The Global Supply Chain & Path Of Inflation

The following was originally posted at custerconsulting.com.

Summary

As summer fades, the global economy is downshifting from months of super-charged growth, pumped up by unprecedented fiscal and monetary policy measures. Growth will continue throughout the year but at a sharply decelerating rate, and inflation will remain stubbornly high.

Supply chain issues — components, commodities, and labor shortages — are now the primary constraint on growth. We do expect demand to continue to soften over the next few months, however.

Even though global electronics production continues to rise, the rate of expansion has slowed significantly in the past few months.

We have constructed a narrative of the global economy, which we believe is unique and reflects the economic reality driving electronics manufacturing. As we have stated in the past, current market conditions are driven mainly by the macro.

We believe it is essential that purchasing managers think “big” – i.e., the global macroeconomy – to understand their market conditions better.

If we could point to one piece of data or chart explaining current conditions and the economic trajectory over the next six months, it is Chart 8, U.S. Retail Sales Are 12.7% & 52-Months Ahead Of Pre-COVID Trend.

What’s The Matter With The Global Supply Chain

The bulk of the problems in the global supply chain are caused by excess demand. Policymakers have injected too much stimulus into the global economy. By combining income support through transfer payments, the central banks have effectively monetized much of the large deficits and spending run-up.

Our view is derived from Chart 8, where we use U.S. retail sales as a proxy for global aggregate demand. The EU’s retail sales chart looks very similar.

Chart 8 illustrates that spending unexpectedly came roaring back after an unprecedented drop when global economies were turned off in March 2020 and had a massive “Bullwhip Effect” on the global supply chain.

See below for the informative interview with TJ Rodgers, former Cypress Semi C.E.O.. on fixing the supply chain.

The spike in demand was, in large part, fueled by the governments’ income support policies and over $9 trillion of digital money created from thin air and injected into the advanced economies by central banks.

July’s retail sales – our proxy for global aggregate demand, which is not observable, by the way – are 12.7 percent above and running 52 months ahead of its pre-COVID trend. Retail sales are inflated by the policy measures and will need time (52-months of zero growth) and/or space (-11.2% down from current levels) to get back to trend. No doubt, it will be a combination of both time and space. A sharp, abrupt correction in retail sales could be painful and confuse the supply chain even further.

We believe only when demand returns to trend will the global supply chains begin to heal. Some will sooner than others, but it will take longer than most expect unless the global economy hits the skids big time or the central bankers panic.

In no way are we taking shots at policymakers. They had just as tough of a job like all of us trying to figure out what was going on after the pandemic began its rapid global spread. Moreover, the problem of too much demand and inflation is a better problem to have, much better, at least to us, than riding out a deep recession.

However, we do question the need to continue such policies, especially further monetary injections, and suspect policymakers fear a significant and hard sell-off in overvalued asset markets. If asset markets do correct hard, it won’t be long before we’re discussing deflation as the advanced economies have become very asset-dependent.

Transfer Payments Fading

Transfer payments, which make up the bulk of the income support policies, are starting to fade. The U.S. government emergency unemployment payments ended this past week, which will slow consumer spending on the margin.

Stagflation Cometh

Nevertheless, Christine Lagarde, president of the European Central Bank, who has started baby steps in pulling back Europe’s stimulus, recently stated,

“The lady isn’t tapering…”

It doesn’t appear governments have the stomach to take the economic pain of clamping down on demand, and our takeaway from the soft rhetoric from the central banks is “stagflation” cometh. That is, inflation will be around longer – not transitory – than conventional wisdom suspects as economic growth slows sharply.

Expanding Long-Term Capacity

Of course, the supply side can adjust, increasing production capacity to meet the current excess demand to bring imbalances into equilibrium. It would also reset the potential output trajectory for higher growth.

A significant expansion of long-term production capacity is not likely, as many producers, rightly so, are skeptical that demand, where retail sales are still two standard deviations above their three-year moving average, is sustainable (Chart 9). We suspect most producers will try to meet demand by working their factories and employees overtime rather than increasing their long-term capacity to produce through new factories, machines and hiring new employees.

We do believe the pandemic has ushered in a structural shift in semiconductor demand as the pandemic had accelerated the digitization of the global economy. (see Charts 5-6).

Demand In The U.S.A.

We suspect much of the excess demand is coming from the U.S.. Chart 10 illustrates most of the world’s ports seeing high congestion rates, are located stateside.

We don’t dismiss that real supply shocks, such as factory shutdowns due to new COVID outbreaks, are hitting the supply chain, but they are not the main driver.

Much of the supply chains problems are also in transportation, where ocean freight takes care of 95 percent of global trade. Check out Chart 11, which shows almost 50- ships are floating around the L.A. and Long Beach ports waiting to offload their cargo.

Last month we worried out loud how the low vaccination rates in Southeast Asia could impact the supply chain (Chart 12). The latest from Toyota,

Toyota Motor Corp. trimmed its production outlook for this year by about 3% because the spread of the coronavirus in Southeast Asia has disrupted access to semiconductors and other key parts. – Bloomberg

Based on our analysis, our best guess is that stagflation is not transitory and will be with us longer than anticipated, and the supply chain will not start to improve until U.S. retail sales move back to trend.

Sales are slowing. Since March, the charts illustrate sales growth has stalled, albeit at a very high level and well above trend.