright amongst retailers in the West who immediately began to put in orders for more inventory. Subsequent lockdowns saw demand plummet and inventories along with it. In both cases, the actions of wholesalers followed those of retailers by a month or so.

David Llewellyn-Smith
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