Image courtesy of Zensimu.
In November 2021, I argued that the supply chain issues should ease by August 2022. Considering August is next month, it’s time to check if I’m right. Not because I want to be noted, but because if I was right, then we might get an idea of whether inflation has peaked. And if inflation has peaked, the Federal Reserve doesn’t need to be more aggressive, which helps me determine the asset allocation of investment portfolios. To understand this, let’s play the beer game.
No no. No beer pong, flip tumbler or magician’s stick. I’m talking about The MIT Sloan beer dispensing game” (originally called the refrigerator game, but apparently the students were more careful when the product was beer).
MIT describes the Beer Game as “one of the oldest and most widely used management simulations…[which] gives participants the opportunity to play the role of managers in a complex dynamic system, in particular, managers in a supply chain representing the production and distribution of beer. (We underline.)
The Beer Game is a role-playing simulation with several participants. Players in the beer game work their way through a four-stage supply chain – from factory to distributor, wholesaler and finally retailer.
The goal of the Beer Game is to keep inventory, and therefore cost of ownership, as low as possible.
The Beer Game reflects what happens in real businesses. Suppose there is a short-term spike in demand for Allen’s Awesome Ale in the retail store. Because there is a delay in delivery, the retailer is soon out of stock. When a new shipment arrives, it is almost immediately sold out. The retailer loses by missing additional sales, so they order larger quantities.
And then the Boost effect occurs. The bullwhip effect refers to how an increase in orders amplifies as it travels up the supply chain, from consumer to production. In other words, unexpected large orders from end users trigger a wave of panic orders and stockpiling.
The retailer is discouraged because he is missing sales. Then the wholesaler gets frustrated because he can’t fill the retailer’s orders. The wholesaler begins to order more from the distributor. The distributor sees the increase in demand and orders more from the factory, so the factory ramps up production.
When the game is over, everyone is left with excess inventory, which all started from a small spike in consumer demand. When MIT interviewed the players, everyone blamed the other person. They didn’t understand how ordering more inventory than needed amplified the problem.
The supply chain in the game of beer is idealized for the purposes of the game. Imagine how difficult the game could be if you played with more sophisticated and sensitive supply chains. In real life, we’ve been through this and retailers are now gagging inventory.
Gagging on inventories
“Look at inventory issues… The thing you never want to be as a retailer is out of stock of what your customer wants to buy… so here is this big shortage on one side, huge demand on the other You can browse the list (of retailers) they are all gagged on inventory for a reason – they wanted to be in stock…so they are digging right now and will be fine But there is a good example of biting the bullet – not wishing for inventory to come out but be aggressive in noting it to get it out. Get ready for next spring. Have your shelves ready to bring next spring’s fashion, or whatever. – Ken Langone, billionaire businessman, investor and author ofI love capitalism! an american storyduring a June 27, 2022 interview on CNBC.
What we saw in real life was the Beer Game on steroids. The reopening of the global economy drove up demand as consumers were well funded and able to buy things despite rising prices. The result has been the hoarding of products along all lines of the supply chain. Hoarding has exacerbated existing COVID-related supply chain issues, compounding the bullwhip effect.
The good news is that high inventories bring inflation down as sellers cut prices to move old products as demand normalizes.
I’m not trying to anticipate the situation; there is still a lot of work to do. Nevertheless, there have been positive signs. Falling prices are an indication that supply imbalances are resolving themselves. Since mid-June, there have been double-digit price declines in things like iron ore, natural gas, copper, wheat and oil. In addition, the automotive industry had significant supply problems, as near-completed cars and trucks awaited delivery of microchips. Global shipments of automotive microchips are back to 95% of pre-pandemic levels, down from 56% in 2020, according to Goldman Sachs.
A reassessment of supply chain issues seems timely, given that it has pushed inflation so high. The Federal Reserve began aggressively raising the federal funds interest rate to combat rising prices. This has shaken confidence in the economy and the stock market.
Fed Chairman Jerome Powell said: “At the end of the day, we need to see progress on the supply side, but we’re not expecting it.” Progress on the supply side has reduced the risk of even higher inflation. As a result, the risk of the Fed raising rates above consensus has diminished. All other things considered, it’s less of a headwind for equity investors.
Allen Harris is the owner of Berkshire Money Management in Dalton, MA, managing over $700 million in investments. Unless specifically identified as original research or data collection, some or all of the data cited is attributable to third-party sources. Unless otherwise stated, any mention of specific securities or investments is for illustrative purposes only. The adviser’s clients may or may not hold the securities in question in their portfolios. The Advisor makes no representation that any of the securities discussed have been or will be profitable. Full disclosures: https://berkshiremm.com/capital-ideas-disclosures/ Address inquiries to Allen at [email protected]