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Workers upload plywood that will be exported on a cargo ship at a port in Lianyungang in China’s eastern Jiangsu province on May 7, 2020.
AFP/Getty Images
Six months (and a lifetime) ago, most people had never heard of Covid-19, unemployment was at historic lows, and President Trump had just signed the Phase I trade deal with China.
At the time,BofA Global Research published a study in which we argued that supply chains were shifting. On the surface, there was nothing controversial about our statement. After all, the past three decades have witnessed a dramatic globalization of supply chains as corporates moved to countries, notably China, that offered the greatest cost, scale and ecosystem advantages.
What did raise eyebrows, though, was our assertion that we were entering an unprecedented phase where companies were experimenting with a “China Plus” strategy. While keeping primary supply chains in place, managers were also experimenting with pilot projects in alternative locations.
More unusual was our observation that companies in half of all global sectors for North America were reshoring their pilot projects. These, we argued, were the first signs of reversal in a multi-decade trend that could have profound implications for manufacturing, as well as the global economy. At the time, we thought that the success (or failure) of these pilot projects would determine the scale and velocity of further change.
Instead, Covid-19 has exposed fault lines in global supply chains. In our new study published this July, we found that companies in over 80% of global sectors have experienced disruptions in their supply chains during the pandemic. As a consequence, management teams expect their supply chains to be subjected to greater scrutiny. While disruptions from the pandemic might have acted as an accelerant, we believe that the underlying structural reasons are grounded in a tectonic shift to “stakeholder capitalism” where corporations focus on shareholders’ interests, as well as a broader community of consumers, employees, and the state.
Companies are also preemptively widening the scope of their reshoring plans by either accelerating or broadening their existing plans or sketching new ones. While each of these stakeholders view the question of supply chains from different vantage points, they are arriving at the same conclusion: Namely, portions of supply chains should relocate, preferably within national borders, and failing that, to countries that are deemed allies.
This reshoring proposition is, of course, accompanied by some trepidation about higher costs. We have delved into our global coverage footprint of more than 3,000 companies to estimate both the cost, as well as the impact, of shifting foreign supply chains out of China.
Our headline conclusion is that the cost would be significant, but surprisingly manageable. To elaborate, we estimate a $1.0 trillion capital expenditure cycle spread over a five year period would support the shift of all foreign manufacturing in China that is not intended for domestic consumption there. In other words – companies would be “in China for China” only. While $1.0 trillion sounds like a lot, at the end of a five year period, we estimate this would reduce the returns on capital employed by a relatively modest 0.7 percentage points (from 8.9% to 8.2%) and reduce the free cash flow to sales ratio by 1.1 percentage points (from 7.2% to 6.1%) for global sectors ex-China.
Of course, not all industries are equal. Those with structurally higher returns—like health care and tech—should be able to absorb this incremental capital expense. Others, with more muted cash flows, may have to resort to external debt or raise capital from equity markets.
We also expect corporate management teams to aggressively explore ways to offset the higher costs associated with reshoring. We don’t expect a silver bullet, but expect the extensive use of automation in future locations. Moreover, policymakers are also helping to mediate these costs through tax breaks, low cost loans, and subsidies with recent announcements to that effect from the U.S., Japan, the EU, India, and Taiwan (amongst others).
This reversal in a multi-decade trend could have important knock-on implications. For a start, financial markets could assign lower multiples for the lower returns on capital employed. Moreover, funding a capital expenditure cycle could dampen the ability of corporates to support dividends and share buybacks. An estimated 1-2% of annual U.S. earnings growth is a consequence of buybacks. On the other hand, stock valuations might actually be helped by lowering exposure to geopolitical risks.
Markets aside, these shifts could have important implications for the manufacturing sector and auxiliary services such as banking, utilities, industrial REITs, and railroads, among others. This is particularly true for the U.S., which has faced long-term headwinds in manufacturing. Plus, any sustained recovery in capital expenditure and manufacturing would have fairly significant multiplier effects on the broader economy. These include more jobs, higher wages, greater R&D spending, more tax revenues, and the creation of industrial clusters at new manufacturing hubs.
Finally, while other jurisdictions would benefit from reshoring and its multiplier effects, China could be presented with the challenge of offsetting the equivalent of approximately 7% of its GDP that is derived from exports by foreign companies based in China, thereby exacerbating the challenge that China currently faces with its domestic debt burden and ageing demographics. We expect this to translate into further efforts by China to stimulate domestic consumption and a doubling down on its Belt-and-Road Initiative.
In sum, Covid-19 has exposed the fragility of far flung supply chains and will accelerate reshoring trends that were already emerging prior to the pandemic. We believe that a $1.0 trillion capital expenditure cycle could substantively remake supply chains without a prohibitive impact on corporate profitability, but with profound implications for the global economy, geopolitics, and the recipients of shifting supply chains.
Candace Browning is head of Global Research at BofA Securities and has been named one of the Top 25 Most Powerful Women in Finance by American Banker for the past 10 years. Earlier this year, she was named to Barron’s inaugural list of the 100 Most Influential Women in U.S. Finance.
