Increasingly looks like markets mistook "bullwhip" effect of supply chain (including food) for secular inflation = Fed less behind = supports risk assets

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To all, my father passed away last week on 6/21. I was always proud of my dad and he was a fixture in my life. I will not be publishing a note this coming Wednesday. If you are interested in hearing about my dad, this is the link to his obituary –> https://www.phillipsfuneral.com/obituaries/Walter-H-Lee?obId=25203489#/obituaryInfo)

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Increasing signs that inflationary pressures easing, except for tight labor

Over the past few weeks, there are increasingly convincing signs that inflationary pressures are easing. But we believe investors are ignoring signs that the incoming data is tracking closer to the “half-full” view — inflationary pressures are outright falling for many items and the lack of “unhealthy imbalances” means the risk to the cycle are lower. In fact, consider these latest developments collectively. These are not congruent with “inflation out of control”

• industrial metals declining
• agricultural commodities declining
• retailers sitting on record inventories
• housing inventory at multi-year highs
• discounts on new home listings
• regional PMIs showing “prices received” are declining sharply

For those in the half-empty camp (nearly entire consensus of investors), the pushback is two-fold: easing does not mean pace of inflation is falling AND economic growth risks are emerging. And to an extent, this is true. But these are arguably more congruent with a “bullwhip” effect and supply chains easing.

The MIT Beer Game has shown how easily the “bullwhip” effect of the supply chain can happen

My co-founder John Bai, a few months ago, talked about how the MIT Beer Game showed how vulnerable the supply chain is to wide swings, even with modest changes in demand. The upshot being huge volatility in double-ordering and massive inventory corrections. The MIT Beer Game is not “beer pong” but instead a game designed to illustrate the foibles and risks in the supply chain.

I have never played the “beer game” but have heard how this game/simulation is a great example of how small changes in the end market (consumer/retailer) create large swings across all areas of the supply chain. The total game takes 20-30 minutes to play, with 50 rounds of orders using chips/proxies passed around. Here is the basic rules of the game.

The overarching takeaway is the change in the end market creates a bullwhip effect across the supply chain. This is due to several factors:

• inventory management at each level of the supply chain
• incomplete information and communication across each level of the supply chain
• the natural delay between order and fulfillment means customers could end double-ordering or cutting orders, not congruent with actual demand
• those higher in the supply chain mistake these swings in demand as structural, not cyclical

Collectively, this is referred to as the “bullwhip” effect. I am not giving the greatest explanation, but hopefully, the basic point is clear.

Kearny (consulting agency) shows below how the changes in sales orders (bottom right chart) lead to an increasingly amplified volatile swing in orders across the supply chain. The greatest “bullwhip” is in the manufacturer.

And another illustration below shows how the step up in orders from the customer lead to a massive 100X increase in orders for the manufacturer.

• customer increased their orders from 400 to 1,000
• but the delays and interaction with inventory (need to replenish) ultimately swing the +600 increase in units
• to a +30,000 increase in units for the brewery

And as a consequence, the brewery ends up with a massive inventory surplus as shown below. Think about that. A simple +600 order could ultimately trigger a 2-year plus surplus at the manufacturer.

Is 2020-2022 a “bullwhip” effect on pandemic-scale?

If a simple beer economy could create massive swings in the supply chain, how about the supply chain disruptions of the past two years due to COVID? I mean it would not be surprising to saw this is a bullwhip effect on steroids.

• look at retail inventories below, they are piling up
• I do not believe companies want to permanently carry higher inventory
• it is expensive (cost of money) and introduces huge balance sheet risk
• thus, companies will want to trim inventories when supply visibility improves
• the logical implication, for me, is prices will come down

Even in the auto industry, there are signs that supply chain and delivery times are improving. In fact, this note from Goldman Sachs notes that:

• global shipments of automotive microchips has returned to 95% pre-pandemic trends
• while it will take time for manufacturers to replenish production and inventory
• this argues strongly that inflationary pressure is to the downside

Perhaps markets should pay more attention to Fed Chair Powell statement on prices…

The future is uncertain, but supply chains easing is a conditional change that will have important implications. As we noted last week, the statement below could be one of the the most important statements made by Fed Chair Powell, even if nobody believes it.

• Powell has previously mentioned the possibility that pricing movements might be more amplified in situations of extremely tight supply
• This applies to pretty much everything for the past 2 years

If one squints, we see this easing of pricing in the regional PMIs

If one looks at the regional PMIs below, we can see the beginnings (possibly) of the easing of price pressures:

• the figures below are based on “prices received”
• not “prices paid”
• all regions have seen this peak in late 2021/early 2022
• Empire (NY) is the region that only saw this potentially easing in 1Q2022 (the last to see it)

STRATEGY: If “upside risk” to inflation is diminishing, Fed is less behind = positive for risk assets

We are nearing the end of 1H2022 and it has proven far more treacherous than we expected. This is due to the far greater surge in inflationary pressures, which in turn, triggered a far more acute response from the Fed.

But if the “bullwhip” effect is indeed underway, we could see many of these inflationary pressures ease in 2H2022. This would be coming at a time when investors are extreme in the risk-off positioning. Take a look at this chart of asset manager positioning from @macrocharts shared by JM (anonymous).

• per CFTC, open interest among asset managers is near a record low
• far lower than the market lows of Oct 2011, Feb 2016, March 2020
• this is an extreme contrarian indicator, in my view
• as this means positive data points could provide risk-on behavior

Similarly, look at retail equity flows. This past week saw the largest retail outflows since 2008 (per JPMorgan) and shared again by JM.

• if retail and institutional are sellers
• but incoming inflation is softer
• and Fed has done aggressive tightening already
• doesn’t it sound like risks are skewed to the upside?

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31 Granny Shot Ideas: We performed our quarterly rebalance on 4/5. Full stock list here –> Click here

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