As China’s strict zero-covid policy intensifies, the impact is being felt on its trading partners. Anthony Okolie speaks with Christian Medeiros, Portfolio Manager, TD Asset Management, about the increasing risks to supply chains and global trade.
- Christian, since March, China has battled another COVID wave, and that's really raised investors' fears about the global economy. What's been the impact of the recent COVID-19 lock-downs in China, specifically on the economies of Northeast Asia?
- China, China has had a zero-COVID policy since the beginning of the pandemic. And so what this has meant is whenever there is an outbreak in cases, they result to strict lock-downs and testing in the cities that are affected. But because Omicron is much more transmissible and viral than past infection waves, this has meant that it's spreading much faster throughout China and harder to contain with lockdown.
So we've seen major lock-downs countrywide, and we've particularly seen them in major economic centers, such as Shanghai. So this knock-on effect means that production has been stalled in factories, and ports have been shut down temporarily. And so this has had a ricochet effect across supply chains in Northeast Asia. Major trading partners that rely on China, such as Japan and Korea, rely on inputs from China and export to China as well. So this has had a slowing-- this has had an issue in continuing the supply chain disruptions that we've seen and will continue to exacerbate issues in semiconductor and other essential supply chains.
The other issue worth noting, though and one that was masked by the initial disruption in supply chains, is that demand is also slowing in China. As you can imagine, severe lock-downs means less consumption. And this is important because China is such a major source of growth within the region.
ANTHONY OKOLIE: So, as demand slows in China, what does this mean for global economies and markets?
- Global economies and markets are very reliant on China and China demand growth. And so this is definitely a headwind. But I think the issue that it really raises is what is in the supply chain. And this is just another wrench in the supply chain issues that we've seen over the course of two years, but these gross distortions are causing a particular risk that I think not enough people are paying attention to.
So in the supply chain parlance, people like to talk about a bullwhip effect. Which is if you think of the supply chain as a long chain of many actors from transportation, to consumers, to wholesalers, to producers, they're all trying to forecast demand from earlier links in the chain. They're playing a very long game of broken telephone. And when things are normal in the economy, it's fairly easy to predict what demand will be for the next quarter. But when things are distorted with constant disruptions, we can see people over ordering, under ordering.
It's really hard for them to know given how distorted the patterns of consumption were during COVID. It's hard for them to predict what our consumption will be post-COVID, particularly if demand is slowing. So what that means is that there's a risk because supply chains have been so distorted for so long that we may be overproducing into a world of slowing demand, and that could be a material risk for an inventory-led recession.
ANTHONY OKOLIE: Let's talk about the impact on China's largest trading partner. What are the knock-on effects on US consumer demand due to further global supply chain disruptions?
- Yeah, so China's slowing, the next biggest consumer in the world is the US consumer, the US household. And so what happens there is pivotally important to understanding how the global demand picture will shake out. The US consumer, of course, has been strong.
And if you look at the chart that I've shared today, we see that US consumption of durable goods-- these are long things that you use for many years, such as fridges, cars, et cetera-- has been way above historic trend lines over the last 10, 20 years. And that's just because of the strength of recovery and all the things that we've talked about on your show.
However, the risk going forward is that there are headwinds to the US consumer. There's high levels of inflation. There's a pull forward of spending. You're not going to be buying a fridge every single year. There's high interest rates and high mortgage rates. And all these things mean that it's quite likely that this high level of durable consumption that you see in the chart, it's going to fall back towards and revert to the mean consumption levels.
If that alone was the only-- was the only trend that we were seeing, maybe it wouldn't be too concerning, just a reversion to the mean. However, because of the bullwhip effect that I mentioned before in which the supply chain is not potentially able to respond to rapidly changing demand picture, that means that we might instead of having shortages in the supply chain, have glut in the supply chain, have an overproduction of goods.
And that, of course, is a major risk to all the companies within that supply chain who are perhaps overproducing or oversupplying that supply chain into a weakening demand picture. That will result in higher recession risk and potential earnings missed for companies involved in that process.
ANTHONY OKOLIE: OK, so given the risks, particularly when it comes to the supply chain, what will you be watching closely over the next few months?
- Yeah, so we're going to be watching the two biggest sources of demand in the world. That being China and the US, as we've talked about. So in the US-- in China, we'll see if China does loosen their zero lock-- zero-COVID policy. That doesn't seem particularly likely, especially with the important People's Congress later this year. But we'll also be watching to see if the Omicron wave is able to crest. In that case, there might be upside to the demand picture. But currently, there's definitely downside risk and threats.
On the US front, which is perhaps more important, we're going to be watching to see how the consumer's evolving. We've seen a weakness in the survey data but not yet in the hard data. So we're going to be watching to see if US consumers are still buying at a strong clip.
And if that turns out not to be the case, however, we're going to be watching out to see how the supply chain is responding and whether companies are able to quickly adjust, or if they're going to be shocked and surprised by the reversion to the mean of the US consumption. So these are the trends that we're watching for, and we think they're critically important because slowing global growth will have implications for Fed policy and the way that the economy goes going forward.
ANTHONY OKOLIE: Christian, thank you very much for joining us.
- Thank you.