Supply Chain

If you’re a music fan such as myself, you’re probably familiar with Fleetwood Mac and one of their greatest hits, Chain. The song was written by all five band members and is a symbol of the bands resilience and strength to remain together despite their differences both personally and professionally. Much like the symbolic chain Fleetwood Mac references in their song, the global supply chain also endures moments of stress throughout time as the global economy shifts from highs and lows. The above picture is from a Forbes article written by Richard Howells on October 7th and he notes that at that point:

• 76 container ships were sitting off the west coast
• Each ship contained on average 14,000 containers
• Each container holds around $100,000 of merchandise on average
• The grand total of all of this is $106,400,000,000

 

 

Supply Chain Challenges:

During the Covid-19 pandemic, US households accumulated an estimated $2 trillion in excess savings leading to a positive outlook for 2022 GDP¹.

Current supply chain bottlenecks stem from two primary sources, transportation difficulties and semiconductor shortages. The rising costs of shipping have helped spur inflationary pressures; it is worth noting that it is not uncommon for shipping costs to account for 10% of the total cost of a product².

On the semiconductor front, the shortage couldn’t come at a worse time as the global economy morphed into a more digitized world increasing demand on the semiconductor industry during a global shutdown. Some industries saw a decline in chip demand; for example, the automotive industry saw a decrease in new car demand as “work from home” took hold. Meanwhile, other industries such as cloud computing, laptops, gaming consoles and Wi-Fi routers experienced the opposite effect from the “work from home” movement. Over the past 5-10 years, emerging market economies have gained greater access to the internet and thus, growing a future demand for semiconductors and an e-commerce driven economy.

To enhance the problem, the complexity of building semiconductors translates into a slow increase in future production to meet increased demand. It is worth noting that the situation may not be as dire as the indicators point too as many chip producers note that some customers duplicate their orders across suppliers to get components faster which in turn paints a false picture of heightened demand. Governments and companies alike are also adapting to a more global based supply chain by building stockpiles of goods, hedging costs with financial instruments and diversifying import sources. Regardless, the shortage in semiconductors will not be amended in the immediate future and 2023 is where most economic forecasts point for a stabilization within the industry.

Why Low Interest Rates?

With inflation rising, many investors are wondering why yields on US Treasuries remain so low. At the end of August 2021, roughly $15 trillion worth of debt within the Bloomberg Global Aggregate Index had negative yields meaning that many international investors could earn positive yield spreads by investing in US debt compared to their domestic currency. Many Euro and Yen investors have remained investors in US Treasuries and thus driven the demand (prices) higher translating into lower yields. Another potential reason for the current low yield environment is that the run-up in equity markets have forced many large pensions and asset managers to rebalance their portfolios from stocks into high quality bonds. This added buying pressure helps suppress yields as investors are chasing the same asset class.

Looking Forward

It’s important to note that Wall Street isn’t looking at what is going on today, the markets are forecasting future economic growth and constraints that are coming 6, 12, 18, 36 months and beyond down the road. The past month of September saw a sell-off in US equity markets, specifically within the US large growth equity arena. Looking at the chart below based on current economic indicators, we may have already experienced the peak from pent up demand that occurred during the Covid-19 shutdown.

Instead of predicting what future impacts the current supply chain environment will have on capital markets and when these impacts will occur, we prefer to position our client portfolios for these potential risks.

rising rates and inflation concerns are to allocate a portion of their bonds into (TIPS) Treasury Inflation Protected Securities and add an alternative strategy called Managed Futures. TIPS can help guard against losing purchasing power that nominal bonds will experience during these rising rate periods. Managed futures also provide a non-correlated asset class that can benefit from inflationary regimes by investing within interest rate swaps and commodity / currency futures contracts.

The Case for Value Stocks

The charts above outline a lesser-known phenomenon that has been occurring within the US equity markets, particularly over the past 18 months. US large cap growth companies have experienced an incredible increase in valuation, far outpacing the S&P 500 index itself and US small cap value companies. Innovation, efficient capital structures and economies of scale have certainly helped these US large cap companies justify some of the increase in valuation but we have to acknowledge the impact that interest rates have played in increasing the value of future earnings.

Stocks are not that different from bonds in the sense that they both derive their value from future cash flows; coupons for bonds and future retained earnings that can be paid as dividends (or share buybacks) for stocks. Duration is a metric often applied to bonds but we can also apply the same measure to equities.

The above chart³ highlights that short-duration stocks are often small in market capitalization and align with value-based investing versus growth. Value stocks tend to have a larger portion of their future earnings imbedded in the near term while rapid growth stocks may not see positive earnings and cash flow until 10 / 15 / 20 years out. The further out your future earnings, the more inflation will negatively impact their present value. Think of it this way; if inflation and interest rates are rising into the future, would you rather receive $10 million from the lottery today or in 10 years….

And if you don’t love me now
You will never love me again
I can still hear you saying
You would never break the chain (Never break the chain)

Chain keep us together (running in the shadow)
Chain keep us together (running in the shadow)
Chain keep us together (running in the shadow)
Chain keep us together (running in the shadow)
Chain keep us together (running in the shadow)
Chain keep us together (running in the shadow)

1 Lazard Asset Management: Outlook on the United States, Oct 2021

2 Dr. Jean-Paul Rodrigue and Dr. Theo Notteboom

3 Schroder, Esterer: A New Measure of Equity Dureation: The Duration-Based Explanation of the Value Premium Revisited – December 2011