Episode 7: Future-proofing: How we fix broken supply chains

Transcript: Season 3, Episode 7: Future-proofing: How we fix broken supply chains

Disclosure: The opinions expressed by Eurasia Group analysts in this podcast episode are their own, and may differ from those of Citigroup Inc and its affiliates.

Christina Huguet: Envision supply chains like a strand of Christmas lights. If one light goes out, then the whole strand will stop working. Rather every single light needs to be functioning on a global scale this means that it does not necessarily matter what the US is doing or what China is doing independently to alleviate the supply chain disruptions if these changes are made in silos.

David Bailin: When we talk about a supply chain breakdown, we have to understand that it was a series of exogenous shocks that basically laid waste to a just-in-time supply chain. And given that as background, we are healing from that, but it takes probably a year in order for those normal supply chain disruptions to heal.

Shari Friedman: Welcome to Living Beyond Borders, a podcast from City Private Bank and GZERO Media. On this program, we examine global risks and opportunities from the angle of both politics and economics. I'm Shari Friedman, managing director of climate and sustainability at Eurasia Group.

Last fall during a press briefing at the White House, then Press Secretary Jen Psaki was asked about a growing supply chain crisis:

Man: People couldn’t get dishwashers and furniture and treadmills delivered on time, not to mention all sorts of other things -

Jen Psaki: The tragedy of the treadmill that’s delayed.

Shari Friedman: Of course as we know, the problem became much bigger than treadmills and furniture shipments, shipping log jams, labor shortages and skyrocketing prices have been an ongoing reality through the pandemic. And since the beginning of the war in Ukraine, the situation has become even more dire with problems going far beyond waiting for a month for a new car to severe cases of food shortages and exploding inflation. Much of the last several decades have been all about finding efficiencies and cost savings through the longer and longer supply chains.

That's led to a situation where something as simple as a table might circulate the globe a few times from the start to the end of its production process. But the pandemic exposed shortcomings in this system, that's the nature of many existing supply chains. A backup early in the process can have an outsized effect later on down the line. A one week delay in a lumber delivery can cause months in delays in a home construction.

Today, we're looking at where global supply chains are today and where they're going. We're joined by David Bailin, Chief Investment Officer and Global Head of Investments at Citi Global Wealth. Hi, David.

David Bailin: Pleasure to be here. Thank you for having me.

Shari Friedman: And Christina Huguet, Industrial and Consumer Analyst at Eurasia Group. Welcome.

Christina Huguet: Thank you. Great to be here.

Shari Friedman: It used to be that nobody even knew what a supply chain really was. And now suddenly everybody's an expert now that we've seen this slowdown affect our daily lives. Going in the other direction to the economic and political landscape, how important is understanding supply chains to the broader geopolitical picture?

Christina Huguet: You know what we've seen, it's really what you've already mentioned. There's been a lot of delays and the optics have just become worse, especially when consumers were unable to get their things like their treadmills and their couches, but really it was exacerbated when pictures with ships waiting by the ports came out. I think the first thing to highlight when it comes to geopolitics and supply chains is that unless policy makers have a deep understanding of the issues at every single node of the supply chain and are addressing these issues with the acknowledgement that they are entirely interconnected with the other nodes, it's impossible to expect that our supply chain problems will be resolved.

A great metaphor we like to use at Eurasia Group is to "envision supply chains like a strand of Christmas lights." If one light goes out, then the whole strand will stop working. Rather every single light needs to be functioning on a global scale this means that it does not necessarily matter what the US is doing or what China is doing independently to alleviate the supply chain disruptions if these changes are made in silos. At the same time, policy changes that impacts one part of the supply chain will complicate the picture further down the line because more focused whac-a-mole approaches will exacerbate or really worsen other constraints and vulnerabilities.

Shari Friedman: That Christmas light is a really good explanation of how this works because then it would take a while to replace that one out bulb, which explains why one piece of it can take so long and have these outsized effects on the timing. And David, where are we now in terms of recovering from that huge disruption? Are companies and economies recovering when it comes to supply chains?

David Bailin: Well, there's definitely a recovery underway, but I think that in order for everyone to understand what's taken place, we have to go back prior to the pandemic to what were the conditions before. And I think the conditions beforehand were excellent. They were an incredibly efficient just in time global supply chain for almost everything. Meaning that if you were going to buy a dishwasher, that dishwasher was probably in production five months ago and it was delivered to the store a month and a half ago and then delivered to your home. And what happened during the pandemic is that the supply chain elements completely blew apart. Meaning that the supply of parts to the manufacturers, the assembly, the shipment of partially assembled goods to the final assembler and ultimately the shipment of goods to the end users, to the retailers or distributors, all of those broke down at the same time due to an absence of parts, an absence of labor and an absence of capacity to ship.

That was then exacerbated by excessive demand as people were forced to stay home and they ended up purchasing more than 30% more goods during that period of time when all of those shortages existed than ever in the history of the global economy. So when we talk about a supply chain breakdown, we have to understand that it was a series of exogenous shocks that basically laid waste to a just-in-time supply chain. And given that as background, we are healing from that, but it takes probably a year in order for those normal supply chain disruptions to heal. And you've already mentioned the fact that we've had a further exogenous shock in the war in Ukraine on top of all of that.

Shari Friedman: Well, this brings us to another point and I think that David, your point about it's not just the supply chain part, it's also the increase in demand part, which is a part of the equation, I think that doesn't get discussed as much. And following up on your point on the war in Ukraine, Christina, going back to you, how have you seen the war in Ukraine exacerbating all of these supply chain issues that we're seeing and what is the likely effect moving forward?

Christina Huguet: Yeah, so I think David did a really good job of pointing out what was happening before the war, the significant constraints that continued throughout the pandemic. There were some efforts to address the constraints, like keeping the Ports of L.A. and Long Beach open 24/7 for a period of time, opening other locations to load and unload containers or even considering the merge fees to incentivize clearing the containers more quickly.

But just as things were looking up, the war in Ukraine really hurt a lot of these efforts that were being put in place. So logistically the war has been a nightmare for maritime and air routes. Not only are parts of the Black Sea and the Azoz Sea now unpassable, but there are significant closures all around for commercial shipping. Many logistics companies have suspended services in Russia, also depressing ocean capacity.

There's also been a big cut to air capacity, which has contributed to price increases that we've been seeing globally. The flying ban canceled many flights and removed about 10 million miles of airspace from international freight routes. So airlines are responsible for around 20% of cargo and pretty much what we saw was an extreme decrease in capacity provided by carriers. So in addition to the rising cost of the delays and the air fly capacity, fuel costs are extremely high, all leading to record backlogs and delays. In addition to the record costs, not only that we are probably going to see even further price pressure on the oil market as Europe and the UK move to ban insurance for Russian oil cargos, which will be implemented in around six months time. So got another aggravating factor into what is currently a lot of inflationary pressures.

Shari Friedman: And David, you had noted that it's not just about raw materials and goods and shipping, but it's also about labor shortages. Is this still the case and how closely related are supply chain issues and labor shortages right now?

David Bailin: Well, if you're in China right now and going through the lockdowns that China has, which remind me very much of what America went through in the April through June period of 2020, there are significant labor shortages that are still taking place regionally. And obviously there are disruptions to labor supply all across Europe, as well, as a result of the war. So labor disruptions are a large part of it.

I think that when we look ahead, there are the negative factors of all of the costs and lack of capacity that Christina talks about, but there is also a slowing global economy. So let me project out the following. I think a lot of the common supply shortages, whether it's toilet paper, dishwashers, bicycles are going to be resolved over the course of the next six months. What's not going to be resolved over the course of the next six months are the war-related activities and the China-related disruptions that are going to be ongoing for a good deal longer.

And those are specifically related to agricultural goods, rare metals, oil, and natural gas. These disruptions in supply chain are going to continue because we're not just talking about physical supply chain, but rather a complete realignment of who people are going to trade with due to politics.

Xi and Putin basically made a statement to the West that the nature of geopolitics was changing and that they were willing to suffer the consequences. And it turns out that the consequences were going to be related to the supply chain. If you are a producer of a good in Europe or the United States, relying on Asia for previously Russia, for any portion of your supply, you've got to be thinking to yourself, I've got to build additional capacity, an alternative supply chain. And that is both inflationary and of long duration and that's going on now as well.

Shari Friedman: Another big topic on people's minds right now is inflation. And what is the relationship between current inflation and the supply chain issues that you've just been discussing?

David Bailin: So I like to divide inflation into what I describe as flexible inflation and sticky inflation. And I like those terms because I think it lets us look at inflation appropriately as what is exogenous, I.e., a war or a pandemic, both of which are unusual events and have very major consequences that don't have to last a long time and sticky inflation. The idea that people are expecting more wages or are seeing costs of goods go up continuously simply because of their scarcity. So when you think about the kind of inflation that we're suffering now, probably two thirds or more of it is of this flexible inflation that's caused by exogenous factors.

Now over the long term, that's a good thing. But in the short term, it's a difficult thing because the only tool that the Federal Reserve and central banks have to bring inflation down is to reduce overall economic demand. They have to take a little from everywhere in order to bring down economic demand. And that does not specifically address agricultural or energy prices. So right now the greatest threat to the economy is the Fed and central banks raising rates very quickly, that brings down aggregate demand, but it doesn't cause oil shortages or shortages of wheat to go away. So we have a situation now where the tools to manage inflation and the nature of the inflation itself are mismatched. And that's what putting the global economy in jeopardy right this second.

Shari Friedman: Christina, going over to you in a previous episode, Ian Bremmer of Euraisa Group noted the shifting. He mentioned that one of the trends he's seeing is more insourcing from chicken in Malaysia to wheat in India, to baby formula here in the US. Are you also seeing this trend and how does this relate to supply chains?

Christina Huguet: I think that generally speaking, this is referring to the growing trend of protectionism that is really aimed at protecting domestic supply of different goods, especially commodities. And so this is a result of several things, really starting with the pandemic where factories around the world were shut down or forced to reduce production because workers were sick or because cities were locked down. So this came at the same time as consumers in the Western world wanted more. And as David mentioned, there's a hike in demand that clogged the system for transporting goods. So now when you have Russia's invasion of Ukraine, extreme weather events in addition to that and rising energy and fertilizer prices, you have policymakers wanting to respond to these compounding issues.

So they're reacting by wanting to make sure that their stable goods are available at home. Essentially a way for leaders to avoid being blamed, especially as rising prices hurt the poorer populations. But the result has been something of an unintended domino effect where one country starts to protect its commodities and then another thinks it needs to do the same thing. So the issues that the trend is not sustainable and when it comes down to our food system and the global food shortage because our food system is extremely global and domestic farmers also need access to extra markets, protectionist moves hurt their capacity to make a living.

So as countries want to become more self-reliant for a wide range of commodity goods, expert bands and protectionism will not actually be a consistent or sustainable policy stand for leaders. In the long term though, even if countries try to increase domestic capacity as much as we can, but we saw the baby formula crisis in the US where efforts for self-sufficiency can lead to crises. In the case of the baby formula, US produces 98% of the infant formula for domestic consumption. But when there was a shutdown of a major production site in Michigan due to contamination issues, other sites were just not able to easily import more ingredients due to tariff and non tariff barriers.

And were thus unable to ramp up capacity or quickly import substitutes. So as more countries impose these protectionist moves, move to increase self-resiliency. We will likely only see more crises and shortages as these policies prove to be quite disruptive and as ongoing shipping delays decreases overall flexibility, even for goods that are high priority.

Shari Friedman: Getting into the bigger picture, we know that economic shifts have big impacts in the geopolitical world. And David had alluded to this, does this shift in who's making what, where and who's selling to whom significantly affect the balance of power. What's your view on this and the relationships between major importing and exporting countries?

Christina Huguet: Oh, absolutely. This trend of protectionism and movement to increase self-sufficiency are changing a number of things. I think in terms of the shift of balance and power, there's definitely a move towards friend sourcing or considering setting up agreements with other countries to increase bargaining power or in to ensure a bilateral supply of some goods. And what we see are some countries are able to weaponize single source dependency. And this has really been an emergence of a new tool of economic state craft as a principle foreign policy tool. For example, the mineral supply chain for semiconductor chips are currently heavily located in China. And Beijing could choose to restrict exports in order to prevent chip production in other markets just as it did in 2010 to Japan, where there was an unofficial export ban on rare earth products.

Similarly, Russia's role as a top exporter of fertilizer has shown other vulnerabilities of single source dependency. With Russia as well, we continue to see supplying of natural gas, despite heavy sanctioning, where Russia is able to use its gas supply as a weapon, which has led to an energy crisis in much of Europe. So what we'll expect to see in the longer term is more of a push to diversify supply chains and create redundancies to minimize and diversify risk. The issue is that this will take time and we will actually see it kind of happen more amongst like-minded countries and really push regionalization of trade relationships.

David Bailin: And Christina's point here is both correct and inflationary because the minute you talk about creating redundancy in supply chains or talk about regionalization or polarization between the east and the west and the economic response to it, that is a costly endeavor. It means building secondary and tertiary supply change, excess shipping capacity, new capital expenditures, all of which require long lead times and take capacity from other parts of the economy. So I would just point out that at Citi, we expected long term inflation if we were to go back three years ago, to be 2% per year on average. And now we're talking about having an ambient inflation rate of 3% to 3.5% part of which is this new supply chain issue.

Shari Friedman: As we look forward beyond just the immediate rebalancing that we're seeing, are you envisioning that when the supply chains bounce back into a more stable form, the form that they will be in moving forward for the next near and long term, Christina outlined a much more regional system, are you also seeing that this is where we're going to be going as they settle into a more permanent pattern?

David Bailin: I think the term deglobalization is way overused. And the idea that we're going from global to regional is probably overstated. What we're talking about will really depend upon the essential nature of goods. So when we have goods like energy today that are scarce or semiconductors that are scarce, or the ability, for example, even for major equipment to be manufactured in areas that have risk of short supply. And I hate to use this term, but weaponry, the things that go into making arms are those kinds of goods. All of those will require regional supply chains to ensure that any of the global components of them could be replaced if they needed to be.

But for most of what people buy, the vast majority, 85%, we're talking about toilet paper, bicycle parts, you name it. There's not just the need to get a given good, but also to have substitutes readily available, meaning that if there are manufacturers of goods in Asia, in Europe and in the US, the capacity of those existing plants would probably be increased to create that redundancy. And so that if a region shut down or if there was an issue geopolitically, you'd have a choice to get excess capacity. The baby food situation, I think is a great example. Why should we actually have just in time manufacturing for baby food, which is in itself a strategic need for all of the kids who use it and the parents who deliver it. That's the kind of thing that I think we will see happen less and less frequently. There will be excess capacity deliberately to address those fundamental needs.

Shari Friedman: So it's like having an extra Christmas light on hand to re-screw in if that Christmas light goes out right?

David Bailin: That's exactly right because remember, a light bulb replacement happens in a normal time. Light bulbs go out. What we're talking about here with a pandemic and a war are not light bulb issues. These are major, major issues. But the announcement by Russia and China as to how they feel about the West and the West's incredibly unified and strong reaction against Russia and its actions in the Ukraine, in my mind have really created a polarization that will have these long term economic impacts requiring more supply chain redundancy, more manufacturing capacity redundancy and more essential parts bifurcation or regionality using Christina's word in the future.

Shari Friedman: And that all sounds like it's going to be more expensive.

David Bailin: There's no way that it can't be. When we think about the difference between the world before and after the pandemic and the war, the one thing that is absolutely clear is that we were running a just in time world prior to these events and the cost of not having that redundancy became incredibly clear. We might have been able to handle it when it was just the pandemic because of the fact that the demand for goods went up because people were trapped at home. But with the geopolitical change, it is very clear that having Europe depend on a single source for the majority of its gas is in fact a political threat and we're seeing that play out now.

Shari Friedman: And so I'm curious about the impact of all of this on sustainability. One upside of some of the insourcing might be the positive impact on sustainability with less shipping all over the place. What are you seeing on that front David in terms of sustainability and supply chains going forward?

David Bailin: One of the only benefits for these terrible events that we've lived through is the recognition that there need to be both substitutes and replacements. And when it comes to energy, this will cause an acceleration of the development of alternative energy or another way to say it is the more profitable it is to produce carbon based energy. The more profitable it will be to replace it. And that was what was going on before the pandemic struck. So I think there'll be an acceleration in alternative energy. When we think about the geopolitics, it's exactly the same, but at much larger scale. So for example, in order for Europe to become energy independent, there's going to have to be a supply chain built between the United States and Europe for liquified natural gas. And there are many other examples of this in the areas of semiconductors or other strategically relevant goods and services.

So that's what's going to happen next. When it comes to ESG, I think the greatest thing that we can talk about is the fact that 400 companies pulled out of Russia voluntarily. And they did that because of the standards and practices that they, their board of directors, their shareholders and their customers wanted to see happen. Russia violated some ethical or essential principles for these companies and they acted upon them without regard to the fact that there was going to be an immediate hit to profitability. This is ESG in action. A change in governance, a change in policy that actually reflects the values of the shareholders and consumers. And so those two things are the large takeaways in my mind from these terrible events.

Shari Friedman: So let's zoom back out into the big picture. Christina, what lessons, if any, has the global economy learned from the supply chain issues that we're facing now?

Christina Huguet: Yeah, I think we can maybe summarize this in into three big lessons, at least from where we sit in the geopolitical angle. The first one is things will continue to get worse unless policy makers address issues along every notice of supply chain. And also work with each other to make sure that there are redundancies and resilience, especially as there is new legislation being pushed forward related to national security. And as the EU and the US are doing their national supply chain reviews. The second big lesson is expect more disruptions as like I said, these new initiatives increase to increase resiliency, come out by moving supply chains closer or onshore. So there will be more delays at borders with this new clean supply chain requirements.

What that would look like in terms of our company is prepared and are importers ready and what the delays look like as customs manages and learns on the spot with some of the new policies. And then finally I think we can also expect that countries will continue to strategically align with other markets to increase their collective bargaining power. While other countries will continue to use leverage and things like their single source of dependency in order to push for their foreign policy or diplomatic agendas.

Shari Friedman: David, what are you seeing specifically from an investor perspective? What have investors learned about this? Either a lesson that they've learned well or a lesson maybe that they've incorrectly learned?

David Bailin: I look upon this as a time when we saw both governmental and investor complacency, an assumption that the supply chain was both efficient, that it had built in redundancies that didn't exist and that it actually could withstand some significant external stress, none of which turned out to be true. So from a policy standpoint, one would expect that governments themselves are going to have to be more involved in creating the redundancies for strategically relevant components and elements of the economy, which we've talked about just using semiconductors and energy as examples, and that they really didn't have sufficient policy in place beforehand. Companies themselves are going to have to be thinking about how they want to actually build those supply chains and where to put their factories. And so you might see much more what I would call home based sourcing take place there. And I think from a consumer perspective, the idea of substitution is going to become much more relevant.

The largest impact that I think will have a long ramification of the valuations that investors place on the subject we've talked about today. Companies that are ESG aware are going to get valued more highly than those that aren't, ultimately, those companies are also going to become more efficient and there's going to be a cost of getting from here to there, which will partially be an inefficiency as Christina's talked about. So we are in a transitional period and I think ultimately the economics of being more environmentally sensitive, more government sensitive and socially sensitive will ultimately be one of the things that makes that an incredible component in the judgment of how investors are going to put money to work in the market and a positive one.

Shari Friedman: So ESG is going to be increasing in the future, which I think is an interesting trend to note right now is there's so much consternation going on in the ESG market at the moment. So we're going to have to take off now, David Bailin, Chief Investment Officer and Global Head of Investments at Citi Global Wealth and Christina Huguet, Industrial and Consumer Analyst at Eurasia Group, thanks so much to both of you for being here.

David Bailin: Yes, thank you so much. It was an incredibly interesting conversation and really enjoyed your questions.

Christina Huguet: Thank you everybody, it was a pleasure.

Shari Friedman: And that's it for this episode of Living Beyond Borders. Stay tuned for more throughout the summer as we continue to track major trends like the shifting US-China relationship and the impact of women on the global economy. To listen to previous episodes, head to gzeromedia.com and click on the Living Beyond Borders tab or subscribe wherever you get your podcasts. For GZERO, I'm Shari Friedman. Thanks for listening.