December 1, 2020

The End Of 2 Really Bad Economic Ideas

While it isn’t getting much press nowadays, there’s a bubbling development in the European Union that reflects a realization America made a long time ago – and that it had to face yet again in the COVID-19 crisis: an over-reliance on Chinese exports has made these advanced economies weak and susceptible to collapse.

It may seem ironic that the European Union, itself considered a symbol of progressive pro-globalist transnationalism, has suddenly sounded very protectionist in its stance to China. “China provides 98% of the EU’s supply of rare earth elements,” wrote the bureaucrats in a European Commission whitepaper. The paper then uses delightfully Orwellian doublespeak to recommend a response: “open strategic autonomy,” which it defines in a footnote as “shaping the new system of global economic governance and developing mutually beneficial bilateral relations, while protecting ourselves from unfair and abusive practice.”

Or, as Trump would say, getting a better deal from China.

That the very anti-Trump technocrats in Brussels use more delicate language than Trump to say the same thing should demonstrate to everyone, regardless of your political affiliation, that a massive restructuring of the global supply chain is underway. This was a necessity before COVID-19 and before Trump; Obama went to the WTO about China’s rare earths dominance in 2012. As usual, partisan politics are a poor way to understand long-term economic and geopolitical developments that have much more to do with national interests, technological developments, and market innovations.

While the EU is eight years late to the party, and while its recommendations are both poorly written and self-contradictory (“The EU’s open strategic autonomy in these sectors will therefore need to continue to be anchored in diversified and undistorted access to global markets for raw materials” is the kind of bureaucratic sentence only a mother could love), its action is not surprising. The EU has decades of agricultural sector protectionism and rule-touting exceptions for its debt-to-GDP targets under its belt to protect its most powerful members. Using globalization when it benefits it and pivoting to fostering a domestic rare earths production sector when it must is the kind of behavior one would – and should – expect from a supranational federation.

But in so acting rationally for the best interests of (SOME) of its constituent states, the EU’s action now, as in the past, demonstrates that the simple viewpoint of the EU among the left (as a darling harbinger of world peace) and among the right (as a corrosive step towards a dystopian New World Order) are both as wrong, as they are cartoonish, because they distort the reality: the EU is a pragmatic group of technocrats who go from protectionism to globalization when it benefits them, all the while promoting itself with a “We are bringing the world together” kind of PR that is about as effective and as honest as Hands Across America was.

Still, the rare moments when the EU breaks from its “We are the world” rhetoric to provide pragmatic solutions to problems caused by globalization are so unusual that they need to be treated as profound exceptions to the party line – made only when absolutely necessary.

And the necessity of diversifying away from the China-as-the-world’s-production-house model of the late twentieth century has never been more obvious than in 2020.

The Rise of Shortages

What really brought this home to me was when my mother, still in America, asked me to mail her some surgical face masks in the midst of the lockdown. I’ve been in Thailand throughout the crisis, and here, those masks (and N95 masks and just about any other kind of mask you want) are not only readily available, but were actually briefly given out for free at some shops.

This wasn’t the case in the much richer, much more developed, and much more politically stable United States, where a shortage was allegedly caused by a “supply chain… stressed [when] demand exceeds available supplies.” This is at best a half-truth; supply exceeds demand here in Thailand, where surgical masks go for less than 50 cents each (friends in China tell me the same is the case there). Rather, it is the United States’s reliance on imported PPE that has specifically caused American demand to exceed American supply.

Of course, it isn’t just masks that have seen a shortage in America. There was the toilet paper shortage at the start of the pandemic, and then there were beef shortages, and drug shortages, and coin shortages, and computer shortages, and all kinds of other things.

There were two causes to these shortages, both which are obscured by the general phrase often used to define them: supply chain disruption. That is true, but there were two types of disruptions that have different causes – and understanding the difference between them tells us much about the economic mistakes of the past that got us here and the economic incentives that will reshape supply chains after the crisis.

Cause 1: Shutdowns and Lockdowns

The first cause is the simplest and easiest both to understand and to fix/prevent: the shutdowns of factories and other production plants as a result of the March-May lockdowns (for the purposes of this essay, I’ll focus on America; the timeline obviously differs from country to country). Hence, capacity utilization – defined as “the percentage of resources used by corporations and factories to produce goods in manufacturing, mining, and electric and gas utilities” by the Federal Reserve – plummeted during the lockdown.

It should be noted that this chart looks like almost every other macroeconomic chart out there. In discussions of the shape of the recovery, I don’t hear anyone talking about what I call a Big Dipper recovery: a period of pain over the period of several weeks, followed by several months of below-the-pre-pandemic trend line.

(Source: EarthSky)

One reason for this big dip in capacity utilization was the shutdown, which meant that people working in close quarters, in slaughterhouses, for instance, could no longer do so, disrupting production or causing it to halt entirely.

Thus, one idea doggedly pursued by the advice of economists and financiers has suddenly become a disaster: driving factories towards efficiency made them less robust. Production plants where workers are inhumanely packed closely together in unhygienic working conditions meant that they could no longer work together during a pandemic. The drive towards efficiency suddenly became a weakness, not a strength, and because humans are hardwired to avoid the most recent crisis (economists and psychologists call this “recency bias”), this means the economic truism that companies must cut costs at all costs, including cutting corners that have non-economic reasons to be, will be significantly challenged in the next decade.

The Investment Lesson

Any company that depends on producing a physical product and has invested heavily in tightly jam-packing the most number of workers in the least amount of space will find themselves forced to invest a little in better working conditions. Companies like Tyson Foods (TSN) will likely see margins contract, as years and years of cost cutting will no longer be viable. Similarly, companies will kick into high gear their attempts to automate jobs and replace the need for workers on the factory floor. Companies like Altra Industrial Motion (AIMC) are set to win. This isn’t news to anyone; the market has already been betting on this hypothesis.

Of course, the relative advantage of being a company that does not produce a physical product and thus does not require factories is even higher in such a world. Thus, software darlings, from Autodesk (ADSK) to Zendesk (ZEN), are likely to look even more relatively attractive over the next decade as the companies working to make tangible products renovate their entire business practice.

Cause 2: Global Supply Chains

In addition to working to lower human-to-human contact on factory floors and sacrificing efficiency for robust production processes, expect companies to also look for more diversified supply chains. Again, this is not news. CNBC, surprisingly, wrote eloquently and accurately about how and why this is going to come about. In short, Chinese suppliers will not be replaced by alternatives, but they will be displaced in pockets as companies look to diversify their supply chains.

For instance, everyone knows that Apple (AAPL) has become intensely dependent on China for its manufacturing needs. Apple itself has been aware of this fact – which is why the company looked to diversify its supply chain to other countries over a year ago. There has been some progress on this front, and here in Southeast Asia, bankers have been selling themselves as brokers to make that diversification come about. A lot more of this is coming, creating more robust and multidirectional supply chains and redundancies that once seemed inefficient but will also make production more robust.

Business owners will not be surprised by this; who can afford to be over-reliant on a single supplier or even a group of suppliers that are exposed to the same risks that can throw off your entire production schedule? Yet, this very logical business decision, amplified in speed and necessity thanks to COVID-19, flies in the face of economic orthodoxy (which should tell you something about said orthodoxy).

That orthodoxy is a very old idea known as the Ricardian equilibrium caused by competitive advantage. That word salad basically means that a country will tend to specialize in one particularly good, so it will export more of said good, while another country will specialize in another good. It doesn’t make sense for the Italians to make beer and the British to make pizza, because the former are better at making the latter, and vice versa.

So the Ricardian model claims – and thus have economists argued for less trade barriers, more free trade agreements, and less economic protectionism for decades, going even towards the extreme argument from George Mason University professor Alex Tabarrok that national borders should not exist and everyone and everything should be allowed to travel anyone with no restrictions at all. Because of Ricardian equilibrium, this would cause greater value to be created as specialists clump together in different parts of the world, creating better pizza and better beer and creating the pizza/beer utopia we all want and deserve.

This is obvious madness and nonsense – as the recent pandemic has proven. When the pandemic began, borders were shut in supposedly xenophobic countries (America) and non-xenophobic countries (Canada) alike. Lives were saved as a result, and I am grateful Thailand closed its borders so mask-less superspreaders can’t come infect the locals as they would in King Tabarrok’s Shangri-la. Restrictions on exports were put in place to protect and guarantee the safety of individuals in different countries (hence, I never could send my mother the face masks she wanted). Had these not happened because of an open-border utopia, the much poorer Thai people would find themselves unable to access masks that were being transported and sold to much wealthier Westerners, where they would go for more than fifty cents apiece.

The utility of border controls became clearer during the pandemic than it has been, arguably, since World War II. This is going to radically upend the neoliberal march towards a more globalized and interdependent economy. It is also going to force greater diversification of national economies as countries learn the need for self-reliance. If America had the manufacturing independence of a Thailand or China, its PPE shortage would have never happened, thanks to domestically produced alternatives immediately replacing imports (this has been happening in the U.S., but at a very slow pace because of the weakened state of American manufacturing).

The notion of countries specializing and producing some things for exports and importing things they don’t produce well will never go away (countries like South Korea don’t have oil reserves; the English will never make a good pizza), but the reverence of this idea as an ideological goal and economic inevitability will disappear.

The Investment Lesson

The sector-driven diversification of nations presents one very contrarian investment opportunity: U.S.-based materials companies, reflected in the Materials Select Sector SPDR ETF (XLB). If we are going to see American companies scramble to make sure they aren’t hit by another major global supply chain disruption by diversifying towards American suppliers, domestic materials firms will be best-positioned to benefit. Interestingly, while materials are doing better than they have been for quite some time, they’re behind a few other sectors, suggesting this hypothesis hasn’t become a widespread belief in the market.

(Source: Sector SPDR)

But, I need to bang the tech drum once again. While hardware manufacturers will face the challenges of a more diversified and thus less efficient supply chain, all hardware manufacturers have recognized this for years and focused their revenue models away from hardware. Even AAPL has a music streaming service, a VOD service, a gaming service, and a cloud storage service, because it realizes it needs to diversify away from a China-centric supply chain both on the supply side and on the monetization side. In reality, there are few tech companies dependent on that supply chain for the bulk of their revenue, earnings, and growth anymore.

Of the top firms in the Nasdaq 100 (QQQ), Apple, Nvidia (NVDA), and Intel (INTC) are the most hardware-focused ones. But instead of following the naive directives of a simplistic Ricardian advantage model developed in the 1810s, these companies have been much savvier. Take Intel’s “Copy EXACTLY!” program, defined by ZDNet thus:

“Before the turn of the century, Intel began conceiving a production methodology it would call “Copy EXACTLY!” Its objective was to build each of its fabrication facilities to exact specifications so that a component built-in one location would be built the same way in another. Any change implemented in one place would simultaneously roll out everyplace.”

This plan had some bumps along the way (the Great Recession caused Intel to pull back from a diversified supply chain strategy), but it is important to recognize that the tech world has a playbook for adjusting quickly and relatively painlessly to a more diversified supply chain. That is, for those firms still in the hardware game. But 7 of the top 10 companies in the Nasdaq 100 are predominantly software companies who won’t have to do much at all to adjust for a post-Ricardian world.

Disclosure: I am/we are long QQQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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