Global Supply Chain Disruption – The Impact On Credit Markets
The war in Ukraine and the recent lockdowns in China are the latest in a series of highly disruptive events affecting global supply chains. This creates challenges as well as opportunities for investment managers focusing on both the leveraged loan and CLO equity spaces.
Geopolitical Tensions and Policies
Production inefficiencies stemming from tariffs, geopolitical tensions, and policies, have driven inflation to the highest observed levels in recent history. Current supply chains have been built and centred around cost-effectiveness. Prior to the onset of the pandemic, we have seen private equity sponsors make a typical move of reducing the sourcing and manufacturing capabilities of a new portfolio company from twelve manufacturing facilities down to two in search of cost efficiencies. This type of calculus has been rewarded handsomely; moving production to the lowest cost region has been a massive tailwind to corporate earnings.
Although market dislocations exist, there is no risk without reward. The question going forward will be: ‘is it prudent to lead with cost-effectiveness or surety of supply effectiveness even if it comes at the expense of earnings power?’ It appears the calculus has been slowly tilting in favour of supply chain diversification. Corporate borrowers are rushing to expand relationships to source goods and raw materials so that they can meet strong demand in a timelier fashion; otherwise, they may risk losing the customer’s business altogether. Surety of supply is taking precedent over price in the current high inflationary environment.
McDonald’s started opening its first restaurants outside of Moscow in early 1990. Today. 850 locations have shuttered under the brand name and have effectively been nationalized alongside many other popular Quick Service Restaurants (QSRs) in Russia. Apparently, the trend of deglobalization and onshoring may already have been initiated.
We are seeing U.S.-based borrowers further invest in domestic production and they are also acquiring businesses in Mexico as part of their M&A strategy to effectively reduce reliance on more distant and remote supply chains. When investing in today’s current corporate credit environment, analysts must carefully consider attributing more significant analysis to relevant investment considerations. Some of these considerations include the end-market of the business and its customers, pricing power (how effective and frequent the pass-through terms are), and manufacturing geography footprint.
The previous paradigm granted a competitive advantage to companies that went into lower cost
production geographies. Now we are seeing companies that can meet orders in a timely fashion taking market share. These companies are able to realize price concessions from customers who are more conciliatory on payment rates.
Companies are likely going to re-examine production sites and may consider moving into less cost-efficient geographies in an effort to de-risk supply-chain and freight cost uncertainty. Investing in companies with astute and forward-looking management teams is just as critical as entrusting capital to savvy managers who are effective stewards of capital.
To the extent that inflation accelerates further and is not combined with real economic growth, loan and bond issuers should experience continued cash flow volatility and some will struggle to maintain their capital structures. Careful credit selection continues to be a key factor to long-term outperformance in this asset class.
To the extent that volatility continues this year and into 2023, CLO managers who are not pressured to buy every issued loan might outperform. Higher spreads on newly issued loans will further add to CLO equity returns; choppy market conditions can create many opportunities for managers to take views on credit and potentially add significant value to CLO equity returns.
Olga Chernova is Founder at Sancus Capital
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