The COVID-19 crisis has profoundly affected global economies in an unprecedented way, putting millions out of work all at once, slowing commerce to a crawl and wreaking havoc on equity markets. And yet the effects of the pandemic may also prove instructive, illustrating plainly some of the systemic weaknesses and deficiencies that were papered over and unexposed during the steady economic growth of the most recent expansion.
In particular, supply chains of unwieldy length depending solely on Chinese manufacturing and ports have shown themselves to be extraordinarily brittle. Also, confidence in the trustworthiness of the Chinese government after initial assurances minimizing the severity of the COVID-19 crisis was found to be misplaced, resulting in an erosion of trust after the government reversed its previous stance and forced manufacturers to shut down operations in January.
Given the lessons being swiftly taught worldwide by breakdowns in supply chains for businesses and consumers alike, there are ramifications that should have long-lasting and far-reaching impacts for manufacturers, domestic markets and ultimately industrial investors looking to capitalize on the shifting composition of supply chain management.
Although the true extent of the frailty inherent in supply chains built without redundancies may just be coming to light, it is likely that the current state of the global economy may only exacerbate trends that were already taking place. Spurred by a number of concerns, including rising wages, total cost considerations and an administration driving an extended trade war with China, the average monthly value of imports from China fell more than 6% between 2015 and 2019, a drop of nearly $2.6 billion.
Over the same period, U.S. imports from other Asian countries, the European Union and Mexico all grew by double-digit percentages, with Vietnam in particular appearing to pick up a great deal of the slack afforded by China’s diminished export numbers. The conclusion appears certain: China cannot remain the world’s sole factory for the long term, and numerous other destinations look set to reap the rewards.
The most likely outcome of the shakeup prompted by the COVID-19 outbreak is a greater focus on building redundancies and increased resiliency into supply chains at all levels. No single country is likely to benefit in a lopsided manner from firms moving production out of China. Instead, a combination of reshoring, which involves shifting operations either to other Asian nations with low-cost labor pools or to regional trading partners like Mexico or Canada, and onshoring a smaller amount of production back to the U.S., will allow companies to diversify supply chains and mitigate the supply risk associated with concentrating in a single nation.
For companies that have chosen to onshore production after a sustained period using offshore suppliers, a number of negative factors related to supply chains prompted their return. Though quality of work and necessity for rework was cited a quarter of the time among the top 10 reasons for abandoning an offshoring strategy, freight costs, delivery or inventory concerns and supply chain interruptions made up 40% of the negatives associated with the practice, according to a 2018 study by Reshoring Initiative.
Similarly, among the benefits cited by respondents to the study were lead times, supply chain optimization and proximity to market, altogether accounting for 34% of the top 10 positives for onshoring production.
It should be noted that most onshored manufacturing is often highly complex, high-value-add work producing goods such as computer, electronics, auto and heavy equipment. This type of manufacturing is also extensively automated, and requires higher skilled workers for the jobs that do end up being created.
A distinct lack of those highly skilled workers domestically limits the amount of offshore jobs that are likely to return onshore from places like China. In contrast, manufacturing goods that require low-skilled labor and are difficult to automate constitute the bulk of production being reshored elsewhere, and are almost certainly not going to return to the U.S.
For industrial investors domestically, an added benefit may be found in inventory shortages created by the crisis. For decades, one prevailing motivation for supply chains was suppressing costs through just-in-time strategies, implementing push-pull management or other ways to reduce inventory and associated holding costs. Inventory-to-sales ratios dropped across the board prior to the Great Recession, most precipitously for manufacturers. The relatively recent rise in e-commerce forced a moderate rise in inventories, though remaining well below the ratios of the 1990s and early 2000s.
Now, however, with widespread demand causing unforeseen shortages for consumer goods, intermediate goods and raw materials alike, it is not unreasonable to expect that firms at a number of levels in the supply chain will see the added benefit of increasing inventories in the short or medium term, despite the associated storage costs. That should contribute to minor increased demand for warehouse space once economies begin to reopen, and will likely push average inventory to sales ratios above 1.4 for the manufacturing and retail segments of the market.
Given that this is largely in response to COVID-19, a “black swan” occurrence, companies are unlikely to sustain heightened inventory carrying costs permanently. Rather, this should prove to be a one-time boost for the segment when entering the next expansionary cycle and then dissipate along with the psychological effects of current shortages.
There are a number of considerations for investors targeting markets that are likely to experience tailwinds from reshoring and potential onshoring of manufacturing from China. Most manufacturing is expected to reshore to other parts of Asia, a factor that will help keep steady port traffic in West Coast markets such as Los Angeles, Seattle and Oakland, and East Coast ports such as New York, Norfolk, Savannah and Jacksonville should see similar returns to stability in the numbers of imported TEUs, or 20-foot-equivalent units, a measurement used in the maritime industry to record international containerized freight volumes.
Increased manufacturing activity in Mexico could likewise boost industrial demand in Los Angeles and the nearby Inland Empire, but could also provide additional demand in Texas markets and eastern ports.
For markets likely to experience smaller boosts from onshoring of overseas production, it’s evident from jobs created from onshoring operations between 2010 and 2018 that Southern markets are heavily favored given their lower costs for labor, the often considerable subsidies made available by these states and business-friendly policies that eschew red tape and barriers to entry. Additionally, the same states are usually equally popular for foreign manufacturers looking to locate manufacturing facilities in the U.S. market.
Though industrial investors in states attractive to firms considering onshoring will benefit directly from increases in the local manufacturing base, the reality of increased reshoring rather than onshoring should reinforce already established national and regional distribution hubs over the longer term, allowing crucial increased stability of supply chains globally and helping to mitigate risk for industrial assets across the U.S. from future disruption.
While this may be of little help in the current crisis, it is reason for cautious optimism for industrial investors looking ahead to a return to economic normalcy.