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How Covid-19 Has Profoundly Infected The Global Supply Chain

Covid-19 is at the cusp of being classified as a pandemic as it spreads to other Asian countries notably South Korea, Japan and Vietnam that also serve as secondary and tertiary suppliers to these same companies. This means that even alternate supply chains are becoming operationally “infected” negating exit strategies. The brilliance of “just in time” shipments collapses if there’s even a slight kink in the supply chain especially if the disruption is prolonged with limited alternatives.

Triad of Challenges

China is facing a Covid-19 conundrum whose supply chains operational, financial and legal chokepoints threaten to tilt many countries into recession and possibly provoke civil unrest. For a smooth-running and efficient operation the following factors must work in harmony:

  • Operations
  • Financial
  • Legal

OPERATIONS

The following charts by Statista, a German an on-line portal for statistics, provide the global impact and outsized role of Chinese manufacturing and more specifically its manufacturing epicenter Wuhan:

Some firm’s critical path is the only path which is highly vulnerable particularly if their suppliers are sole source because of their expertise. The more specialized the product/industry, the more restrictive the supply chain options.

Even if a firm could switch to alternate supply sources quickly the supply chain has become stupefying complex pressured by hyper-competition with respect to costs. Alternate sources are not geared for a quantum leap in production or have the [skilled] manpower, and logistics to meet an increased demand that may not abate for many months. Under these extreme circumstances there are considerably higher costs at each chokepoint of the supply chain because it’s now a seller’s market. It goes without saying that these costs will be passed along to the consumer.

The two specific industries that are severely impacted by the public health crisis is automotive parts and technology shipments represented by the following charts provided by Statista:

FINANCIAL

Chinese firms

By political and economic necessity large private and public Chinese firms will receive the necessary government financial support to maintain employment, even if they don’t achieve modest operations.

With respect to Chinese small firms, most have a couple of months of cash reserves. Once they’re depleted workers are let go. According to the Bloomberg article Millions of Chinese Firms Face Collapse if Banks Don’t Act, 24 February 2020, the government can provide necessary financing to keep them operating. However, there are caveats as the article states:

“Stringent requirements and shortlists restrict who can access special loans earmarked by the central bank for virus-related businesses, while local governments and banks have imposed caps on the amounts, according to people familiar with the matter. A debt banker at one of China’s largest brokerages said his firm opened a fast lane to ease debt sales by businesses involved in the containment effort, with borrowers required to prove they will use at least 10% of the proceeds to fight the disease.”

In other words, government financial assistance may not be sufficient for many smaller firms to adequately maintain production and employment for workers particularly for a prolonged period.

Foreign firms

Foreign firms have an enormous exposure because they’re highly dependent, sometimes exclusively, on Chinese suppliers at one point in their production.

Despite their size large corporations run “lean & mean” with inventories but have greater financial leverage. For this reason they can successfully go to Plan B for alternate sources and “crowd out” smaller firms with competitive pricing.

The crisis is far more challenging for small and medium firms with less cash flow and who compete against larger firms for limited alternate suppliers. One huge advantage is their decision-making nimbleness to make critical decisions and few, if any, shareholders to appease.

The firms that have a greater chance of surviving in this environment are those that already have far shorter and more diversified suppliers with limited Chinese exposure. A savvy operator can’t plan for Black Swan events but can adjust swiftly.

Either way the disruption in the supply chain will be long-term and inflationary across every industry because these dramatically higher costs will inevitably be passed onto consumers enabling firms to at least maintain their market share despite lower margins.

LEGAL

When firms successfully solve the operational and financial challenges they sometimes run into a legal roadblock from their law departments whose job is simple, “To protect [the firm] from themselves.”

In the Wall Street Journal Asia article 21 February 2020, Why Many Businesses Will Be On The Hook for Coronavirus Losses, insurance companies learned their painful lessons [large payouts] from SARS 2002-03. Because they are reluctance to offer coverage for events that are difficult to quantify which is why insurers across the board exclude epidemics/pandemics in standard business-interruption policies.

Even when a contract modification is achieved through negotiated revised pricing and terms & conditions, the insurance policies of counter-parties have a far different perspective and interpretation on risk. The C-suite can make a “business decision” [an internal process to override a recommended course of action] to proceed on shipments without the necessary insurance coverage for the purposes of protecting cash flow and perhaps its survival. Nonetheless they still may face blowback in various forms from their shareholders if the result of the C-suite’s decision goes sideways.

For this reason in the post Covid-19 era firms will create more robust and diverse alternative supply chains thus Chinese manufacturers will permanently have less business even if their costs are competitive.

WORSE CASE SCENARIOS

If the crisis isn’t bad enough there are two immediate scenarios that would send a second shock wave to the markets:

Covid-19 mutates

Although a vaccine is being developed and projected to be available this April, its production and distribution will require additional time. But if it’s discovered that Covid-19 has mutated, then another vaccine to combat that each subsequent mutation would have to be developed prolonging the efforts to stop the spread of the virus.

Civil unrest

Even if many firms can restore their supply chains to an acceptable level of functionality, civil unrest can undo those efforts. This can take the form of laid off workers from bankrupt firms or protests over governmental incompetence at providing medical care.

RECOMMENDATION

As stated in my earlier SA articles on the impacts of Covid-19, for all the aforementioned reasons I’m bearish not only on firms operating in the Chinese market but foreign firms that rely heavily on Chinese tourism to their respective countries particularly the luxury market and supporting industries such as air travel and hospitality.

Additionally investors should consider potential short plays in specific sectors and/or a broad-based approach such as the China economic & investment index (MSCI China Index).

Finally seek investment safety in precious metals such as gold (iShares Gold Trust – IAU) and short-term US government securities such as Federate US government securities (FSGIX).

Disclosure: I am/we are long IAU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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