Friday HighlightNov 19 2021

How are supply chain issues disrupting profits?

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How are supply chain issues disrupting profits?
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There are currently a number of bottlenecks. First, the quick rebound in demand after the first Covid-19 lockdown caught many producers by surprise.

This resulted in their placing large orders for components that could not be provided by their suppliers.

Shortages of semiconductors are causing disruption to a number of industries at the moment, including the auto industry, while last year timber prices soared as construction activity rebounded. Also, cement prices in China have recently increased by 50 per cent. 

Second, regional lockdowns have disrupted distribution systems, with ports closing in China and ships in short supply (the Baltic Dry Index rose 14-fold between May 2020 and July 2021). 

Third, a lack of workers in key sectors is resulting in much disruption.  

The UK finds itself in a delicate position, with the triple whammy of workers retiring or leaving the country due to Brexit, and those that remain being unavailable due to the high level of Covid infections. 

The food industry is suffering particular problems, both on farms and in abattoirs/processing plants, while a lack of HGV drivers is causing widespread disruption. 

This is not just a UK problem, with ports such as Los Angeles suffering congestion due to the lack of drivers to take the goods away – warehouse space is now at a premium. 

All of these labour problems are leading to wage pressures, which can only be exacerbated in the UK by the recent announcement that the living wage is set to rise by twice the rate of inflation.

The rise in natural gas prices could also be considered to result from supply chain issues, with the lack of wind power resulting in higher demand for gas at a time when gas networks were undergoing maintenance. 

Given that natural gas accounts for one-quarter of the world’s primary energy usage, the recent surge in prices can only add to cost pressures. UK natural gas prices surged 35-fold from the low of May 2020 to October 2021 or sixfold if we compare to the norm of recent years. 

This has had a knock-on effect on oil and coal prices, thus raising energy prices in general and electricity prices in particular.

After a 24 per cent gain in earnings per share in the year to end-September (my calculation based on the Datastream UK Index), I suspect that UK profit growth will be more sluggish over the next 12 months. 

Profit growth predictions

Firstly, profit growth follows the pattern of industrial growth, though with a lag of six to nine months. 

Given that the UK economy has plateaued over recent months (with retail sales volumes falling for a fifth straight month in September), I would not be surprised to see less profit growth as the end of 2021 approaches. 

Second, the UK stock market is heavily weighted towards resource sectors; the MSCI UK Index has an 11 per cent weighting in both energy and materials sectors (for the MSCI World Index, the weightings are 3 per cent in energy and 4 per cent in materials). 

That suggests the UK stock market received a profit boost from the recent surge in raw material prices and I suspect the support from that source will be more limited over the next 12 months. 

Finally, the confluence of Brexit and poor pandemic management implies the UK may be more susceptible to many of the supply chain problems mentioned above.

So, where will the profit squeeze be the most acute?

I suspect manufacturing sectors will be hit first (component shortages and/or rising energy prices) but that eventually most sectors will be impacted by rising energy prices, especially transportation and heavy industry, higher wages (mainly in traditional low-wage sectors such as agriculture, food manufacturing, hospitality, retail and logistics), and product shortages/lost sales, in the auto and retail sectors, for example. 

However, some industries have more pricing power than others, with those least able to pass on higher costs also being those with low profit margins. Unfortunately, it is those low-margin companies that suffer the biggest hit to profits when costs rise. 

Sectors that I would put into this category are retail, hospitality, auto, construction and transportation. 

Many of those sectors have had a torrid time during the pandemic and they will not be helped by the cost pressures coming from supply chain issues (any further Covid restrictions would add to the misery). 

Less impacted will be high-margin sectors such as technology, pharmaceuticals and service sectors such as financials, which will see relatively low impact from supply chain disruption. 

Some sectors such as semiconductor makers and oil and gas companies are actually benefiting from the current situation.

Lastly, governments around the world have shouldered a lot of new debt during the pandemic and fiscal rebalancing is likely to include a rise in corporate tax rates. 

In the UK there will be a 1.25 per cent increase in national insurance contributions from April 2022, which will apply further pressure to labour-intensive sectors such as hospitality. 

Further down the line, UK corporation tax is planned to be increased from the current 19 per cent to 25 per cent in April 2023. All else being equal, that would cause a 7.4 per cent decline in post-tax profits, but the impact is unlikely to be that big as tax allowances complicate matters.

In conclusion, the strong profit growth seen among UK quoted companies over the past year is unlikely to be repeated, with particular pressure likely to be seen in sectors such as retail, hospitality, transportation, auto and construction.

Paul Jackson is global head of asset allocation research at Invesco