Why Supply Chains Suddenly Matter

SPEAKER_01 0:00

Hello and welcome to another edition of Equitile Conversations. I'm Gerald Ashley and once again as usual I'm joined by my good friend and colleague George Cooper. George, good to hear you again.

SPEAKER_00 0:14

Morning, Gerald. How are you?

SPEAKER_01 0:16

I'm well. Um though I don't think we're going to have a particularly optimistic conversation today because I think it's time to talk about supply chains and the whole US war that is unfolding in the Middle East. And of course, from our perspective, the uh uh the impact on financial markets. Um let me just throw one or two thoughts at you to start off with, George. Back in January, we talked about the market was starting to move towards physical assets, and that there was this feeling that you had to have stuff rather than just sort of digital code, and that uh financial markets were starting to see the value in companies that did things and made things. Now, of course, um we had no idea this war was going to break out, but this has now really heightened that situation. Everybody's suddenly talking about supply chains. I can't let that go without the um the sort of joke uh misquote of Russo, which is to say that all men were born free but end up in supply chains. And of course, uh we are all in supply chains. What's what's your take on the general big picture here, George?

Conflict Escalation And Energy Shock

SPEAKER_00 1:34

I think we should say, actually, uh, before we get into the conversation, we're recording this on Sunday, 29th of March. And I say that just because things are changing so rapidly um that everything we say today could be out of date uh within a matter of hours. But having said that we're recording it on on Sunday the 29th, as things stand, it looks like over the weekend we're seeing a pretty dramatic escalation of the conflict uh in the Gulf uh with the US now planning to send in ground troops into Iran, which looks like it's going to exacerbate all of these supply chain uh shocks. As as things stand, I would say we're looking at probably the biggest energy supply shock and and related commodities, fertilizers and other other things that we've we've seen in in modern times. And because so much of the infrastructure is being destroyed in the Gulf, I think we've got to assume that this supply shock is going to be measured in months, quarters, or even years. So it's not a this is not going to be something where they can suddenly sort of kiss and make up and everything goes back to normal.

SPEAKER_01 2:53

So so this is a really big deal. And this is the second time that Donald Trump has uh sort of thrown a really large rock into the pond. We had his tariff uh announcements almost a year ago now. I think it was in early April of of last year. But the market quickly recovered from that as to be honest, he rode back from the initial uh announcements, and then there's been a lot of toing and frowing and negotiating as to what has actually happened with tariffs, and the market shrugged it off. It was a extremely volatile April last year from memory, but we moved on. That doesn't feel the case with this situation.

SPEAKER_00 3:36

No, I don't I don't think it is the case, and I think at the moment it appears to me that it's not in Donald Trump's power to row this one back. It's within his power to keep escalating it, which seems to be the path he's going for, but it doesn't seem that he's got a path to turn it off, uh, because the the Iranians don't seem to want to come to the negotiating table.

SPEAKER_01 4:01

And I think underpinning all of this is our old friend time and timey. Financial markets, as we know, live by the sort of nanosecond these days, and uh as you just said earlier, any scrap of news in either direction is very quickly leapt upon. But in the case of supply chains, or if we want to be slightly more in economic terms, call it a negative supply shock, these things take a little while to unfold, or in this case break apart, but probably even longer to put them back together again. So is it fair to say that we're in the early stages of the breakdown of supply chains, and there's probably far worse to come?

SPEAKER_00 4:47

That's the way it's looking at the moment. I mean, there's been some short-term attempts to sort of dampen the shock. There's the announcement of releasing strategic reserves, there's the the pretty remarkable desanctioning of Russian energy and desanctioning even of Iranian energy. So allowing the uh what what's called oil and water to to be sold into the market. And that's that sort of brought oil back down from I think it was$120 a barrel was the original spike. But in the last few days it's it's started moving up again. It's above$110 now. So you just hear the stories, you know, the stories of petrol stations running out of fuel in different parts of the world. It it does feel like it's tightening. And I think that's what we're seeing in the uh in the physical markets as well.

Food Inflation Through Fertiliser Shortages

SPEAKER_01 5:44

And as ever, there are second-order effects because it's not just oil. It's uh one of the big ones that seems to be heavily involved in this is going to be production of fertilizer. And I read a report just yesterday that Australian farmers are running out of diesel just as they uh start their growing season, and they're worried about future supplies of fertilizer. Okay, that doesn't affect food in the shops next week, but it may do come August, September, October time.

SPEAKER_00 6:16

Yeah, I I think that's a good point, Gerald. And what what I think this is lining up to be is a pretty durable energy shock and then a pretty durable food price shock. You know, given the the growing season, the length of time it takes to to grow crops and get it into the food chain, if there's a problem planting now, we're going to see inflation, I guess, six, nine, twelve months time. So we've got an immediate inflation shock, and then we've already got a pent-up inflation shock coming into food supplies. So I think this is going to start to look like uh a pretty protracted, dare I say it, 1970s, late 1970s style inflation cycle. There's a there's a lot of people, you'll see them on Twitter circulating this chart showing the uh the the sort of triple peak of inflation in the 70s, which ended uh in the early 1980s. And what we're now going into is looking eerily close to a repetition of that, with the the biggest inflation peak being the third one that we're probably going into now, I think.

Central Banks Facing A Bad Choice

SPEAKER_01 7:29

Well, I did warn listeners that we weren't going to be overly cheerful, and I'm afraid that does you know ground us in in what could be the realities going forward. One element in all of this is going to be the action of central banks. I see the ECB have already made noises that they may have to consider uh raising interest rates if this if this persists. And I think it's fair to say that the Bank of England is at sixes and sevens, having looked like it was definitely cutting. It's now umming and areing in public about what it might do next, none of which can be good for confidence in the markets or with the consumer. Would it be sensible or potentially a big mistake to raise interest rates now?

SPEAKER_00 8:16

If you follow the textbook recipe, you would raise interest rates. Right. Because we we've definitely got higher inflation coming. Um, and that's the the textbook response. Personally, I think it would be the wrong response. And the reason I say that is I think interest rate policy is good for dealing with endogenous inflation dynamics, and that's an economics term. What what that means is internally generated inflation.

SPEAKER_01 8:43

Yeah, yeah.

SPEAKER_00 8:44

So if the economy is running very, very fast and is overheating and it's generating its own internal inflation, then it's it's sensible to put up interest rates and try and slow things down. But if the inflation is coming from an exogenous shock, an external shock as it is now with the energy prices, then I think you you run the risk of sort of compounding the trouble by having the economy hit by an energy price shock and then hitting it again with an interest rate shock. And that's um I don't see that that's necessarily going to fix this the energy supply issue. You're not going to pump more oil because you've got higher interest rates. In fact, if anything, you're going to run the risk that you reduce the necessary investment that's needed to correct this energy shock.

SPEAKER_01 9:37

Yeah.

SPEAKER_00 9:37

So it might actually exacerbate it. So I think it's going to be a mistake if they do hike. I really hope that the central banks can look through this. But of course, we're we're they're on the back foot because they've allowed inflation to come into the system after lockdown. Uh, so they might feel that they just have to do it.

SPEAKER_01 9:59

Yeah, they're they're not in the best sort of part of ground to fight this next battle, are they? Um, and that uh also sort of prompts the thought that if they do raise to get things back on an even keel in a growing economy, we would be talking some months in no, not months, I mean years in advance, I think.

AI Bubble Risks Meet Higher Energy

SPEAKER_00 10:23

As as you warned readers, that uh this one might be a more uh downbeat podcast, but I I think there are you know there are times to be upbeat and there are times to be realistic. The other thing that's hitting the economy at the moment is we've got a problem in the private credit markets. Yes. Which is this is a sort of interrelated thing. We've got a we've got I think probably the the start of the the the financial markets questioning the investment boom in the AI sector. You know, asking asking themselves, is this really going to be viable?

SPEAKER_01 11:00

Yeah.

SPEAKER_00 11:01

And a lot of that's been funded with private credit. So those two booms or bubbles, I think they're bubbles myself, are perhaps bursting at the same time. And of course, the big issue that was always hanging over the data centers is could you actually get enough energy to supply them? Well, now we're in an energy shock. The cost of running those data centers has has just gone up dramatically. Uh, so the economics has deteriorated.

SPEAKER_01 11:29

Yeah, the map the math completely changes now in terms of the viability of doing some of those things. Um, just to just to flesh out the background as well, um, particularly in the UK and of course in the United States, but I think most of Western Europe, um we're not in a good financial position on on the sort of fiscal front. Um the the British government or administration continues to need to raise taxes in an effort to sort of get ahead of the amount of spending that is still happening um in government and uh and the rest of it. So how do we start to square all of these circles, if I may use that strangulated uh term?

Demand Rationing And Social Pushback

SPEAKER_00 12:18

Um this is a pretty serious supply shock into a market that's got very low elasticity. In other words, prices are going to go up, but still people people are still going to demand the energy. So that runs a risk of a price spiral. How do you deal with that? I don't think you can deal with it other than try to address the demand side, yeah. Which is what we're already starting to see. We're starting to see uh I think Egypt has already asked restaurants to close early and other places in the world. I think some Asian countries are asking for four-day working weeks, working remotely. I think that uh governments are gonna respond like that. We're gonna be, you know, if we were we were banging pots and pans for the NHS in in lockdown, I I don't think we'll be very far from oh, you shouldn't be driving your SUV because the ambulances need the diesel. I I think we're gonna go down that sort of path.

Debt Politics And War Incentives

SPEAKER_01 13:23

Right. And this in a sense is the the the ripple effect of as these supply chains break down or become blocked in in some areas. And um as you s as you say, it could take a long time to bring things back into balance. And the supply chains themselves, I mean, I think the lessons of COVID was um, as we know, markets and people do adjust, and hopefully they adjust quite quickly. But we I know it's a cliche, but we are in such an interrelated world these days, it it seems it could take a very long time to put things right. One other element to this that sort of comes to mind. I think I've said on a couple of podcasts, my new favourite word is trillion. And uh trillions are now coming up all the time. And the big one, of course, is the US deficit, this time last year at$36 trillion, now just going through 39 and heading towards 40. And projections were done before the cost of this um Middle East uh situation. So yet more pressure coming on that front?

SPEAKER_00 14:38

I actually think I think there's an even bigger uh issue behind the Iran war. Uh, and this is really big geopolitical questions. I mean you could you could ask the question, you know, is the is the Iran war pushing up the US debt? You could uh you could reverse the causality and you could say is the US debt causing the Iran war? Right. You know the the reason I say that is is the debt load in Western governments now so high that the economy's in distress and the governments of those countries are now looking for a scapegoat, they're looking for a diversion. Yeah. They're looking for something to distract the electorate from uh a problem that they've got themselves into. I think there's the you know in in economics frequently causality runs in both directions. I think this is one of those cases.

SPEAKER_01 15:39

That's quite a cynical view, maybe, George, but may may well be right.

SPEAKER_00 15:43

Uh well, it it it might be it might be cynical, but uh one of one of the favorite little factoids that I I sometimes like to uh point out to people is on a close reading of Keynes's uh famous book, there is a passage in Keynes's book where he explains that war is a good way to stimulate the economy. And yeah, unfortunately, it's true. It it causes spending, it does cause stimulus. Um he recommends, I think it is uh in the same passage, uh building pyramids, yes, burying money in disused coal mines, or even starting a small war.

Elastic Limit And A New Order

SPEAKER_01 16:28

That's a sobering thought. Um just to widen it out a little into the the geopolitical sphere, though not ignoring the market reactions. We often on this podcast give you the opportunity to uh educate us a little bit more on physics. And you you mentioned earlier the fact that maybe the markets feel somehow or another everything's going to go back to normal. Either the Americans win and it's a slam dunk, or there's some sort of so-called off-ramp, everybody calms down and the whole thing goes away. I know that's not your view, and you've got a bit of a physics take on it.

SPEAKER_00 17:11

Yeah, this is you know, for for listeners, this is something Gerald and I were chatting about before we started the recording. So in physics and engineering, there's a concept known as the elastic limit. Basically, if you're operating within the elastic limit, if you stress a system, so you squeeze a spring or stretch a spring, um, if it's in the elastic limit, once you take away the stress, the system goes back to its original configuration. But if you stress it so much that it goes beyond the elastic limit, when you take away the stress, it doesn't return to the same configuration. And I think that's possibly what's happening in the world at the moment. Uh I rather fancy that uh even when the Iran conflict uh finishes, the global economy is not going to revert to its old configuration. I think we we're probably going to have reset the geopolitical uh power dynamics. I suspect uh the way things are are looking at the moment, I suspect we exit the Iran conflict with China, possibly Russia in a much stronger position, and America in a much weaker position.

SPEAKER_01 18:28

Right.

SPEAKER_00 18:28

And I think that's also going to ripple through to the role of the US dollar in global trade. I think we might be accelerating demise might be too strong a word, but uh the the world was already, I think, rebalancing somewhat away from the dollar towards a more multi-currency structure and and even a gold, gold-backed structure. Um I I think we've probably accelerated that by a couple of decades in the last in the last couple of weeks.

SPEAKER_01 19:02

Maybe in a few years' time, looking back, uh Trump will be remembered for two things, the the tariff tantrum, as we called it, and now this event, that has actually really weakened US global power, not strengthened it.

SPEAKER_00 19:20

Yes. I mean the there's two there's two analogies that we've both kicked around between ourselves, Gerald. There's the the sewers crisis, uh, where you know after after World War II, Britain still had allusions to being an imperial power, uh, and that was sort of knocked on the head with the sewers crisis. Sure. And then there's the another one, which is the uh the Gallipoli debacle, uh, which may also be analogous to what's about to happen in Iran, both of which were major sorts of shots across the bow for the British Empire. We might be seeing this for uh for America at the moment.

SPEAKER_01 20:04

Yeah, I mean, um just a little bit of context for Gallipoli for people who are not um deep into First World War history. This was a an attempt by the British to sort of strong arm Turkey uh from uh getting involved in the war. They were neutral and to seizing the uh the vital choke point, uh, the Dardanelles. So here we are again, a big shipping route that was considered absolutely vital, maybe not as vital as Hormuz is these days in the global economy, but seen as incredibly important. Uh the British completely misread the situation and thought it would be really quite easy to sort of kick the door down and and and make demands of the Turks, and um it didn't work out like that at all. And as you say, it's a debacle. So I must say, when I hear Donald Trump sort of blithely talking about invading Karg Island and boots on the ground, um I I have similar fears, but of course um we shall just have to see how that unfolds over the the next few weeks.

SPEAKER_00 21:10

And as of yesterday as well, we we do also have the risk of uh the Red Sea being closed again.

SPEAKER_01 21:16

Yes, which again may be um this is maybe one for the armchair admirals, but this is yet another choke point, which would be controlled um by missiles from the Houthis, who sometimes are characterized as just a bit of a warlike tribe. I think a little bit more than that, as they seem to have uh surface-to-air and surface-to-surface missiles. So they're certainly a little bit more sophisticated and just a warring tribe.

SPEAKER_00 21:46

I think well, actually, since you brought that up, I think there's another dynamic which I'm I'm finding quite interesting, and I think we've seen it in the Ukraine conflict. Uh the or or the First signs of it in the Ukraine conflict, and I think maybe we're now seeing it even more in the Iran conflict. And that is, are we seeing a major shift in the functionality of military technology? It's it's um I've sort of characterized it as are we seeing a situation where mid-tech trumps high tech? In other words, the the relatively cheap drones and and missiles uh can be used in in swarms and insufficient numbers, that they render the big aircraft carriers and the super fighter jets that cost hundreds of millions each, they render them not entirely useless, but uneconomic.

SPEAKER_01 22:46

Yeah, I mean this is the so-called asymmetric approach to warfare, where you know maybe it's David and Goliath, but um maybe that's not quite the right picture. But certainly, as you say, um uh the mismatch in weaponry may be not what we think, and most importantly, as you just said, is the mismatch in cost, because drones are almost, you know, as as as cheap as chips, so to speak, and some of the uh missile technology that's been deployed in Israel and um the United Arab Emirates for air defense is millions of dollars ago. And um, you know, also it takes a long time to produce more of those. So could we get a situation where high tech gets overwhelmed because it's impossible to uh produce enough of the stuff in in a in a given time frame?

SPEAKER_00 23:44

Yeah, and I think this is you know, it it feels almost glib to try and to bring this back to investments and consequences for for monetary policy in that, but that is the day job. Um if if that is the case, then it becomes much more difficult for America to project power over great distances.

SPEAKER_01 24:07

Yeah.

SPEAKER_00 24:09

It's much more expensive for America to continue dominating the Middle East. If America therefore cannot dominate the Middle East, then does Iran and perhaps Iraq? I mean, we've we've we've seen elements in both countries now working together rather than against each other as as has been historic. Could we see that region emerging as a new regional superpower, Russia perhaps being strengthened, China being strengthened, and we quickly go from a monopolar world into a quadrupolar world? Who knows?

Recommendations And Closing Notes

SPEAKER_01 24:46

And this is your physics point that maybe we've we've stretched the old model so much it breaks down and and something new will have to emerge. Now, as you said, um we're just on the 29th of March here. Lord knows how the first week of April and the next few weeks are going to go, but I think hopefully we've sort of covered the uh the main points for people to think about and and to look at. So no more on the Middle East and geopolitics for today, though I suspect we will almost certainly come back to it uh in in future episodes. And let's move to our books. As usual, I always barge forward and go first. And on this occasion, I'm not going to recommend a book. I'm going to recommend uh a little bit of online software, a game, in fact, called the beer game. This doesn't involve lots of drinking for those of you who feel need to be cheered up after this podcast. But it what it is, is a rather nice um bit of modelling that looks at how a brewery and a wholesaler and a retailer manage uh the supply chain of beer. And so it seems quite a good time to talk about uh talk about that now. I will in the show notes I'll put a link, an explanation of what the beer game is and its history. It goes back to the 1960s, it's not a new thing. Um, and one or two links of where you can just click on it, and for free, you can have a go and see if you're any good at managing the supply chain. So uh the beer game and George, I think you do have a book.

SPEAKER_00 26:32

Yes, I'm I'm gonna continue my um my biographies of interesting entrepreneurs. And so my my book, this this podcast is Tiny Rowland, a rebel tycoon. Tiny Roland, for those who don't know the story, um was uh a very big name in I guess the 70s and 80s in in the UK uh and Africa. One of the big um mining entrepreneurs, uh very colourful character. Um the the book's fascinating. His story, he's he's an Anglo-German, he spent uh World War II in an internment camp in the Isle of Man, um, went to what was then Rhodesia and ended up um after a pretty mediocre start to his career, it has to be said, turning into um you know this super tycoon. Fascinating story.

SPEAKER_01 27:31

And for those of us that in vintage can remember the huge takeover battle um of Harrods department store. So there's there's there's plenty to uh to uh chew in uh on that book by the sounds of things. George, thank you very much. I think we'll finish now and we'll talk again soon. Thank you.