Out of the Bottleneck
Supply chains move fast - let’s get ahead! Supply chains in 2022 were defined by war, the pandemic, bottlenecks, and industrial policy. All are long-arc themes that will play out in 2023.
Riding the Long Arc into 2023
What were the significant issues affecting supply chains in 2022? It’s impossible to be complete, but the major topics we observed include the war in Ukraine, the evolving pandemic, supply chain debottlenecking in goods and logistics, and the rise of industrial policy. All are long-arc topics that will continue to play out in 2023.
Russia’s invasion of Ukraine in February kicked off a series of supply chain disruptions, focused initially and primarily on the commodity industry. Physical disruptions to food availability and industrial supply chains have followed, in part due to the imposition of sanctions by the G7 and their allies.
The chart above compares the surge in commodity prices in March 2022 (shortly after the invasion) to September 2021, just before hawkish comments from President Putin regarding Ukraine in October 2021. Prices across a range of commodities where Russia or Ukraine are leading exporters rose by as much as 110%.
The reversal in prices since, particularly oil, in part reflects an effective bifurcation in commodity markets between those willing to buy Russia’s products and those who are not. Most commodities - except aluminum - are still well above their pre-conflict levels.
In early 2023 the next sanctions test comes as the EU enforces a ban on imports of Russian refined oil products as well as its new gas price cap in February. An escalation in the conflict could lead to the imposition of secondary sanctions if existing measures fail to deter Russia.
The third year of the COVID-19 pandemic saw supply chain operations return to normal in most countries, with the notable exception of China. Lockdowns in Shanghai and Yantian in the spring were followed by more targeted disruptions, most notably in November for Foxconn.
While the lockdowns have been regional, their impact can be seen in China’s overall export data. The orange line in the chart above shows exports lagged in April 2022 and dropped to the lowest in over five years in November.
The outlook is highly uncertain. China has moved away from the strictest zero-COVID policies. That’s led some epidemiologists to predict three waves of infection over the winter, with a potential peak in April. Disruptions may make themselves felt more in a general degradation of manufacturing than in specific plant closures.
The lunar new year falls on Jan. 22, 2023, the earliest it can occur and last seen in 2014. The chart shows the historic seasonality of Chinese exports. There may be a larger-than-usual downturn in January and February before a sharper-than-normal recovery in March.
The bottlenecks that have beset supply chains have begun to improve in 2022. Trade flows of semiconductors - a key product constraint for many industries - have steadily improved. The combined value of exports from the big four exporting regions, shown above, was on average 46% higher in 2022 than in 2019.
Right at the end of 2022, there’s been a slowdown, with shipments down 25% year over year in November across the four combined. That likely reflects a slowdown in demand for personal computers and smartphones in particular.
There’s also the prospect of a recession in 2023. Business confidence has already declined and could evolve into a decreased willingness to invest in supply chain improvements or technology investments in the coming year.
Disruptions in the logistics industry have also been rapidly unwound. A decline in demand after early-shipping strategies has helped. That can be seen in lower container shipping volumes, a collapse in shipping rates, and reduced airfreight usage.
The chart above shows volumes in airfreight are well below both 2021 and 2019 levels. A combination of less need for freight services in aggregate terms, as well as less need for expedited shipping, may both have weighed.
The new year may bring the start of a shakeout in the logistics sector as profitability declines. The arrival of new shipping capacity as well as environmental regulations (IMO 2023) will play a part. Evidence of capacity discipline will need to come from scrapping old boats, reduced use (blanking) of existing capacity, and outright cost cutting.
The U.S. logistics sector avoided strike action in 2022 as Congress stepped in to stop rail strikes. The risk of West Coast port negotiations will continue in 2023. Labor action in Europe, and particularly the U.K., was more prevalent and could continue.
The process of debottlenecking in many industries, including autos, is far from over and could take at least the first half of 2023 to unwind. Shortages took a long time to build up and won’t disappear overnight, absent a sharp recession.
The chart above shows U.S. inventories of autos fell to a trough of 64,500 vehicles in February 2022 and have since risen to around 110,000. Yet, that still only represents half a month’s sales.
It’s worth noting that inventories were falling before the pandemic, from around 2.5x sales in 2018 and 2019. On the basis of 2022’s average 250,000 monthly sales and 2019’s (“pre-bottleneck”) production and imports of 300,000 vehicles, getting back to that inventory-to-sales ratio could take several months.
Decisions on long-term inventory strategies across all industries, as well as sourcing mix (i.e. location and diversification) in the wake of five years of supply chain upheavals, may only begin to take effect later in 2023.
Supply chain decision-making also has to take into account evolving government policies. In 2022 much of the policy action has focused on industrial promotion.
The tariffs resulting from the U.S.-China trade war continued, though exemptions have been exempted. Post-Brexit wrangling between the EU and U.K. continued. Export restrictions, particularly regarding technology supplies to China, have become more common.
The U.S. Inflation Reduction Act, including support for electric vehicle and renewables production, caused controversy with allies in Europe and Asia and may test relations in 2023. The U.S., China, and others launched new support measures for semiconductor production.
The current battleground surrounds the one-in-a-generation shift to electric vehicles and renewable energy. Auto and utility-scale battery supply chains are evolving rapidly.
U.S. imports of lithium-ion batteries set a record high in dollar terms in October 2022, as shown above. China has led the way with growth of 238% in October versus a year earlier and an 81% share.
The roll-out of environmental measures that advanced in 2022, particularly the EU’s Carbon Border Adjustment Mechanism, will have an impact on international supply chain decision-making well beyond 2023.
Healthcare, Consumer & Tech - Pain Meds’ Supply Chain Headaches
U.S. pharmacy retailers CVS and Walgreens have instituted limits on sales of pediatric ibuprofen and acetaminophen (paracetamol) “due to increased demand and various supplier challenges.” That’s come at the same time as a shortage of antibiotics in Europe which is partly blamed on packaging and material delays from China.
U.S. imports of analgesics improved by 39% year over year in the three months to Oct. 31, 2022. Yet, they are 17% below the same period in 2019. Shipments from Europe have fallen by 61% and have only been replaced in part by imports from China and Canada.
Separately, the U.S. Trade Representative has directed the International Trade Commission to investigate the impact of relaxing intellectual property protections, under the UN TRIPS program. A report is not due until October 2023, suggesting further progress on relaxing regulations may proceed slowly.
Nike reported a 17% rise in revenues and a 43% increase in inventories in fiscal Q2’23 (the three months to Nov. 30) vs. a year earlier. That came despite the firm applying “higher markdowns to liquidate inventory.” Nike’s inventory-to-sales ratio of 0.70x for the quarter compares to 0.54x on average for the past 10 fiscal Q2s.
The apparel industry more broadly has entered a period of declining inventories after a significant rebuild. U.S. apparel retailers’ inventories were down by 2% in October, seasonally adjusted, from their June peak while sales are 2% higher. That left the inventory-to-sales ratio at 2.15x, as shown above, down from a peak of 2.23x.
A similar process is underway for consumer hardlines (furniture, electronics, appliances, etc) with the inventory-to-sales ratio down to 1.58x in October from 1.71x in June. The October level is in line with the 2017-2019 average.
Furniture specialist MillerKnoll expects revenues to fall by 3% in the coming quarter, while orders in the current quarter fell by 13%. Profit margins fell due to “higher commodity costs and other inflationary pressures.”
Apple may move manufacturing of its Mac Pro desktop machine out of the U.S. That would allow assembly at a lower cost. Manufacturing may move to Vietnam, the potential new home for other Apple products.
Memory chip maker Micron has stated it will cut costs “because of the oversupply that exists in the industry.” Inventories are expected to peak in the current quarter before falling thereafter. As noted above, there’s already been a significant downturn in chip trade flows in late 2022.
Commodities & Industrials - Plenty of Gas, For Now
EU energy ministers have agreed on a natural gas price cap of 180 euros per MWh, with some conditions applied. That’s much lower than the original proposal and reflects a recent downturn in market prices. The cap still needs legal approval and won’t come into force until February. It can be withdrawn if it leads to “adverse effects.”
As shown above, EU natural gas stores have emptied more slowly than in previous years. Between Nov. 1 and Dec. 20, reserves have declined by 11.6%-points to 83.2% of capacity. In 2021 they fell by 19.7%-points to 56.3% while in the 2011-2020 period the average decline was 15%-points of use to 76% of capacity.
Warmer weather conditions have reduced demand pressures. On the supply side, a new German floating LNG receiving terminal has come online, with two more to follow. A recent explosion on a key natural gas supply line has not limited shipments.
India doesn’t expect any disruptions to supplies of Russian refined oil products as the result of EU sanctions due to come into force in February. Unlike the recently agreed oil sanctions, the rules for refined oil in terms of coverage, pricing, and measures have yet to be agreed upon.
The Russian government may cut its oil output in early 2023 in response to the G7 sanctions.
Indonesia will ban exports of bauxite from mid-2023 in a policy to encourage domestic refining into alumina. The country was the third largest export of aluminum ores in 2021, accounting for 13% of global exports. Zimbabwe has launched a ban on the export of raw lithium for similar reasons.
The U.S. government has delayed publishing details on eligibility for electric vehicle subsidies until March. That may allow for further negotiations with allies, including the EU, to determine the geographic eligibility of Inflation Reduction Act payments.
There’s already been a shift in supplies of electric vehicles to the U.S., as shown in the chart above. Imports from Europe have declined to 48% of imports in the three months to Oct. 31 vs. 61% in Q4’19.
Imports from Mexico of Ford’s Mustang E and shipments from South Korea by Polestar (built in China) and Hyundai have increased to 25% and 21% respectively in the past three months.
Imports from Mexico may increase further, with Tesla reported to be considering assembly in the country. The firm has already established ed a cross-border supply chain using parts from Mexico.
FedEx reported a 12% drop in package handling in FQ2’23 (to Nov.30) versus a year earlier. Similarly, freight volumes declined by 9%. The firm expects the downturn to continue but “to begin moderating” in the next six months. FedEx is working through a significant cost-cutting program in response to lower demand.
Container shipping rates for all routes out of China fell for a 22nd straight week through Dec. 23. They have fallen by 61% year-to-date and by 64% from their peak. Rates currently sit at their lowest since Nov. 27, 2020, but are still 1.6x their 2019 average level.
The WTO has ruled against the U.S. Trump-era rules requiring manufacturers in Hong Kong to label their products as “Made in China”. That follows a recent ruling against steel and aluminum tariffs, again instigated under President Trump and continued by President Biden.
The WTO decisions are largely moot given the appeals process remains non-functional. There appears to be little momentum toward correcting that state of affairs heading into 2022.
The U.S. will expand the range of military equipment supplied to Ukraine to include the Patriot anti-aircraft missile system. That came alongside other new military systems and aid worth $1.9B and $44B of total aid to come from a new spending bill.
Military supply chains in the European Union and the U.S. will need to rebuild stocks and meet new sales demand in 2023. The chart above shows that U.S. export deliveries increased by 9% year over year in the 12 months to Oct. 31, including a 38% jump in shipments of weapons and munitions.
Yet, that was still 21% below the pre-pandemic peak, with a slide of 39% in shipments of military aircraft and an 8% reduction in weapons. Note that these figures do not include direct military aid, including that to Ukraine.
Pauncefote & Hay will be back on January 6. We wish you and your loved ones a joyful holiday season and a peaceful new year. Thanks for all your support in 2022!
Disclaimer: This report is for information purposes only, not for legal, business, or financial decisions. It’s based on the latest available information on the publication date - that information may have changed by the time you read this report. Use it at your own risk.