Earlier this year, CTMfile published the findings of a global survey of Bank of America (BofA) analysts which argued that supply chains for companies representing US$22 trillion market cap were on the move. More importantly, in the first signs of reversal in a multi-decade trend, it found companies in North America were planning to ‘re-shore’ production.
Although most of these planned relocations were small compared to their installed base, the breadth of the shift was striking. At the time, BofA characterised these movements as 'tectonic': slow moving, persistent with major changes to the business environment.
The COVID factor
COVID-19 has accelerated these calculations. Stepping back, global supply chains were built to maximise returns by optimising labour cost arbitrage and lower overheads. The pandemic has, however, exposed the fragility of far flung supply chains and a fresh survey of BofA analysts reveals that companies in more than 80% of global sectors experienced supply chain disruptions during COVID-19. As a direct follow-on to these disruptions, three-quarters plan to enhance the scope of their pre-existing plans to re-shore production.
While disruptions from the pandemic might have acted as a catalyst to accelerate re- shoring, the BofA Research report states that the underlying structural reasons are grounded in an ongoing shift to 'stakeholder capitalism', where corporations focus on shareholders’ interests, as well as the broader community of consumers, employees and the state. As a case in point, a survey of BofA analysts suggest that companies in 75% of global sectors in North America and Asia Pacific and 67% in Europe are expecting to face additional scrutiny around their supply chains from governments, corporate boards and shareholders.
While each of these stakeholders are examining the location of supply chains from very different perspectives, they are arriving at the same conclusion: namely, portions of supply chains should relocate, preferably within national borders and failing that, to countries that are deemed allies.
Starting with governments, last year the BofA Asia and EM Equity strategy team wrote about how the world is becoming more government-heavy with heterodox policies reversing 40 years of free, global markets. The report suggests that government scrutiny of supply chains locations will be primarily driven by national security considerations and notes that the US has recognised China as a strategic competitor - a view articulated in the National Defense Strategy documents. Similarly, the European Union in March 2019 concluded that the “the balance of challenges and opportunities presented by China has shifted”. This geo-political assessment is resulting in a combination of legislation, incentives as well as moral suasion to relocate supply chains from China to alternative jurisdictions.
Influence of ESG
The views of corporate boards, shareholders and consumers are also increasingly influenced by environmental, social and governance (ESG) considerations. The influence of this perspective is reflected in the US$90 trillion in assets under management (AUM) being invested along the Principles for Responsible Investment (UNPRI).
Against that backdrop, BofA's ESG team has examined the ranking of countries on a range of criteria and concluded that manufacturing in Europe and North America have under-appreciated advantages. These include higher use of non-fossil fuel power and proximity to consumers (implying lower carbon footprints) as well as lower risk locations from the perspective of climate change. Interestingly, the BofA team concluded that ESG favours states like Brazil, Mexico, India, Poland and Vietnam over China. Overall, this leads to the same conclusion as the national security calculus. Namely, that there is a growing case for re-shoring from China to within US or European borders or to allies with shared values.
For more information on the importance of ESG in the supply chain, in July CTMfile spoke with Baris Kalay, head of Trade and Supply Chain Finance for GTS EMEA at Bank of America, to get his take on how corporates can integrate ESG policies into their supply chain.
While political, social and corporate pressures to re-shore production are growing, they are also accompanied by trepidation about the costs that this shift would incur. This is grounded in concern about losing the unrivalled cost, scale and ecosystem advantages built up by China over the past few decades.
BofA Research has estimated those costs and concluded that a US$1 trillion capex cycle, spread over a five year period, would support the shift of all foreign manufacturing in China (c.40% of Chinese exports) that is not intended for consumption in China. In effect, foreign firms could continue to be 'in China, for China', but would have moved their manufacturing destined for global markets back within national borders, or to alternative jurisdictions.
While a US$1 trillion capex cycle would be significant, the BofA Research report does not believe that it is prohibitive. At the end of the five year period, the report estimates this would reduce aggregate return on capital employed (ROCE) by 70 bps (from 8.9% to 8.2%) and reduce free cash flow to sales by 110 bps (from 7.2% to 6.1%) for the global sectors ex-China. Of course, not all industries are equal. Those with structurally higher returns - like health care and tech - will be able to absorb this incremental capex. Others, with more muted cash flows, may have to resort to external debt or equity financing.
The report also cautions that capex required to shift manufacturing should not be conflated with operating costs, which could be higher outside China and could act as drag on margins. BofA Research expects management and policymakers to aggressively explore ways with which to offset higher costs associated with re-shoring. While the report does not expect a silver bullet, analysts were struck by the universal declaration (in the survey) of intent to automate in future locations. This was equally true of North American, as well as Asian companies and may be meant to mitigate the higher cost of operation in developed markets and offset lower productivity in emerging economies.
Policymakers are also expected to help through tax breaks, low cost loans and subsidies with recent announcements to that effect from the US, Japan, the EU, India and Taiwan.
Financial markets could - of course - assign lower multiples for lower ROCEs. Moreover, funding a major capex cycle could dampen the ability of corporates to support dividends and share buybacks. This is material at a time when an estimated 1-2ppt of annual US earnings growth in recent years is a consequence of buybacks. However, valuations may be helped by lowering exposure to geopolitical vagaries. Plus, historical parallels suggest that heightened competition between two great powers may lead to innovation and increased productivity, providing a much needed boost to nominal growth.
These tectonic shifts could have important implications for the manufacturing sector and auxiliary services. This is particularly true for the US, which has faced long-term headwinds in manufacturing. Any sustained recovery in capex and manufacturing would have multiplier effects on the broader economy. These include jobs (an estimated seven indirect jobs created for every new job in durable goods manufacturing), higher wages, greater research and development (R&D) spend, more tax revenues and the creation of industrial clusters.
Investors, especially those with a long investment horizon, may like to position portfolios towards sectors that stand to benefit from this dynamic - construction engineering and machinery, factory automation and robotics, electrical and electronic equipment manufacturing, and application software to name a few. Moreover, banks in North America, Europe and Asia South are expected to benefit from greater economic activity.
Finally, the report concludes that it is worth noting while other jurisdictions would benefit from re-shoring and its multiplier effects, over time, China could be presented with the challenge of offsetting the equivalent of c.7% of its GDP (currently derived from foreign company exports). BofA Research expects this to result in further efforts to stimulate domestic consumption and China's regional ecosystem/Belt-and-Road Initiative.
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