Breaks in the supply chain

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Supply chain robustness and the quality of a company are intertwined. Walter Scott investment manager Murdo MacLean explains why.

One area where you can immediately see if a company is good is the robustness of its supply chain, according to Walter Scott’s Murdo MacLean. Never has this been more highlighted than over the past two years of disruption caused first by the pandemic and more recently by Russia’s actions in Ukraine, he notes. Pent up demand and a reduction in the global labor force have exacerbated the situation further, he adds.

He says: “Some supply chains are relatively straight forward; they involve relatively few inputs, maybe not even crossing international borders. There are also supply chains that are incredibly complex requiring lots of different inputs, suppliers, involving multiple borders across the world. It is the latter we have seen come under significant pressure.” Quality companies, he argues, have greater ability to not only combat such pressure, they can adapt with it.

Displacement of labor

Since, and because of, the Covid-19 pandemic there has been a shift in global labor markets. In January the International Labour Organization (ILO) downgraded its 2022 labor market recovery forecast, projecting a continuing major deficit in the number of working hours compared to the prepandemic era.i According to the report, the participation rate of the 2022 global labor force is projected to remain 1.2 percentage points below that of 2019.

MacLean notes some employees are not coming back into the workforce and many are still working from home and corporates are still struggling with how to keep people safe. All of this has displaced labor, delaying repairs to pre-pandemic supply chains and making them less prepared to deal with a resurgence in demand, he adds.

China’s influence and geopolitics

China has been known as the “factory of the world” despite its efforts to upscale its economy. Over the past 30 to 40 years China has become more globally connected, which we believe, has also made it more predictable and appealing as a trade partner.

China is the largest exporter and second largest importer of goods in the world and its manufacturing sector still accounts for 19% of global GDPii, MacLean points out. But while skilled and relatively cheap labor is present elsewhere in Asia, many countries don’t have the necessary infrastructure to take over China’s manufacturing mantle. “Port infrastructure is key to production. For this and many other reasons, China is not easily displaced; it is still very important in global supply chains.” Even, he adds, as many recognize the problem of an overreliance on China, an issue that came to the fore in 2018 when US/China trade tensions erupted.

The ongoing reliance on the country is highlighted by the impact from China’s zero Covid policy. “China still accounts for some 60% of global consumer goods and 40% of TMT (tech, media and telecos) supply chains – it is a very important cog,” says MacLean. “The longer the zero Covid policy plays out, the greater a challenge and how companies react to that will be very important going forward.”

Russia’s invasion of Ukraine, aside from the humanitarian crisis it has wrought, has also served to disrupt global supply chains. MacLean says: “The conflict has had major ramifications for the movement of energy supply and commodities around the world and it has caught many industries on the hop. For instance, Ukraine is a key supplier of an integral gas used in the semi-conductor industry.” In addition, almost 11 million people, including workers, have been displaced.iii

From just-in-time to just-in-case

All of this has combined to force companies to rethink, turning their traditional approach to capital management on its head, MacLean says. Today companies are diversifying their manufacturing with regional hubs and local suppliers; inventory supplies are also being increased to keep more on hand. Until now companies have tended to use the principle known as just-in-time inventory systems, a strategy whereby companies receive goods only as they need them for the production process, reducing waste and increasing efficiency.

MacLean explains: “Because of what is happening, the disruption to supply chains around the world, the inability to get crucial components to move supplies globally – even the energy required to power plants – companies have had to think differently.” Still, more can be done to future-proof supply chains, he says. “Just in time worked well but limits flexibility. Carrying more inventory may impact a company’s profitability a little bit but it does enable them to be more resilient in the face of these sorts of disruptions.”

Quality companies, he says, may have already had such a model and if they didn’t before, they are headed down this path now. Cash flow is what sets such companies apart, as industries change with these times. MacLean adds: “By having a good cash flow, they have a good source of funding, the type necessary to buy a new plant or carry more inventory. Good businesses aren’t so much worried about how they survive disruption like that seen with the pandemic, they have a strong capital base on which to then make sensible investment decisions about how to run their business for the future – including how to evolve their supply chains.”

i ILO World Employment and Social Outlook Trends 2022. January 17, 2022

ii Statistica, China’s share of global GDP. IMF estimate. April 20, 2022

iii BBC News. May 2022

 

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