The domino effect of global supply chain decentralization

How does the decentralization of supply chains affect the economy in the U.S.?

Jonathan Coleman: One of the first implications – and one of the most significant – is that we will need more workers in many industries. For example, according to the National Association of Manufacturers, the U.S. needs about 800,000 more workers in manufacturing, and that’s on a base of about 13 million total workers employed in manufacturing today.

Meanwhile, the amount of money spent on manufacturing-related construction has increased more than 40% in just the last year. I think that’s part of an early trend that will continue for years to come. As a negative, we may not have enough skilled workers to meet the demand for their services.

The decentralization of supply chains should also reduce our reliance on China going forward. Given geopolitical concerns, that may be a positive.

In addition to being good for employment levels in the U.S., I think all these factors will ultimately increase supply chain resiliency because companies will be manufacturing closer to the primary consumer of goods.

It’s important to note that these factors will be inflationary to the U.S. economy. However, the service economy accounts for about 70% of gross domestic product (GDP). And when workers have more money in their pockets, they spend more money on services, which creates a positive flywheel effect.

So, on balance, we believe supply chain decentralization will have a positive long-term impact on the U.S. economy. For perspective, it took 25-plus years to offshore production supply chains. I think nearshoring and onshoring will probably happen much faster than that but will still provide a decade-plus of tailwind to the U.S. economy.

Which countries do you expect to be beneficiaries of supply chain diversification away from China, and do you see an investment opportunity on the back of this trend?

Matthew Culley: We do see this as a key driver for investment returns in emerging markets (EM) over the next decade. But I think what’s different this time versus what you saw in EM 20 years ago is that a rising tide probably is not going to lift all boats – some countries are going to benefit disproportionately.

That said, I think the key beneficiaries will be Mexico, India, Vietnam, and Indonesia. But it’s important to remember that it’s not just about labor arbitrage; it’s also about the ability for countries and governments to be able to build out the logistics capacity and then deepen the breadth of the supply chain. We’re seeing a lot of interesting innovations such as digital cargo logistics that will help increase the efficiency of trade lanes from Mexico to the U.S.

Indonesia is another great example: We’re increasingly seeing the government working to create an investment-friendly framework to encourage local investment. So instead of just exporting some of the critical commodities for electrification and green energy, for example, they’re pushing for the ability to create end products. Instead of just exporting raw materials, they’re verticalizing and bringing more of that benefit in-house.

Going back to the U.S., how does decentralization of supply chains affect the investing environment in the United States?

Coleman: First, we think wage inflation is likely here to stay, especially in industries with worker shortages, and I think that has clear implications on the investing front. With this backdrop, the Fed is unlikely to go back to super accommodative monetary policy any time soon. This will have implications for equities, which require a low discount rate to justify their current stock prices.

Second – and somewhat related to the first point – companies that can’t automate some of their workflows will need to raise prices to offset the higher wage bill. They may also see operating margins compress, which is something investors should be aware of.

Third, recent legislation – such as the CHIPS Act and the Inflation Reduction Act – should create regulatory and government spending tailwinds. And there are state-level incentives for a lot of companies to locate manufacturing in certain regions that are seen as business friendly.

I think it’s important for companies to be flexible and agile in this environment, and to have some redundancies in their supply chain. The shortening of supply chains could also be good for free cash flow because companies should be holding less inventory, which could help returns on capital.

Lastly, I think we’re likely to see less cyclicality in certain industries because they will have fewer inventory corrections. Oftentimes when goods are manufactured a long way away, companies don’t react quickly enough to a demand slowdown, and they don’t understand that there will be a glut of supply. But if companies are manufacturing closer to end-market demand, they will have less of that supply-chain correction dynamic, and ultimately less cyclicality.

Is the demand for greater supply chain diversification that some EM companies might have from North American or European customers positive or negative for shareholders of those companies?

Culley: EM businesses are known to produce things cheaper, better, and faster. But today they must contend with the cross-trend of potential stranded capital, in that they’ve already built supply chains and manufacturing in China.

EMs must also contend with the prospect of increasingly investing fresh capital in regions that don’t provide the lowest marginal costs, and that’s necessarily inflationary and likely margin dilutive. But a lot of these companies’ customers believe this is a strategic imperative for them. So, one thing we’re starting to see is deeper engagement with global multinationals – as well as governments – on how to share that cost.

And it’s not just about setting up a manufacturing facility outside of China, because again, it’s not just labor arbitrage – it’s a lot deeper. The breadth of the component supply chain is so extensive in China that the cost and speed of doing business has developed over many, many years. A manufacturing facility without a similar investment in nearshoring components really won’t achieve the desired outcome. For example, if the final assembly of an iPhone is in India but all the components are imported from China, does that yield the desired supply chain diversification? Probably not. Again, it’s a much deeper conversation.

Ultimately this means that the big EM companies will keep getting bigger. Those companies that have scaled and help rearchitect a lot of the supply chains are the ones that will be able to command a fair return on their investment. But there will be some upfront capital required.

What do you consider direct beneficiaries of the decentralization trend in the U.S.?

Coleman: It’s important to understand what the U.S. government views as strategic, and a couple of areas stand out to us on that front. One is semiconductor manufacturing with the CHIPS Act. Another is EV batteries and the extent to which U.S. companies can help support domestic innovation on that front.

And then there’s medical supply, pharmaceutical, and biotech manufacturing. I think it was quite alarming from a societal perspective that the U.S. had previously outsourced so many of those critical functions to China when the COVID pandemic hit. I think we would be better off as a country if we had a meaningful source of manufacturing and supply nearshore or onshore for those areas.

Another area that seems to be a direct beneficiary to the U.S. is the capital goods sector. I referenced earlier the significant increase in capital expenditure associated with manufacturing capacity in the U.S. over the last 12 months, which we expect to continue. And with the worker shortage, the focus on automation will be critical.

There’s also an opportunity for small caps to perform well in the United States as a result of this trend, because their ability to be more agile may allow them to move faster than some larger and less efficiently managed large-cap companies.

Lastly, with all this manufacturing going on, somebody has to build the incremental capacity, and engineering and construction companies can benefit substantially from that.

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