Into the Last Innings

14 October 2021

Pascal Blackburne

The supply chain is in trouble: productive capacity is not geared to current demand, logistical bottlenecks are rampant and inventory “buffers” have been largely depleted. Odds are high that the resulting inflationary pressures will last longer than generally expected.

To better understand how this severe supply-demand mismatch came to be, let us turn back the hands of time. To 2019 more precisely, when businesses overall had limited pricing power and consumer prices were trending down – both signs that productive capacity was quite sufficient to meet demand. Then, of course, came the Covid pandemic.

On the demand side, governments – with the full backing of central banks – were fast to fork out cash to households, in a bid to offset lost wage income. During the first few months, much of this financial state support was hoarded, because of limited opportunities to spend in a locked down world, and because future prospects were very uncertain. Towards the end of 2020, once it was clear that a vaccine would soon be available, setting the stage for a progressive return to some form of normality, it became reasonable again for consumers to be more profligate. Pent-up demand was unleashed as broadly expected but, somewhat more surprisingly, the usual consumer spending patterns did not resume. In particular, the share of household budgets typically devoted to leisure was spent differently – on “stuff” and on home improvement notably.

Meanwhile, on the supply side, entrepreneurs have not been rushing (nor indeed incentivised) to increase productive capacity. It is true that, with interest rates near zero, the cost of borrowing is low. But that is not to say that the cost of investing in new capacity is low. To give the financial go-ahead to the building of a new factory, a management needs to be confident that it will be used, i.e. that demand will prove sustainably stronger. For if a factory remains empty, not only must its cost be written down in the books, but the loan taken out to finance the investment needs to be paid down. Also, in this world of internet immediacy, it is probably worth reminding our readers that building a factory to produce real “stuff”, and getting it up-and-running, is a complicated process that can take years – quite unlike the invention of a new app.

Surging and different-to-usual demand on the one hand, constrained capacity on the other: the only way to balance the supply-demand equation has been through rising prices. And with central banks, particularly the Fed and ECB, standing firm on their stance that these price pressures are only transitory, hence still very reluctant to hike rates, we expect inflation levels to remain high for much longer than the consensus currently expects.

In turn, this means increasingly negative real rates, that bite into purchasing power. To offset this impact, investors have little option but to invest in risky assets (the famous TINA – There Is No Alternative – driver). The fact that retail investors are now rushing into equity markets reflects just that, even if it is generally a sign (as is, incidentally, the proliferation of IPOs) that the rally is moving into its latter innings. We thus reaffirm our portfolio positioning, with a short duration on the fixed income side – to be prepared for when the Fed and ECB do eventually start to hike rates – and diversified investments in equities, staying clear of extreme valuations and maintaining option protections to help navigate inevitable corrective episodes.

 

The Oil Market: An Inflationary Case In Point

Energy is no exception in terms of the supply-demand mismatch. Crude oil inventories and total oil inventories, which include products, are plummeting (see chart). This drain looks set to continue through at least until the end of this year. Oil demand is now back to its 2019 level both internationally and in the US. Travel restrictions are finally getting looser and air ticket sales surged in the wake of the US government’s decision to accept vaccinated international travellers. In China, according to IEA data, demand is even attaining new highs.

On the supply side, the US oil rig count stands at less than half of where it was the last time the oil price hit this level and production will start to decline if drilling does not pick up. Internationally, the rig count continues to inch higher but remains close to its 2003 level, with the list of large projects about to move into production looking sparse for the foreseeable future.

Further, with the international natural gas price at an all-time high, many countries are replacing gas-powered generation with diesel-powered generation. This switch from gas to diesel could add 500,000 to 1 million barrels/day of oil demand during the winter months.

Power prices have started to make new highs in several European countries, while China and India are experiencing waves of blackouts. In short, a full-fledged energy crisis is in the making.

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