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Pivoting the Business - Wilmington Trust Market Forecast 2021
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Supply chain rethink

Companies have been incentivized to examine the resiliency of their supply chains against everything from trade wars to pandemics. While there is no one-size-fits-all solution, a common theme in today's environment is supply chain diversification.
In certain cases, this may involve reshoring or an exit from China.

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Contributor

Rhea Thomas, Senior Economist for Wilmington Trust Investment Advisors, Inc. View bio

Like everything else, supply chains are vulnerable to the effects of COVID-19. The pandemic has led to large-scale supply chain disruption that only compounds the impacts started when the U.S.-China tensions first erupted in 2018. As the virus has accelerated this trend, myriad additional factors, including cost, the environment, and government policy, are at play. The result? After decades of opting for the same global suppliers, domestic firms are diversifying among a variety of nations—including reshoring or onshoring back to the good ol' U.S. of A., and we don’t expect this to change in the wake of the election. President-elect Biden’s campaign platform on trade had a broadly similar theme to that of President Trump’s administration. He proposed a number of policies to promote domestic production, including tax penalties aimed at companies that outsource jobs, as well as tax incentives to bring jobs back. The combined effect of all factors will be an ongoing shake-up in the historic patterns of globalization.

Made in China? Made in America?

Made globally is more like it. Traditionally, a global supply chain refers to a multinational network of suppliers that produces and delivers goods to customers worldwide. Driven by efficiency considerations, the process is broken up into stages, each of which adds value to the final product.1

Consider, for example, that the production of a single North Face® Women’s Denali jacket involves 23 different suppliers and six countries. From which, you ask?

Picture of jacket and world map
Guatemala

Cord lock tie-downs, shock cords, interior neckline tape, and hand pocket linings

Source: https://open.sourcemap.com/maps/embed/59f3a2c245206cbe5137423b

A look back at globalization

Centuries of scientific, industrial, and even political revolutions propelled globalization, which improved forms of and lowered costs for transport and communication that helped encourage trade. For example, the inflation-adjusted cost of a three-minute phone call from New York to London declined by 99.9% between 1930 and 2000, while average shipping costs declined by nearly 60%,2 making it far more cost-effective to do business overseas.

Chart showing Trade (as a percentage of GDP) between 1970 and 2018

Source: International Monetary Fund. Data as of 2019.

The most recent boon in globalization (1990–2008) was fueled by a number of cost-reducing factors—agreements that lowered tariffs, attractive new markets abroad, and novel technologies. China, as the world's largest exporter, was a key beneficiary of this trend. Since the financial crisis, however, the pace of globalization has eased due to forces that include: slower growth, a shift toward domestic consumption, a growing swell of protectionism, and rising wages in emerging markets. In China, for example, the average monthly wage rose from $55 in 1990 to $990 in 2018,3 prompting companies in labor-dependent industries like apparel and footwear to shift out of the country.

The necessity of supply chain resilience

Company decisions around supply chains are highly complex and driven by multiple influences, including operational costs, infrastructure, regulation, political and institutional stability, labor issues, and distance from other industry suppliers and customers. Costs, particularly for labor, have typically been the central driver in the past and will likely continue to be so. With the wage disparity between the U.S. and China remaining stark, it is not surprising that global supply chains have migrated to and stayed with China for so long. According to the Reshoring Institute, the cost of a machine tool operator is roughly $26.10/hour in the U.S., compared to $4.60/hour in China.4 But cost is not everything. Unexpected trade tensions and pandemic-related shocks have served as a wake-up call that the cost and convenience associated with concentrated supply chain structures can come back to bite hard. It is for this reason that firms have and continue to pursue supply chain diversification on a massive scale.

Tariffs, Covid, and company thinking on supply chains

American companies rely on overseas suppliers to remain competitive. The combination of inexpensive labor and superior logistics performance makes all the difference.

Pie chart
39.7%

of companies were considering relocating or had already relocated manufacturing facilities outside of China as a result of increased tariffs.

Tariffs—the first major nudge

An American Chamber of Commerce survey from May 2019 found that roughly 39.7% of respondents were considering relocating or had already relocated manufacturing facilities outside of China as a result of increased U.S./China tariffs.5 Companies such as Apple, GoPro, and Hasbro are just some that started the process of diversifying portions of their supply chains out of China in response to rising tariff-related costs. However, in the case of companies like Apple, the shift out of China started with smaller product lines, moving to Vietnam (AirPods), India (lower-end iPhone models), and the U.S. (Mac Pro computers).6

Pie chart 39.7%

of companies were considering relocating or had already relocated manufacturing facilities outside of China as a result of increased tariffs.

Pie chart 93%

of supply chain executives plan to increase resiliency across the supply chain as a result of the pandemic.

COVID to China: “Move over”

The far more acute impact of COVID-19 laid bare the scale of vulnerability due to concentrated China exposure. Major companies across a range of industries (Apple, 3M, Hyundai, Nintendo) saw disruptions at the start of the pandemic due to factory closures or export restrictions in China. A McKinsey survey of executives revealed 93% plan to rely less on one country for supply chains, with about 50% looking to dual source raw materials or increase inventory of key products, and roughly 40% looking to nearshore (bring production closer to end markets) and expand supplier bases, or regionalize supply chains.7

Pie chart 93%

of supply chain executives plan to increase resiliency across the supply chain as a result of the pandemic.

Structural Factors Shifting the Balance

The existential question firms now face is whether they will be able to justify the additional price tag of shifting to markets with higher labor costs. The answer is not straightforward and depends on a variety of industry- and company-specific considerations. There are, however, a number of structural factors beyond the need for resilience that may further support company decisions to shift supply chains out of China, highlighted below.

Increasing need to be flexible and adapt to unexpected shocks, such as pandemics or climate events

In an example of resilience driving an international supply chain decision, Taiwan Semiconductor Manufacturing (TSMC) announced plans in May 2020 to build a chip plant in Arizona despite higher costs, stating that "This project is of critical strategic importance to a vibrant and competitive US semiconductor ecosystem that enables leading US companies to fabricate their cutting-edge semiconductor products within the United States..."

Source: https://fr.reuters.com/article/us-usa-semiconductors-tsmc-idUSKBN22Q38T

Increasing need to be flexible and adapt to unexpected shocks, such as pandemics or climate events

In an example of resilience driving an international supply chain decision, Taiwan Semiconductor Manufacturing (TSMC) announced plans in May 2020 to build a chip plant in Arizona despite higher costs, stating that "This project is of critical strategic importance to a vibrant and competitive US semiconductor ecosystem that enables leading US companies to fabricate their cutting-edge semiconductor products within the United States..."

Source: https://fr.reuters.com/article/us-usa-semiconductors-tsmc-idUSKBN22Q38T

Automation can reduce labor costs

Nike, which has had supply chain operations in Asia since the 1970s, is a key example of this. It decided to invest in machines made by a company called Grabit, that can help a human worker assemble a sneaker in just 50–75 seconds, something that would have taken 10–20 minutes for a human worker to complete without the aid of the Grabit machine.

Source: https://fortune.com/2017/08/30/robots-static-electricity-nike-sneakers

New technology may alter the makeup of products and services, allowing for more customized, local production

BMW utilizes 3D printing for small-scale custom parts currently, but as this technology advances could allow for larger scale use.

Source: https://www.bmw.com/en/innovation/3d-print.html

Growing focus on reducing carbon footprints and supporting local communities as a part of corporate ESG goals

Patagonia is an example of a company that uses environmental standards as a driver in its supply chain decision-making processes as it screens new potential suppliers.

Source: https://www.patagonia.com/our-footprint/working-with-factories.html

National security concerns and rising inequality in the wake of decades of globalization have prompted increasingly protectionist government policy to encourage reshoring of supply chains and creation of jobs domestically

Trump administration policy (via tariffs, restrictions) has already put incentives in place to encourage reshoring; Biden\'s "Made in America Plan" also seeks to bring production back to the U.S.; survey conducted by The Reshoring Institute suggests that consumers are willing to pay up to 15% more for products that are made in the U.S.

Source: https://www.sme.org/smemedia/podcasts/2020/covid-19s-impact-on-reshoring-and-the-supply-chain/

Core supply chain factors such as cost, logistics, and competitiveness are critical drivers of supply chain strategies. The chart below compares how China, Vietnam, Mexico, and the U.S. compete in numerous supply chain drivers. Although the U.S. fares well in terms of overall competitiveness and logistics performance, its labor costs can prove prohibitively high relative to China and other countries. And while Mexico and Vietnam are attractive on a cost-labor basis compared to China, both are in need of infrastructure improvements. Additionally, Mexico suffers from domestic security issues and Vietnam could face capacity constraints as a number of multinationals already have large-scale operations in the country, e.g., South Korea’s Samsung. The ability to shift to these countries will depend on their capacity to manage these challenges.

How we got to this point

China has benefited from a combination of relatively low labor costs compared to the U.S. but also relative strength in logistics and overall competitiveness compared to other emerging markets.

China
Vietnam
Mexico
United States
Labor costs
$6,675
$4,066
$4,439
$40,140
Logistics performance
(0 is lowest, 5 is highest)
3.61
3.27
3.05
3.89
Global competitiveness
73.90
61.50
64.90
83.70
Labor Costs
U.S.
$40,140
China
$6,675
Mexico
$4,439
Vietnam
$4,066
Logistics performance
(0 is lowest, 5 is highest)
U.S.
3.89
China
3.61
Vietnam
3.27
Mexico
3.05
Global Competitiveness
U.S.
83.70
China
73.90
Mexico
64.90
Vietnam
61.50

Labor Costs: 2019 annual manufacturing wages; U.S. Bureau of Labor Statistics, PwC.
World Economic Forum Global Competitiveness Index, 2019; captures quality of institutions, infrastructure, Information and communication, technology adoption, macroeconomic stability, health, skills, product market, labor market, financial system, market size, business dynamism, innovation capability; World Economic Forum.
World Bank Logistics Performance Index, 2018; captures efficiency of customs/border management clearance, quality of trade, ease of arranging competitively priced international shipments, competence/quality of logistics services, ability to track/trace consignments, frequency with which shipments reach consignees within expected delivery time; World Bank.

The location of end-customer markets will be another key factor for consideration, leading to a variety of potential options for companies.

Reshoring to the U.S. may be one option for companies with U.S. customers, though much higher labor costs will likely need to be offset through automation and/or tariffs, subsidies, etc. The latter may be particularly important for industries deemed as critical for the national interest, such as medical equipment, pharmaceuticals, or semiconductors. For example, the U.S. currently imports roughly 80% or more of personal protective equipment such as gowns and gloves8 and 28% of overall medical equipment from China.9

Nearshoring or regionalization (bringing supply chains closer to end markets) is another option, which suggests Mexico could be an alternative for companies with U.S. end markets. These solutions would mean having to contend with the challenges of being far from existing supplier networks in Asia. For multinational companies with worldwide markets, diversification through multi-regionalization may be a key option, and many companies already have such "local production for local market" supply chain structures.

Alternate Asia location: Some companies could choose to prioritize maintaining supplier networks over distance from end-consumer markets, but still diversify by shifting some production to another country in Asia. A number of potential candidates such as India or Indonesia come to mind, and Vietnam is at the top of many lists. Some companies have recently announced plans to manufacture in the country, including Google (Pixel 5 smartphone) and Microsoft (Surface line of devices).

China or China +1: For companies in some industries, the vast investments and supplier networks built over years may be difficult to part from or replicate. Other firms may need to maintain access to the Chinese market, one that is large and growing; for example, China is now the world’s largest market for automobiles and smartphones.10 For these companies it may make sense to stay put in China, or maintain a China presence while adding an additional location for diversification.

Potential Supply Chain Shift Options

Companies must weigh their options carefully. Here are some of the pros and cons of shifting supply chain from one country to another:

Reshoring: U.S.
Pros
  • Lower logistics costs
  • Lower tariffs
  • Proximity to end market allows for speedier delivery and response times
  • Potential to reduce carbon footprint
Cons
  • Higher labor costs
And the winners are . . .

It is still early to tell definitively which way the winds will shift with regard to supply chain re-evaluations, as complex company- and industry-specific dynamics mean there won’t be a one-size-fits-all solution across the board. Industries most likely to engage in a supply chain rethink include those that are deemed critical for national interest—such as defense, pharmaceuticals, medical equipment, technology, and communications. Industries that have a low reliance on labor and are best able to utilize automation to lower costs (such as the automotive industry) are also likely candidates for supply chain shifts.

On the whole, we expect the heightened need for resilience to accelerate the trend of diversification in supply chains. Companies that manage this process well will be long-term winners. We view global mega-cap stocks as best positioned to benefit from this trend. These large, multinational firms have the greatest capacity to be adaptable in making supply chain decisions, and have operations in major regions all around the world, allowing them to easily regionalize supply chains to bolster resilience. Regions and countries most likely to gain from supply chain shifts include South and Southeast Asia (India and Vietnam in particular), Taiwan, and North America (Mexico). We also expect that the automation industry will be a beneficiary, no matter the end destination.

1. Though supply chains are also sometimes referred to as global value chains (GVCs), there is a distinction. The term GVC is used to encompass aspects beyond the physical production process that add value to a final product or service, including R&D, design, marketing, and post-sale customer support. The value chain is what makes the difference between a $5 store brand T-shirt and a $50 designer T-shirt.
2. (Busse, Matthias, Tariffs, Transport Costs and the WTO Doha Round: The Case of Developing Countries, 2003)
3. Congressional Research Service, China’s Economic Rise: History, Trends, Challenges, and Implications for the United States, June 25, 2019
4. https://www.sme.org/smemedia/podcasts/2020/covid-19s-impact-on-reshoring-and-the-supply-chain/
5. AmCham China and AmCham Shanghai, "Second Joint Survey on the Impact of Tariffs," (May 2019) https://www.amchamchina.org/about/press-center/amcham-statement/second-joint-survey-on-the-impact-of-tariffs
6. https://www.wsj.com/articles/tim-cook-and-apple-bet-everything-on-china-then-coronavirus-hit-11583172087?mod=article_inline
7. https://www.mckinsey.com/business-functions/operations/our-insights/resetting-supply-chains-for-the-next-normal?cid=other-eml-shl-mip-mck&hlkid=189ad76fbc2f46ecacf9b2f2f726a525&hctky=11435384&hdpid=11f359ad-1215-44b6-8a04-cb672f55294d
8. https://www.cato.org/blog/new-data-show-americas-limited-dependence-china-essential-medical-goods
9. https://www.stlouisfed.org/on-the-economy/2020/april/us-rely-other-countries-essential-medical-equipment
10. McKinsey Global Institute

Clement K. Miller, CFA, senior portfolio manager serving with Wilmington Trust Investment Advisors, Inc., reveals his insights on how investors can take advantage of the changes we’re seeing in international supply chains.

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