The butterfly effect redux

How a lockdown in one city impacts the entire world

The retailing giant Target’s stock had its largest single day drop (25%) on June 6th this year, the day it announced its quarterly earnings.

There were several reasons for it - product mix issues resulting in inventory that it needed to sell at a steep discount, supply chain woes continuing to impact it, significantly increased freight costs and more.

This isn’t an article about Target though; Target’s woes are an illustration of what we’re going to speak about.

Right now, the world is in a state of significant unease. COVID still hangs over us even as most countries have started to treat it as moving to an endemic state. The war in Ukraine has paralyzed Europe in significant ways and is redrawing political and economic boundaries. The chip shortage is still ongoing, impacting everything from specialized equipment to automobiles to computers. Finally, Shanghai has been in a complete lockdown for large parts of the year.

One of these is not like the others, you might say. Shanghai’s lockdown is just a local issue. Every major city has been in lockdown before. Why is this any different?

Shanghai’s lockdown has an outsize impact on the world economy for several reasons. China accounts for 15% of global trade. Shanghai is both hub and headquarters to a lot of this. Shanghai’s port handles 20% of China’s volumes. Its share in some key industries such as integrated circuits is even higher. For any item with sufficient complexity coming out of China, it is hard to see how Shanghai wouldn’t be involved.

And this is the heart of the issue. In a world where prevailing economic mindsets have worked to optimize and streamline the supply chain for maximum efficiency and profits, a disruption to a single critical part of the chain leads to a Rube Goldberg machine of dominoes being triggered long after the original domino has fallen. A lot of the world’s freight capacity is being used sub-optimally and will continue to do so. The logjams that have piled up at Shanghai’s port will only move elsewhere to other key ports when it opens. It will take the world a long time to stabilize.

What does all this do with investing? Several things come to mind:

  • Companies will look to build more diverse supply chains and add more buffers in them, even if there is an impact to margins
  • Companies that are integrated forwards and back locally and catering broadly to a domestic market form a good hedge to a portfolio that is sensitive to globalization disruptions
  • China +1 strategies will pick up speed, and if you can identify good candidates to benefit from this, you’ll do well
  • A good thought experiment would be to look at how things would be if Shenzhen were to be as badly affected as Shanghai, or if the lockdown recurs

I’d like to recommend reading Nassim Taleb’s book Antifragile; it’s central idea is how systems and institutions can benefit from disorder rather than falling prey to it.