TLDR: Companies will keep investing in redundant, diversified supply chains. Countries will force more localization due to national security risks. Energy prices will remain high. China will stick to its zero-covid policy. Rising rates will reduce demand and make credit more expensive. Reduced demand will hurt the economies of scale. Expensive credit will make ongoing investments more expensive to complete. Prices will keep going up for a few years, until these factors are mitigated. The market bottom will be when the companies cancel stock buybacks and start printing shares.
Long read
The prevailing narrative today is that central banks will keep raising interest rates and sucking money out of the economy by other means, which will tame inflation sometime soon in 2023 due to reduced demand and economic slowdown. This is what the financial markets are pricing in, judging by bets on rates and bonds.
However, the global inflation we are experiencing today is not driven purely by monetary policies. That’s why inflation is global, spanning the whole world, even though different countries have vastly different monetary policies.
There are pockets of inflation, which are global, and were caused by relentless money printers, like real estate, travel, luxury goods, crypto, and various other assets. This is where the largest price reductions will continue. If you have any type of asset, it’s safe to say it will depreciate even more. Declines in housing and rent will drive down inflation metrics across the world, helping the central banks get closer to their inflation targets.
But the central banks cannot meet their 2% goals, because they cannot mitigate other factors causing global inflation. These are supply chain issues, caused first by COVID-19, then strict China zero-covid policies, then Russian invasion of Ukraine. We have an energy and food crises on top of that, also caused by the war in Ukraine. There’s nothing central banks can do about restructuring of supply chains, food scarcity, and energy shortage. They won’t be able to meet their inflation targets anytime soon and will have to keep higher rates in place for a few years.
Just-in-time vs Redundancy
Up until COVID-19, just-in-time production was the way of manufacturing. Whoever was more efficient at doing this was winning the profits race. The approach first pioneered by Toyota eventually was applied across the global economy. Until the priorities changed.
First, the pandemic exacerbated problems of this model. Companies suddenly became unable to get the parts needed anymore and were dependent on various government policies regulating lockdowns. Production of everything, from bicycles to cars, was disrupted, often delayed by a single missing part. For example, Ford currently delays production of its most lucrative F-150 trucks, because its single supplier of company badges and logos is in trouble.
Ford’s Latest Supply-Chain Problem: a Shortage of Blue Oval Badges
Second, there was a strong belief that global trade and mutual benefits would prevent countries from starting large scale conflicts, because it would devastate the quality of life of everyone involved and beyond. This belief was shattered after Russia started a full-scale invasion of Ukraine, the governments across the world are scared, and want to mitigate their national security risks. This includes everything, from food, to energy, to semiconductors, to commodities, etc.
Combined, this led to manufacturing being restructured from just-in-time into a redundancy model. Companies want to secure their own exclusive supply chains and have back-up options. Countries want to have localized manufacturing of various goods to mitigate national security risks.
The pandemic and the war are not the only factors they fear. Whether it’s an earthquake in Taiwan or a blockade from China, it’s the same risk to have all your chips manufactured there. The risks were always present but became much more prominent in a short period of time.
Restructuring of supply chains is a very expensive process on its own. This will keep driving prices higher over the next few years, until we see the first benefits coming to fruition. The prices won’t go down after that either because redundancy is more expensive. Combined with higher cost for local wages, more expensive locally sourced materials, higher environmental standards, etc., this will stick prices to a higher level. We are years away from reaching those levels.
Micron case
Let’s have a detailed look at a specific company to highlight the trend. Micron is not unique in what it’s doing, but perfectly illustrates what the companies around the world are going through.
Micron is a great company. It has valuable, high margin, industry leading products. It has been around forever and will outlive all of you reading this text.
However, its stock is down roughly 50% and may as well lose another 50% until we reach the bottom. Why is that?
First, they need to invest a lot in local manufacturing in the US. They do not have an option of not doing this. And we are talking about $150 billion over the next decade.
Micron to spend up to $100 billion to build a computer chip factory in New York
Micron breaks ground on $15 billion U.S. chip plant, says more to come soon
Micron Announces Over $150 Billion in Global Manufacturing and R&D Investments
The company also must diversify its supply chains. For example, Ukraine used to supply 70% of neon gases used in semiconductors manufacturing. Micron is adding redundancies to avoid bottlenecks like this one in the future.
Micron has diversified sourcing for its noble gases
It will take years for Micron to see the first benefits of these investments. And many more years for these investments to pay off. At the same time, the PC market is going through the worst slowdown in 20 years, while their current supply chains are still damaged by the war and zero-covid policies in China.
PC Shipments Plunge Nearly 20%, Steepest Drop in More Than 20 Years
How would Micron pay for these investments? Micron does not have $150 billion to invest and will have to find a way to finance this endeavor. It cannot avoid or postpone the investments and would have to drive them to completion no matter the cost.
This is a weird situation, where the central banks are trying their best to reduce inflation, but making mandatory investments like these more expensive, which will drive prices higher, and keep inflation elevated. A conundrum, which is mostly ignored today.
Micron, as well as other global companies, would go through a path, which would force them to raise prices for their products, but still end up indebted, strapped for cash, going through periods of unprofitability, and having their stocks at depressed valuations.
Buy High, Sell Low
Unfortunately, companies typically purchase a record amount of their stock at peak valuations when they have record profits. Last year the top companies spent their entire yearly profits on stock buybacks (Microsoft, Meta, Google, Nvidia, etc.). They bought the all-time high number of shares at the all-time high prices.
For example, last year Meta spent $44.8 billion on buybacks, which is roughly its yearly profit. And Meta spent almost $19 billion on buybacks in the last three months 2021 alone, at the top of the top of its stock price. What this means, is the company made no money last year. They spent all of their profits on buybacks, but the stock fell by 60% anyway.
Meta Fourth Quarter and Full Year 2021 Results
Companies are reluctant to cancel buybacks because this would immediately tank their shares. Instead, they try to reduce costs, freeze hiring, do layoffs, issue debt, postpone investments, and when everything else is off the table, they finally cancel buybacks. And only after that do they reduce dividends.
Cost reduction, freeze hiring, small layoffs, and debt issuance are already ongoing across the US economy and increasing by the day. Investments, which would typically be postponed in this situation, are increasing, and financed through debt. Let's look at Meta again. Even though this company is not affected by supply chain issues, it's also in the process of going through the largest restricting in its history and betting its future on it. This trend seems to be universal and encompassing even unrelated companies, probably due to record profits last year.
Meta raises $10 billion in first-ever bond offering
The interest rates are rapidly rising, and it will soon become too expensive to issue more debt. The companies will then tap more into their cash reserves and future profits. At some point, this won’t be enough to cover the expenses and buybacks would have to go. This would crash their already depressed stocks. Then companies would have to go through a period of unprofitability and finance their needs through issuing shares at the very bottom of the market.
It's typical for companies to issue shares at the bottom of the market when they have no other options. For example, they almost unanimously printed shares during the bottom of 2020 pandemic crash. And next time, when stocks are at their most depressed levels, when companies are hammered in the news about their poor financial choices, and start printing shares again to stay afloat, would be a good time to buy in. This would be the bottom of the bottom.
Whether it's Micron, or Meta, or pretty much any other large public company, they all are going through a similar path. The next few years are going to be rough.
Expensive Transition
This transition could have been easier if China or Russia did not change their constitutions to appease their leader. But both of them did everything to let their leaders stay in power for life.
China is going to stick to its most damaging policies, because their supreme leader is not allowed to admit mistakes. Whatever choices were made must be the right ones. This means zero-covid policies and frequent lockdowns of hundreds of millions of people will continue. This will keep randomly damaging supply chains for any product imaginable, spiking prices here and there, until redundancies are in place.
Similarly, the supreme leader of Russia can not admit his mistakes and would have to wage the war until the bitter end. Losing the war is the end for him and his inner circle. This will exclude Russia from the global economy for the foreseeable future and continue the energy and food crises.
The central banks will continue their fight against inflation. They know they messed up by printing too much money and inflating every asset price imaginable. They cannot back down from this path, because otherwise there’s a risk of hyperinflation. Hyperinflation is much worse than a recession. But because inflation is partly caused by non-monetary factors, the central banks would make ongoing changes in the economy more expensive and inadvertently force inflation to remain higher than their typical 2% targets.
If the central banks had not printed as much money as they did over the last decade, and kept their interest rates reasonably higher, this would the perfect time for them to reduce the rates and help companies finance their massive investments. Instead, the central banks will make this process more expensive, which will result in higher prices, and will make it harder to bring inflation below 2%.
The central banks will be able to reduce demand. However, reduced demand won’t always make prices cheaper either, because it will decrease the benefits of the economies of scale.
Consider an industry like travel. If fewer and fewer people can afford to travel, and energy prices remain high due to a shortage, then reduced demand only makes flying more expensive. If there’s not enough people to occupy all the seats in an airplane, then each ticket becomes more expensive. The economies of scale benefit from high utilization, once demand goes down, profitability is reduced everywhere, from cloud services to food delivery.
Submitted October 17, 2022 at 06:20AM by tebedam https://ift.tt/wa3Qob2
