Coronavirus and Supply Chain: Implications for the Industrial market

Mar 6, 2020, 15:12 PM by Ibrahiim Bayaan

The Coronavirus (COVID-19) was first identified in China at the end of last year in the Wuhan province and has since infected thousands of Chinese citizens. As a result, Chinese officials placed travel restrictions on nearly half of its population and restricted movements in and out of Chinese ports to contain the deadly virus. Many factories have been either temporarily shuttered or are running well below capacity, as Chinese manufacturers are unable to bring workers back after the Chinese Lunar New Year celebration. This has resulted in significant disruptions in the global supply chain, as trade with China has become increasingly difficult. Freight transportation connected to China has nosedived as a result, and companies across the globe are slashing earnings forecast in anticipation of the supply chain and demand challenges associated with the virus.

From a macroeconomic perspective, the COVID-19 virus comes at a particularly unfortunate time for the manufacturing sector. Manufacturing industrial production declined year-over-year in each of the last three quarters of 2019, falling to -1.2% as domestic producers faced headwinds from slumping global growth, the relative strength of the U.S. dollar, falling business investment, and the ongoing trade conflict with China.  The Phase 1 trade deal with China and improved readings for global manufacturing activity generated some optimism that things may be stabilizing for global trade flows at the start of the year. In addition, data on core capital goods orders growth returned to positive territory in December 2019, indicating businesses were beginning to feel more confident about spending on investment in the U.S.

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It is likely that the supply chain disruptions and general uncertainty caused by the Covid-19 virus are going to prolong the difficulties of the manufacturing sector. Domestic producers are already adjusting their increasingly globalized production processes, as Covid-19-related production delays in China have ripple effects throughout the supply chain. From an industry perspective, some industries will be hurt more than others based on the percentage of inputs that come from imports from China and the availability of alternative sourcing countries for supplies. For example, the chemicals industry plays a significant role in the U.S. import sector, making up nearly one-sixth of total imports by value. However, only a relatively small fraction of the industry’s inputs (<2%) come from China. By contrast, the apparel industry makes up a significantly smaller proportion of total U.S. imports but relies heavily on goods coming from China. The computer and electronics industry is in a particularly precarious situation, in that it is a large industry that relies heavily on imports from China, and also has few alternatives for critical inputs.

Even prior to the COVID-19 outbreak and the trade war, companies were looking at alternatives to China for manufacturing. Many companies were looking elsewhere for a variety of reasons including rising labor costs and intellectual capital theft concerns. The trade war increased this diversification in 2019, with companies moving into emerging Asian markets including Vietnam and Singapore, as well as Mexico. The increasing trade flow from these countries have increased import volumes along the east and gulf coasts and significantly improved real estate fundamentals in the surrounding markets. The COVID-19 outbreak is yet another factor that will push both retailers and wholesalers to diversify its product sources, further shifting its supply chain strategies at home and abroad.

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It is worth noting, however, that these types of dips in manufacturing activity stemming from temporary supply chain disruptions are typically followed by a rebound in activity when the issue is resolved. Lost activity during the COVID-19 outbreak should become pent up demand in subsequent months.

Inventories and the Silver Lining from the Trade War

Typically, to weather these types of supply chain disruptions, businesses across sectors respond by drawing down inventories. During the SARS outbreak in 2003, total real inventories declined outright after the first quarter of 2003, including a 2.2% decline in the manufacturing sector. A similar, but milder decline in inventories occurred after the tsunami and earthquake in Japan in 2011 and the West Coast port strike at the end of 2014.

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The supply chain disruptions stemming from the COVID-19 virus may be more severe than any of these previous episodes; China is a significantly larger participant in global supply chains now than it was during the SARS outbreak in 2003, and the current disruptions are likely to last longer than either the port strike or the tsunami and ensuing rebuild. However, the manufacturing sector is in a generally favorable position to deal with such shocks, in part thanks to the experience during the current trade conflict with China.

For one, manufacturing inventories are generally high in the economy. U.S. manufacturers began importing additional supplies from China and storing them in inventories throughout the latter part of 2018, attempting to buffer against further escalation in U.S.-China trade tensions. This, combined with the disappointing manufacturing environment throughout 2019, has translated into elevated inventory/sales ratios in the manufacturing sector. This makes widespread shortages of supplies in the manufacturing sector less likely. Additionally, many businesses have already gone through the process of evaluating alternative sources to imports from China and should be further along in the process if these trade disruptions from the Coronavirus persist.

Implications for Industrial Real Estate

Regardless, the spread of the Coronavirus will negatively affect the performance of the manufacturing sector, and the general uncertainty surrounding the spread of the virus and the ability to contain it will likely suspend some economic activity that would otherwise occur. History suggests that this has some spillover effects in industrial real estate. Compared to other types of commercial real estate, industrial leases are longer-term and are less likely to respond to short-term disruptions like the ones caused by the Coronavirus. As a result, it is unlikely that manufacturing and warehousing lessees vacate industrial properties because of the spread of the virus. However, many businesses may hold of on signing new agreements until some of the uncertainty subsides. There was a noticeable downtick in industrial demand in the middle of the SARS scare in 2003. Net absorption dipped during Q2 2003, falling into negative territory briefly before rebounding later that year.

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There is likely to be similar temporary downward pressure on industrial demand during the Coronavirus outbreak. As mentioned earlier, China plays a larger role in U.S. manufacturing process now, so an outbreak is a bigger deal than it was in 2003. However, industrial demand hinges less on manufacturing performance than it did 15-20 years ago as over 85% of existing inventory in the U.S. is used for distribution. Growth in e-commerce has propelled much of the strength in industrial over the past several years, as retailers continue to look for warehousing space to better position themselves for residential deliveries. E-commerce retailers may face similar short term-disruptions, as they will also have to worry about having imported products available for sale. But e-commerce has consistently been one of the strongest growth areas in the economy over the last 15 years, even during periods where they overall economy was growing slowly, and the push to deliver goods to households quickly should continue to provide support for industrial real estate demand.

Beware of Knock on Effects

Much of this analysis assumes that the virus is contained in a timely fashion and the supply chain disruptions are largely contained within China. Our current forecasts assume that the virus subtracts from growth in the first half of the year, but the economy rebounds in the second half, leaving the annual growth forecasts for 2020 minimally changed. So far, the virus has spread to dozens of other countries, causing many companies and countries to limit travel to affected areas but falling short of the kind of supply-chain disrupting restrictions in China. COVID-19 cases have already slowed in recent days and the Chinese government is moving toward easing travel restrictions.

A prolonged outbreak or a further acceleration in cases within the domestic economy could derail consumer and business confidence and cause a more significant downturn, however. If some of the fundamentals of growth are affected, the impact could be much more than a temporary hiccup in the economy and would cause a noticeable change in the industrial real estate outlook.

 

Deconstructing CRE

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