All uncertainties about supply chain and inflation

by Carol Liao

The recovery in supply chains is accompanied by high inflation, while other risks loom on the horizon. The analysis of Carol Liao, China Economist and Allison Boxer, US Economist at PIMCO

After months of COVID-related disruptions, china's economy appears to be on the path to normalization. In June, the count of new daily cases of coronavirus stabilized at around hundreds of people. More people get on planes and trains, intercity highway traffic has returned to pre-epidemic levels, and city traffic is congested again.

In June, industrial production showed signs of recovery for the first time since February, as production centres came out of lockdown, production increased and supply chain delays decreased. The Manufacturing Purchasing Managers' Index (PMI) crossed the 50 mark, entering expansionary territory, and industrial production increased by 3.9% year-on-year (y/y). Notably, China's June exports grew at the fastest pace in five months, indicating the resilience of the country's manufacturing supply chain.

The Chinese government has given priority to the production and delivery of exports. To be sure, the robustness of China's supplies to the global goods market has been repeatedly tested since 2020 by COVID waves, blackouts and regional geopolitical crises, all without major hitches. As China's domestic supply chain normalizes, supply-side pressures are expected to ease. In addition, weak domestic demand has helped China keep inflation in check, and producer price inflation (PPI) has eased in recent months. This, together with the depreciation of the yuan at the beginning of the second quarter of 2022, led to a moderation in inflation of Chinese export prices to the United States.

Given the weakening demand in developed markets and the growing risks of recession, we do not see the country's supply chain as a major problem for global inflation in the future, despite continued COVID-related uncertainty.

Moreover, while China has stepped up stimulus to support infrastructure spending, the outlook for the housing market remains bleak, dampening China's demand for global commodities. Therefore, China is unlikely to become a deciding factor for global inflation.

In the U.S., the recovery of the supply chain also appears to have begun, thanks to a combination of a shift in consumer preferences toward services, a slowdown in overall spending, and an increase in inventory levels. This has resulted in a reduction in delays in ports, an increase in transport capacity and a fall in transport prices. The inventory-to-sales ratio for sectors such as general goods, household goods, home electronics, and construction supply stores, which represent the main categories of Chinese exports to the United States, has normalized. Inflation in the prices of imports from China has also eased in recent months.

Despite these signs of improving supply chains, U.S. asset inflation has recently accelerated again. The continued acceleration of retail inflation – despite the recent slowdown in spending and easing supply chain pressures – suggests that inflation may be more entrenched than previously thought. Although there are still reasons to think that commodity price inflation will eventually moderate, we are also witnessing the transmission of inflationary phenomena to other categories.

Shelter inflation, which stems from rent-based housing costs within the ICP, has increased sharply in recent months, and geopolitical risks continue to raise concerns about the outlook for commodity prices. As a result, inflation risks appear to have shifted from being driven primarily by China's supply chains and bottlenecks to a broader set of sectors that tend to be more rigid, less sensitive to Fed policy action, and harder for consumers to replace. This increases the risk that any further upside surprises in inflation will be accompanied by a more marked slowdown in consumption.

In the short term, disruptions to the global supply chain may persist, despite China's continued recovery. Disruptions due to war in Europe and strikes in some major markets could still pose a risk to global supply chains. Disruptions in food and energy supplies are already spurring global inflation, but rising risks of gas shortages and related rationing in Europe could exacerbate supply chain difficulties if factories were forced to close to ensure sufficient energy supplies for households. Inflation could remain high, helping to increase the risk premium.

In the longer term, we see the risks of deglobalisation and fragmentation of capital markets growing. China's weight in the global supply chain could shrink over time, as the U.S. government is trying to reduce America's dependence on China's massive manufacturing base for goods, spare parts, and materials of all kinds.

These trends could increase economic inefficiencies and increase inflationary pressures in the years to come, causing many investors to focus on building resilient portfolios.