Peter Goodall

As we emerge from the pandemic, global markets continue to struggle to reach supply/demand equilibrium. Lumber futures jumped 538.64% from the March 2020 lows before the bubble burst on 5/7/21. Since then, lumber futures have fallen 55.12% but still remain at elevated levels. Elevated prices in lumber markets had knock-on effects like increasing the cost of new homes in the US by approximately $36,000 and caused smaller vendors to scramble to find alternatives, with builders eating the cost in many cases.

Early this summer, US urban core inflation shot up to 5%, the highest since 2008. When the Federal Open Markets Committee met in May, fears of a reflation trade put significant pressure on the Federal Reserve to walk the line between supporting the jobs recovery while preventing runaway inflation. At the time, Federal Reserve chairman Jerome Powell indicated that, while inflation was coming in higher than forecast, the majority of it is temporary. Since the FOMC meeting, the unwinding of the lumber bubble supports this position.

Current inflationary challenges

The shipping and container industries have emerged from the pandemic as somewhat sticky drivers of inflation. Around 80-90% of the volume of international trade in goods is carried by sea, and the percentage is even higher for most developing countries. This is because sea freight has a significant cost advantage compared to air freight, which is roughly five times the cost.

Costs of shipping goods have dramatically risen since the start of the pandemic. For example, the cost of shipping a 40-foot container from Shanghai to Genoa has risen to $11,774 (up 502% in the last 12 months). So why are prices going up? The largest contributing factor is the price of shipping containers.

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Shipping container production became concentrated in China during their manufacturing boom in the 1990s. Fast forward to today and Chinese factories account for building more than 96% of the world’s dry cargo containers and 100% of the world’s refrigerated containers, according to UK consultancy Drewry. Three companies account for 82% of the production: CIMC, Dong Fang and CXIC.

At the start of the COVID-19 pandemic, the industry was facing significant challenges. Demand for dry freight containers had fallen 27% by August 2020. Combined with industry overcapacity and weak demand, prices fell sharply. At the end of August 2020, prices for 20-foot standard dry freight containers were in the US$2,100-$2,150 range, which compared with $1,975-US$2,025 at the end of June and $1,900-$2,000 at the end of the first quarter of the year. At the beginning of 2020, companies could buy this size and type of container for just $1,650-$1,700 a unit.

Manufacturers were losing money on practically every container that was produced. This proved unsustainable, so minimum price levels were put in place for various types of containers, and standard but shorter working hours for factories were also introduced in an attempt to ease stockpiles of equipment. Most plants started operating on shorter shifts of 10 hours a day, five days a week.

Contrary to industry expectations, the pandemic resulted in a surging demand for commodities such as medical equipment, home office supplies and computer equipment, causing supply chains to import many products and materials from China to fulfil consumer needs. As China rebounded from months of suspended trade, it created an imbalance in available containers – exporting approximately three containers for every one imported. This effect was compounded as passenger aircraft that were grounded during the height of the pandemic cut possible air freight routes. The Drewry World Container Index shows the costs of a 40-foot container has risen to $8,399.09 (a 346% gain from a year ago).

This issue has been compounded by breakdowns in the supply chain. When the Ever Given blocked the Suez Canal in March, it blocked about 12% of daily global trade. That represented about 1 million barrels of oil and roughly 8% of liquified natural gas each day. In Canada, wildfires have caused the rails to buckle, creating a bottleneck of exports and delaying imports. Shipments are getting rerouted but Teck Resources Ltd warned that steelmaking coal sales could drop by 300,000 to 500,000 metric tons in the third quarter. It is also impacting crude oil, lumber and grains.

Who is impacted?

Inflationary pressures are either absorbed in the supply chain or borne by the consumer. We would expect to see consumers experience higher prices for inelastic goods. We are seeing that in the real world currently. In Bermuda, we have seen this directly as the cost of beef (+40%), pork (+50%) and chicken (>+100%) have all risen. These industries typically run on tight profit margins and food is considered inelastic. Consumers may be able to protect themselves by substituting to cheaper alternatives while the supply chain sorts itself out.  However, companies selling products with elastic demand will need to have strong enough market power to push their costs upstream on their supply chain or absorb the costs themselves.

Outside of demand elasticity, industry will likely be a defining factor in relative performance. Discount retailers (like US-based Dollar General) will experience price pressures as they operate on tight margins. However, the pain should be blunted by consumers that elect to buy cheaper alternatives as they did during the height of the last two recessions. The financial sector may not ship tangible goods but larger players like banks are going to be sensitive to changes in the interest rates. Higher inflation expectations should translate to higher interest rates on bonds. Since higher interest payments lower the value of existing bonds, who wants to pay full price for a bond paying 3% when inflation is 5%?

A pathway out

Political and economic incentives appear to be clearing the way out of this mess. We are already seeing growing international pressure on China to alleviate issues with the container shortage. Carl Bentzel, a US Federal Maritime Commissioner, is looking into the availability of containers, intermodal chassis and railroad equipment, and whether the US has become overly dependent on such equipment owned and managed by China. The FMC appear to be concerned that a key component of US infrastructure is consolidated in a state-run monopoly managed by a political rival. That could result in enough political will to support the development of a domestic container company to alleviate supply chain constraints.

Large players like Amazon have been investing in ocean freight infrastructure through their Amazon Logistics branch to support their already colossal supply chain network. By 2018, the company had organised the shipment of over 5,300 containers from China to their US distribution centres.

Inflation will likely persist throughout the year as the supply chain sorts itself out. The political pressures are going to be too slow to fix the immediate problem, though they could create the incentive structure to support a more robust supply chain to protect against future shocks.

Peter Goodall, CFA, FRM, is Associate Portfolio Manager at LOM. Please contact LOM at +1 345 233-0100 for further information.

This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.

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