Global supply chain disruptions may call for ‘shock therapy’

Citi global markets strategist Matt King: ‘Central banks may need to suppress demand until supply chains normalise.’ Picture: John Feder/The Australian

Matt King has spent a lot of time thinking about supply chain disruption of late.

Like many aspects of the coronavirus pandemic, the resultant shortages of goods and changes in prices and consumer behaviour are without modern precedent and hard to predict.

But Citi’s global markets strategist argues that the consensus view of a return to previous equilibria once bottlenecks ease is too optimistic, and that in the worst case central banks may need to suppress demand until the supply chain normalises.

That would mean a more rapid than expected tapering of bond buying and earlier interest rate hikes. Markets simply aren’t pricing in enough risk for that possibility.

What was commonly expected to be “transitory” by the world’s central banks is already taking longer than forecast as problems spread from one sector to another in an apparently unpredictable fashion, exacerbated by a nascent global shortage of energy.

“This raises the threat of a return to a boom-bust cycle which central banks find hard to control, and which is certainly not reflected in asset prices,” King says.

“In both physical and financial markets, when price-insensitive demand meets inelastic supply, today’s exponential price rise has a tendency to be followed by tomorrow’s crash.”

King was speaking ahead of the two-day Citi Investment Conference which starts Wednesday with an impressive line-up including Treasurer Josh Frydenberg, former US treasury secretary Larry Summers and former foreign minister Julie Bishop.

“Everybody is puzzled by these very nonlinear or exponential moves in many different markets – most obviously energy prices – and the presumption is that the system will simply return to normal, or go back to where we were, once we get over the temporary shortages,” he says.

On the one hand there’s precedent for that – toilet rolls, flour and other consumer staples experienced panic buying at various stages of the pandemic globally.

“In the UK at least, you couldn’t get them at all, at any price, for a week or two, but they have become fully available again, and not really at any greater expense than previously.” But shortages in one sector have spilled over to other sectors, often in unanticipated ways.

From an inflation perspective, it may look as though there has just been a whole series of idiosyncratic shocks.

“At a certain point, it kind of looks continuous,” King says.

It may not be a classic wage/price spiral, a series of sustained shocks.

But if one month it’s used cars, the next month airfares and then energy prices and so on – as has been the experience in the US this year – “at some point it starts to look like the inflation problem that central banks had promised us that we wouldn’t need to worry about”.

“What’s a little bit alarming is to see this series of problems taking a while and being much less transitory than the central banks imagined.”

Ultimately, it starts to change behaviour, and it’s not necessarily a function of inflation as such.

“Maybe I was a bit biased by my own experience of going to UK supermarkets or petrol stations, because what I noticed was my own desire to buy an extra bag of flour is inversely proportional to whether or not it’s available.

“So when it’s there on the shelf, you think ‘oh well, I will just buy the one that I need’. But when it’s down to the last couple, the temptation, unless you’re feeling very unselfish, is to buy all of them.”

Considering that dynamic, he concludes it isn’t enough to restore supply to what it was.

“You may need to do considerably more than that, because you need to make people believe that supply will continue to be available so that they don’t stock up and that may take more than getting supply back to where it was previously,” he says. “You may need to actually squash demand in order to do so.”

Like a double pendulum, which, when nudged gently, behaves smoothly and predictably, a harder nudge on the supply chain may see it go “completely bananas and remain that way for a long time”.

“I see these systems, which, instead of mean reverting, they go one way and behave quite irregularly, and this interferes with the traditional notion of ‘it will all settle down again’,” King says.

“Once you get into this boom-bust cycle – even if it’s just a supply chain problem and central banks say ‘well we can’t fix a supply chain problem by raising interest rates’ – you may have to squash demand to get the system back to what it was previously, and it may be harder than you thought.”

It makes for an outlook that’s more uncertain than implied by the massive and broadbased rise in financial risk assets that followed unprecedented fiscal and monetary stimulus since the pandemic.

To be sure, there’s also lingering deflationary pressures from global forces like digitisation and automation that could take hold again if there were to be a sell-off in asset prices.

“I have generally been in the disinflation camp, but we have given the system a mighty jolt and there’s potential for it not just to be temporary, but the potential for the fundamental behaviour of the system to have changed is larger than is widely recognised.

“Even if I do remain very uncertain about the whole inflation outlook, the one thing I do know from a market perspective is that there’s nothing in the ‘price’ – all the risk premia everywhere have been crushed and again that’s a big problem for investors because low real interest rates are the foundation of just about all the extended valuations across the board.

“If we start to question those valuations, or even put a risk premium back on them, you can undermine a great many markets at the same time. This risk of a paradigm shift – or ‘the death of Goldilocks’ – investors are only just getting their heads around this, and I don’t think it’s reflected in market prices yet.”