Manufacturers are starting to have supply chain problems

An article in today’s Financial Times points out that global manufacturers are beginning to have trouble getting component parts from suppliers, especially in IT-related areas like semiconductors.  The newspaper calls this difficulty a “threat” to global economic recovery.  It’s not, in my opinion.   Quite the contrary.   This development will prolong the period of strong growth for industrials and enhance the profits of suppliers.

world trade has been a long-term growth industry

There are two reasons for this:

–since WWII and picking up steam over the past twenty or thirty years, world governments have tried to promote world trade, in the belief that closer economic ties will foster overall growth, as well as promote prospects for world peace.  In particular, governments have tried to coordinate and stabilize interest rate and exchange rate policy, and to work to dismantle legislative barriers to trade.

–generally speaking (and I know there are lots of special cases), as real GDP rises so too does real personal income.  As income rises, discretionary income (what’s left after taxes and necessities) grows at a faster rate.  People spend a portion of their discretionary income and save the rest, the proportions of each varying from country to country.  As the amount spent (not necessarily the proportion) rises, consumers tend to allocate an increasing amount to imported goods.

Put this all together, and we come up with:   consumer discretionary spending rises (and falls) faster than GDP, and spending on foreign-produced goods moves fastest of all.  So in a generally expanding economic environment, trade-related industries tend to be high-beta beneficiaries.  In fact, over the past twenty years, world trade has declined in only two–2001, when the Internet bubble popped, and 2009, when the sub-prime mortgage crisis hit.

the Great Recession impact

The contraction in 2001 was by a mere .2%, according to the World Trade Organization.  In 2009, in contract, the fall was a whopping 12.2%, the worst experience since 1975.

Why so bad?  In the aftermath of the Lehman collapse, bank financing for imports and exports came to a standstill, as financial institutions worried about the solvency of their counterparty banks in other countries.  Armed with supply chain management computer systems, companies were able to understand the falloff in their businesses that the financial crisis was causing much more quickly than before.  Also, having had the experience of not reacting fast enough or decisively enough after the internet bubble burst, firms were much more aggressive in cancelling orders and shrinking inventories.

a sharp bounceback in 2010

The WTO estimates that world trade will expand by over 7% this year, despite lackluster overall growth in the developed world.  They’re pencilling in +5% or so for 2011, as well.  So trade seems to be continuing its high-beta role–something we can confirm on a micro level by listening to recent reports from transportation companies like FDX.

Why supply shortages already?  If we do the simple arithmetic and say 2008 world trade was 100, the decline in 2009 dropped it to 87.8 and the anticipated bounceback in 2010 will return it to 94.4.  So, all other things being equal, there should be at least some spare capacity in the world’s supply chain system.  But, as the FT highlights, big companies like Siemens or Caterpillar are telling us, for them there is none.

How can this be?

–Maybe world trade growth will be higher than 7%+.  Yes, but it would need to advance by almost 14% to get back to 100.

–Clearly, some industries, like component makers for cellphones or PCs, are expanding at an extremely fast rate, so shortages in these areas shouldn’t be too surprising.

I suspect, though, that both manufacturers and suppliers have, as I have done, concluded that a slow-growth world would not result in any demand for new supply capacity.  So manufacturers have directed all of their business to their most trusted suppliers, without worrying too much about the fate of the second tier.  Suppliers, in their turn, have opted not to take the risk of adding more capacity (virtually no one does this in a recession, anyway).  The result is now that industry has exhausted the first tier supply capacity–and the second tier has either gone out of business, can’t get trade financing or has shifted to support different, less fickle, industries.  (Personally, I’d bet most heavily on the going out of business possibility.)

what does this mean?

More demand for components and constrained supply should result in higher component prices, at least in the short run–meaning until suppliers decide to invest in new capacity or until manufacturers’ design teams find a way to work around shortage components.

It also means that many industrial companies are effectively capacity constrained.  So the very strong figures they are currently reporting understate the true demand for their products.  Record backlogs mean the present high level of revenue and earnings will be sustained for longer than one would have expected.

To the extent that companies all long the supply chain decide that they must keep buffer stocks to guard against temporary shortage (and they are doing so), these two positive effects will be intensified.

This means, I think, that industrial stocks will be better performers for longer than the markets think.  It also means that the eventual consumer recovery way also be a bit better than expected.