In 1944, the Brenton Woods agreement established the US Dollar as the global reserve currency, with all other currencies pegged to the dollar. That link came undone in 1971 when the US went off the gold standard, which caused all currencies previously tied to the US Dollar to have free-floating exchange rates. The initial result was a significant devaluation of the US dollar. This increased demand for US goods and, combined with the energy crisis of ‘73 and ‘79, caused runaway inflation. After Chairman of the Federal Reserve Paul Volcker increased interest rates to 20%, the dollar re-evaluated back to its peak in 1985 and oil prices stabilized.
In the early 1980s, China’s currency was approaching parity with the US dollar. But, after mass devaluation efforts, its value bottomed in the early ‘90s at around 8.5 yuan to the dollar. At the same time, China’s working population increased by 240 million, which is more than four times the increase seen in the US and Europe during the same period. In effect, the world’s advanced economies’ working populations doubled from 1991 to 2018.
The combined effect of the US currency appreciation, China’s currency devaluation, and China’s population boom made Chinese labor incredibly cheap and caused mass offshoring of US manufacturing. From the early 2000s to 2017, China’s percentage of global manufacturing output increased from 8.7% to 26.6%
This globalized workforce, an efficient and effective supply chain, a relatively strong dollar, and US energy independence have created an environment characterized by low interest rates and low inflation for the past 35 years. But, those factors are beginning to change.
US energy independence is beginning to wane. The energy market downturns in ‘18 and `20 cleared out most traditional oil and gas investors. At the same time, the rise of an investment philosophy prioritizing the Environment, Social impact, and Good Governance (ESG) has made new investors shy away from the industry altogether. During the pandemic, new drilling dropped 75%, and this decline has only partly reversed. In addition, new oil wells lose 70% of capacity in the first year, and the US is on track to lose significant oil production capability over the next few years. The race is on for the US to decrease oil consumption through electrification before another conflict in West Asia recreates an energy crisis like those caused by the Yom Kippur War (‘73) and the Iranian Revolution (‘79).
A natural gas energy crisis is also unfolding. Natural gas demand is at an all-time high. In an effort to meet climate change targets, countries are replacing coal-fired power plants with natural gas. Meanwhile, an unseasonably cold winter drained global inventories and necessary maintenance, delayed by the pandemic, is just now being done. US production is further hampered by less fracking and the continued impact of hurricane Ida which took production offline. All the while, logistic bottlenecks continue to prevent supply from reaching demand. The result is near-vertical natural gas prices, which are likely to get worse come winter.
End Of The Global Workforce
While China’s currency is still significantly manipulated to maintain a high level of domestic manufacturing and exports, the tides have turned against them.
- The international community is fed up with China for a number of reasons: it is inextricably tied to the emergence of COVID-19, it’s persecution of its Uighur population, and the increase of nationalist hostilities against Hong Kong, Taiwan, and in the South China Sea.
- China’s political environment has become increasingly bleak between tariffs, bureaucratic crackdowns, and reprisals against American businesses.
- The climate crisis’ unpredictable and dangerous weather patterns have disrupted the global supply chain and present an ongoing concern for the ability to reliably move goods around the world.
- While the US peak labor force seems terrible, China’s social policies have left them with the worst dependency ratio globally and will drive labor costs up going forward.
- In 2000, it was 34.6 times cheaper to hire a Chinese employee than an American worker at the height of offshoring. This has been reduced to 4.5 times cheaper and continues to approach parity.
The current message is clear, “invest in China at your own risk.” Businesses from all over the world are reducing their footprint in China, limiting its influence to the regional markets established by Regional Comprehensive Economic Partnership (RCEP).
The Rise Of Regional Trading Blocs
Globalization is being replaced with regional trading blocs – the RCEP, the EU, and USMC (United States, Mexico, Canada). In response, multinational companies are seeking a localized manufacturing presence in each region.
The pandemic also exposed the fragile nature of America’s ability to produce essential goods. And, recently enacted tariffs are unlikely to go away as they provide financial cover for reshoring manufacturing back to America. With the recent passage of the US Innovation and Competition act, the US government is now invested in several new initiatives to address the lack of manufacturing capacity to produce essential products while shoring up the supply chain.
Foreign direct investment in local manufacturing and the accompanying job growth due to reshoring is expected to surge 25% in 2021. Companies like Samsung have announced a $20B plant in Austin, Texas, while Taiwan Semiconductor Manufacturing Company plans to build a plant in Arizona. A survey of US manufacturers shows 83% are likely or extremely likely to reshore, up about 30% since March of last year.
In a rising interest rate environment, companies will seek shorter supply lines to keep working capital requirements in check. Additionally, trade inside each regional bloc is nearly tariff-free, while trading across blocs is vulnerable to dynamic political disputes and at the mercy of unpredictable weather.
Global Tax Code Changes
A diminishing working population, and in turn, diminishing tax base, along with increases in corporate productivity, demands that the tax code reverse a 50-year trend of decreasing corporate taxes. The G7 and 130 other nations have already agreed to a global 15% tax floor while shifting the tax code from where the company is located to where profits are earned. Such policy changes also make offshoring disadvantageous and drive the push for near sourcing.
The Rise In Interest Rates & Inflation
A global contracting workforce and reshoring operations will likely drive a return of inflation over the next decade.
As the baby boomers retire, they will go from net purchasers of US Treasuries to net sellers as they cease work and liquidate their investment accounts to finance their retirement. That switchover is projected to occur in 2024. The mass-selling of US treasuries will be a driver of interest rate increases going forward. An increase in interest rates will strengthen the US dollar, leading to further foreign investment in the US.
Productivity gains through automation will have to outpace wage increases to prevent passing those additional costs to consumers. Luckily, the price of industrial robots has decreased more than 50% since the 90s. Robot density is around 1% in the US, far below the 8.3% obtained in Singapore. This means that the US could increase the current automation levels eightfold without additional technological advancement.
The current business environment of record profits and low taxes will give companies lots of wiggle room to compress margins before passing additional expenses to the consumer. But, a failure to keep pace with the declining workforce through automation could lead to a protracted inflationary period.
What Companies Can Do To Thrive During The Global Supply Chain Restructuring
Businesses over the next decade should expect record revenues but a higher cost of capital, higher cost of labor, increased investment in CapEx, higher taxes, and ultimately lower profitability.
- The single best thing a company can do right now is also the most counter-intuitive:
- De-leverage when interest rates are low. Don’t become the next Blockbuster Video who should have beat Netflix in the streaming wars by all accounts. They lost because they became overleveraged, taking on questionable acquisitions, and then lost access to the capital markets during the ‘08 collapse.
- While debt financing is cheap, equity finance has never been cheaper. Take on a private equity or family office partner now, while corporate valuations are at record highs, to keep debt levels as manageable as possible and ensure access to capital in the future. It’s much easier to raise growth capital in an environment where all your competitors struggle with refinancing while you’ve maintained capital capacity.
- Near-shore operations now. The rising cost of capital and combined with ballooning working capital requirements, will destroy any advantage previously provided by offshored operations. Companies may be one supply chain disruption away from bankruptcy.
- Seek to gain new clients from companies reshoring and foreign direct investing.
- The most significant determinant of a company’s financial success is its Intrinsic value, driven by revenue growth and return on invested capital. Get lean now by focusing on return on invested capital.
- Return on Invested Capital = EBIT/ (Capital Expenditures (not depreciated) + Cash + Accounts Receivable + Inventory – Accounts Payable)
- Improve ROIC by reducing cycle times through minimizing supply transit times.