Odd Lots - This Is What The Coronavirus Means For The Chinese Supply Chain

Episode Date: February 26, 2020

Apple's recent revenue warning reminded the world of how exposed the company is to China, and in particular its factories. As the coronavirus continues to shutter huge swaths of the Chinese economy, this is a potential risk for numerous companies beyond just Apple. On this week's Odd Lots podcast, we speak with Dan Wang, a China tech industry analyst at Gavekal Dragonomics about how this, along with pressure on Huawei, are putting extraordinary pressure on the Chinese supply chain.See omnystudio.com/listener for privacy information.

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Hello, OddLod's listeners. Of course, normally we release new episodes on Monday. But today we're bringing you a special midweek episode. That's because it's very timely one. Obviously, a lot of interest in the coronavirus and the effect that it's having on supply chains around the world. So we didn't want to wait. We didn't want to slot it in, future in the schedule. We wanted to get it out now.

Hopefully you enjoy it. Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Wisenthall. And I'm Tracy Allaway. Tracy, you know what's really struck me in the markets over the last several weeks? Uh, go on. Well, obviously the crisis over the coronavirus continues to be this massive story for the global economy, for China, Asia, all kinds of different companies. And yet, investors in a weird way outside of some specific names or specific currencies still seem surprisingly, or maybe not surprisingly, but generally not that worried right now. Yeah. I find this pretty amazing. So at the time that we're recording, I think the S&P 500 is still pretty close to its all-time high. And what amazes me about that is we spent two years

collectively worrying about how trade tensions between the U.S. and China were going to affect global supply chains and economic growth and consumption. And we sort of followed every tiny in and out when it came to the trade negotiations. And now when you have something, the coronavirus and the containment efforts underway in China, you have something that is guaranteed to impact production and consumption in the world's second biggest economy as well as disrupt a bunch of supply chains and no one seems to care. Yeah, it's, it's really odd. It's really surprising. It's counterintuitive. It's not what I would have guessed. Even this week, the week that we're recording it, we got a warning from one of the sort of emblems of U.S. China trade globalization, Apple, which is

heavily exposed to China on the supply chain front and heavily exposed to China on the revenue front, saying, look, this quarter is going to be worse than we previously expected. Factories aren't opening up for our suppliers as fast as we had anticipated a couple of weeks ago. We're not totally sure when things will be back to normal, not to mention the fact that people are out less shopping. And, you know, the stock fell about 2% in the immediate wake of that, maybe because people figured this was the case already. and then the next day, the stock immediately basically erased all of those losses. So even a company coming out and saying, you know, this is a serious issue for us, even it's not having that much effect on them right now, I guess people are so confident that the effects will just be transitory and everyone will, okay, but be back to work eventually. Yeah. And our colleagues over at Bloomberg intelligence actually counted up the number of companies that are talking about the coronavirus.

the moment and I think they counted something like nine trillion dollars worth or companies accounting for nine trillion dollars worth of market cap have mentioned the coronavirus but so far we only really have a handful of them who are issuing you know the kind of warnings that we saw from Apple most of them are just talking about how it's too early to say that you know they'll get a direct hit but again frankly watching all of this go down in in China and in Asia, I find it really difficult to see how global supply chains would not be impacted at this point. Right. So obviously, look, we don't know what the markets are going to do and nobody does and we'll just see what happens. But I do think, and I did think in light of that Apple warning,

we really need to dive deeper into the question of supply change because so much of the world, so many companies that manufacture anything are exposed to China or East Asia and some way and getting some sort of handle on what the risks are is key and what the risks, of course, to the China economy are going to be. That's also key. So that's what we're going to discuss today. Great. I think that's a good, good, good idea given the circumstances. Let's do it. All right. We have a really great guest. We've had him on the podcast, I think a couple of times before, at least once, but I'm pretty sure twice. He's Dan Wang. He's an analyst at Gavkau Dragonomics. He's talking to us from Beijing. He's a tech analyst, really knows a lot about

Chinese manufacturing Chinese supply chains, the interaction with global tech. And he'll walk us through the risks posed by this virus, what we're seeing right now, as well as other risks that maybe people aren't even thinking about right now beyond the virus. So Dan, thank you very much for joining us. Thanks very much for having me on again. We've all seen the images of various cities. across China, either quarantined or de facto quarantined, empty streets and so forth. We know that there are numerous factories that have yet to reopen, and the schedule for that remains unclear. We got the warning this week from Apple that this is going to be a hit to their

performance in the current quarter. So that's known. What to you, based on your work that you're doing, looking at the industry, what you've seen, what really jumps out at you, in terms of the coronavirus hit to China's industrial economy? So I think you've led by saying, in a really good way, by saying that basically the market seems to be prepping all of this off. I think there could be an economics way of thinking about that in just, you know, if you assume that the virus is going to be mostly contained in this current quarter. and there's some evidence that that could be the case. And that the Chinese economy will basically bounce back into the normal previous trend growth that will be well expecting.

There will be some pent-up demand that would be released later on, and it will be quite bad quarter, but everything gets back to trend. I think that case could be made for the general macro economy, and that's why most people are not reacting very much. But in terms of electronics, I think that story would not be so simple. And that's because electronics manufacturing involves some of the most complex supply chain ever. You need basically a lot of different components in place in order to begin production. You need a thousand and one or maybe even a million in one component all at the right place and all at the right time.

And so if you have this delay, which hasn't really resolved itself yet, I think that can ripple on and cascade on throughout the supply chain all the way throughout the rest of the year when it comes to basically the peak selling season, which is the Christmas season in the U.S. I think that will ripple on throughout the rest of the year. How much flexibility is there when it comes to altering global supply chains for electronics companies? Because, you know, during the trade tensions, we saw a lot of people talking about, well, they'll just move production from China to Vietnam or to wherever. There was that option. But in the current situation, it seems like, first of all, you'd have to do it much, much more quickly. And secondly, no one's really sure how the virus is going to play out. So you don't necessarily have the motivation to move production if you're thinking that it's going to end very, very quickly.

So how easy is it to do? to shift supply chains for electronics companies? It is all pretty difficult, and we have not seen a great deal of production move overseas as a result of the U.S. tariffs on Chinese production. We have certainly seen some. We have seen a few marginal products, some things like servers and some things like wearables, move overseas, especially to Vietnam. That's the most decided place.

But in general, it hasn't been a wholesale movement of supply chain. And I think that's a pretty difficult thing for companies to deal with on a short term. A manufacturer made a statement a while ago to say that, you know, the tariffs are something that we can deal with. That's a cost increase, and that's something we have to transfer into, but that is a predictable and something that we are able to resolve. Whereas if we do not have a lot of parts as the coronavirus has threatened, if we do not have workers in our factories because they just are not coming back or we cannot pass these sanitary checks or quarantine checks imposed by the local government, then we don't even have the parts in place to engage in production. So this seems like a much bigger deal. Talk to us a little bit more about modern electronic supply chains. And in a sense, they're an absolute marvel because all these different companies come together and the logistics are such that companies can hold very little inventory.

And the key part arrives just in time for the other company or the other manufacturer to assemble it into something. And then that goes into something else. And it's this sort of beautiful orchestra maybe when it's working ideally. Talk to us about what you said when you pointed out. Look, it's not as simple as just restarting this. Because it's so complex, it's not just a matter of, okay, the switch goes off for a few weeks, and then maybe you just turn it back on. What is that cascading effect you're talking about, and why is it not so simple to get it going again once you're ready to restart?

Yeah, that's exactly right. So basically, to really get production going at the major manufacturer like Foxconn, you need a lot of different components in place. So you need, let's say, something like a thousand components in place. You need all of the labor in place also to begin staffing. You need to make sure that all of the components are arriving on a daily basis that there is a lot of flow. You need to make sure that the components are of pretty good quality and you need to make sure that the labor is of good quality. And right now, basically, none of those conditions are holding.

So Foxcon has not said publicly very much about how many workers have been able to return. Our estimate is that something like half of China's migrant labor force has arrived back into factories. It's going to take quite a while probably in March or early April for everyone to get back into their place. And so, you know, I think that the larger manufacturers are probably able to, to deal with a lot of these problems. So Foxcon, in spite of a lot of bad press that has received over the last decade, is still the best paying of the large manufacturers.

It has the best working conditions. It is just really large. It employs about a million people in China every year. And then the five other big contract manufacturers in Taiwan employ about collectively 500,000. So about 1.5 million people total working on, not just directly on all types of electronics, but especially the smart phone. And so basically, Apple needs a lot of people in place,

and it should be able to hire all of the people that it needs. But if Foxcon is able to hire for everyone because it is working for its largest customer Apple, which has a lot of cash to throw at these problems, it might suck away the labor from a lot of the sub-assemblers, so the component makers that are supplying good for Foxcon to put onto lines of people to actually produce. So, you know, again, I want to emphasize that it only takes a few missing pot-by chain not to be functional. And so there will be a lot of these gaps out there, even for Apple. Apple every year launches a new iPhone by Q4.

That is highly predictable. But even for Apple, it is a supply chain. are things like Apple are able to get through this. Many smaller companies are going to have a lot more problems. Q1 is typically the time of the year where many consumer electronics companies engage in prototyping and development with the manufacturers. And if the manufacturers just have persistent labor shortages

and supply shortages are going to be dedicating all of their people to their large customers like Apple. And I think the case would be here that this year that consumer electronics will be pretty bad. A lot of smaller companies won't even be able to launch the products they had hoped to launch by the Christmas season. That's already probably the case, and it's going to be a stretch even for Apple. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple

flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline. It's a commitment to your clients. We're talking top grade products across the board of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income. So if you're looking to give your clients consistent results year in and year out, go see the record for yourself at vanguard.com slash audio.

That's vanguard.com slash audio. All investing in subject to risk, vanguard, market. Marketing Corporation Distributor. Could you talk to us a little bit more about the labor shortage idea and how the containment efforts that we've seen rolled out across China at this point, how those actually impact the way the labor market functions? So China today has a lot of restrictions in place in who can go where. When I leave my apartment in Beijing, I have to flash this little card at these dorm men who

are newly set up to exit and enter the building. Every three blocks I go, there is someone taking my temperature to make sure that I'm all right. And one thing that I'm struck by now is that the amount of state capacity that China has brought to bear on this problem is impressive and also frightening that China has been able to quarantine about 60 million people. around the population of Italy and the span of around 12 hours. My thought here is that China can mobilize the citizens more quickly than many countries can mobilize their armies. And so it is imposing many sorts of restrictions on labor even today. Many migrants are not able to enter the large cities to actually begin production.

So a lot of the public transportation in terms of trains are shut, a lot of roads, a lot of cars are not able to go on the road. And this is creating a lot of problems for factories that really need labor. And I think the biggest issue here is that there's considerable uncertainty about when this virus could be declared eradicated and for everybody to feel safe to go back. So these travel restrictions could evaporate. Let's say next week. or take could take something longer, let's say a month, but it will take probably even longer for all of the flights to resume and for all of the people to feel that they can safely travel about in China. And that will create a lot of uncertainties. There is just a lot of human contact that's required to engage in production.

Yeah, and one of the things that we've seen anecdotally as well is this notion of a sort of patchwork of, local and national rules. So, for instance, in order to open up a factory, you know, local officials will require the factory owner to give face masks to all of its workers. But of course, there's a giant face mask shortage. And so they're unable to do that. And we've seen a lot of chaos, let's say, and confusion when it comes to what the rules are and what they are not when it comes to a work environments. Right. Kenna, trying to deal with that right around the holiday and, you know, the huge moves extraordinary. Dan, is there a compounding effect of the delays such that, okay, you know, I know that at one point, the goal was, okay, reopened by February 10th,

that didn't happen in many cases? But is there a sort of non-linearity where a week of delays does not just mean a week of problems, and each week the situation sort of snowballs and grows, you know, compounds or grows exponentially. Yes, there is that risk that there is a lot nonlinear aspect of this. If you were expecting basically a lot of components to arrive and if you don't, then a lot of manufacturers could be quite stuck. And for the manufacturers like Foxcon who are at the end of a supply chain, basically waiting for everybody to send everything through,

they don't necessarily have great visibility into which little parts they require that just doesn't necessarily make it. So every time there's an earthquake in Japan reminds us, reminds the world about how dependent the entire world is on perhaps a particular factory making a particular widget. And so these things can be a little bit unpredictable. But I think the large companies like Apple realize that at this point, and I think everybody is going to be in a scramble in the coming weeks

to really understand how deep the supply chain are. Another issue for Apple right now is that Apple sends a lot of engineers from its headquarters in Cooper Tino to come over to China and then actually monitor, station these engineers, and monitor the progress that these component makers have for quality assurance and product zone and perpetrators. A lot of those flights are canceled, and I expect that Apple is only able to send a trickle of staff over to China to actually monitor all of that production. So there are a lot of these risks out there.

Dan, talk to us a little bit about, I guess, the big picture long-term impact when it comes to China's technology ambition. So I think the first time we had you on this podcast was to talk about the Made in China 2025 initiative, where China is really trying to bulk up its own technology expertise, would you expect something like the coronavirus outbreak to have a long-term impact on those efforts? Certainly, I think it will push greater geographic diversity. I think that the events of the last two years have shown that companies are highly dependent on China for production.

I think many companies are thinking more deeply about what geographic diversity actually means. So previously, we thought that geographic diversity, you know, is important in case there's a flood or an earthquake, which are fairly localized events. So if you want to basically have a more robust supply chain, you should locate a lot of her factories just geographically quite far away from each other. And I think the events, at least of the last year, have shown that when President Trump has impose tariffs on Chinese goods.

But there is a political element. So even if you produce in northern China and then south-eastern China, you may necessarily, you might still be hit by a lot of these same risks. Now, whether and how it impacts China's technology development, I think it is going to make it a little bit more difficult for China to do everything that I would like. At the very least, it is turning some foreigners and expats off the idea of living Shanghai, and I think that will be at least a lot.

Dan, I think that's a great opportunity to sort of segue into another risk factor facing Chinese manufacturing Chinese supply chain because it was just a few months ago that there was this thought that, okay, the big risk was just on the trade front. That seems to have cleared up. They got the phase one deal. Now, suddenly there's this, which is, as you point, could potentially change everything or at least change, really change the way companies around the world think about their exposure to China. But as you point out, and as you've been writing, the coronavirus is really not the only major threat to Chinese supply chains, Chinese manufacturing, and that there's another thing lurking out there that people need to pay attention to. So what is that?

So that is technology flows. And so as part of the trade war, there has also been a bit of attack U.S. policy action. I think the first major shot of that was last year or almost a year and a half ago now, when President Trump's administration designated VTE to something called the Deny Person's List, which more or less cut off VTE's entire ability to be. procure from American technology, especially semiconductors. And so that has brought the firm to its needs almost to the verge of bankruptcy until President C. and Trump reached a political solution to save the company. So there has been this element hovering in the background of the U.S. exercising

investment restrictions on the ability of foreigners to invest in U.S. firms, especially technology firms. There has been a process initiated by the Department of Justice to scrutinize Chinese actions much more closely in terms of trade secret misappropriation, but also Chinese activities in, say, universities working with certain professors. And then it also manifested in specifically this issue of Huawei becoming a large player in the tech world, and then the administration is, I think, much more care. What would be the impact on? China's tech industry, if the U.S. does actually go through with a lot of the things that it's threatening, and what options does China have to offset the impact of those curves?

I think the issue right now for China is to figure out how to be Americanized supply chain. So, again, this is sort of a supply chain story in which the lack of a few components can really defeat the system. So if you take a look at your smartphone, it has something like 1,500 different components in it, and if you lack even three or four different components, so your phone needs, for example, a battery, it needs a processor, it needs memory chips, and it needs a screen. And if you don't have these, then you don't really have a phone. And given that the U.S. has figured out that it is almost a monopolist on very important technology, and by denying U.S. semiconductors to particular firms, it's figured out it can really create

cripple China. Now, I take the view that over the long term, China now that has realized it technologies, it should be able to figure out a lot of those who has monopolized a key in the century when the mills and machinery to the U.S. rising power through a ship and then went to the U.S. So one of these people is Samuel Slater, who's known. A lot of knowledge just consists had there was that knowledge travels that it's being so long as you can just talk through these sort of thing is able to travel. The Chinese don't have to enter technologies, including the capital equipment, to actually advocate the sending conductors, and also in things like aviation engines in which China is also trying to catch up. And so this is why there has been a pretty

analogies to market and then also generate the revenue. It's so interesting just sort of thinking about the symmetry or the asymmetry, or I guess it's the symmetry of the needs and priorities of China when it comes to trade and the needs and priorities of the U.S. when it comes to trade. Obviously, we know President Trump feels that he would like to bring back jobs from China and though maybe it's debatable whether anything that's been done so far would really accomplish that. Obviously, that was a key driving aspect of his campaign and his message and so forth. And then you have the Chinese economy and the Chinese priorities that you've talked to us on the podcast before. And it's not about jobs per se. It's about the over-reliance

and, you know, winning back the tech war against the U.S. So it's really sort of the same thing in a sense of both just wanting to not need the other. Yeah, that's right. So both, which is right now mostly an American affair and the Chinese are also wanting many of the same thing. So I guess then my question is, you know, obviously in the first half of the conversation, you were talking about, okay, U.S. companies are going to think about geographic diversity for manufacturing. And of course, during the trade war, we heard a lot about Vietnam. But there's really no country immediately that can just suddenly absorb a huge influx of new demand for manufacturing. I mean, there's just all kinds of things that need to go into that. It's not like you just build a Foxcon in Vietnam overnight or a Foxcon in Brazil overnight or anything like that.

Who wins the race? Like how long, say, will it take for China to accomplish what it needs on sort of, you know, being able to design some of, of its own semiconductors so that it can wean itself off of U.S. tech? That's a great question thinking about it in terms of a race. And I tend to think that the U.S. has the advantage here. It is a lot more straightforward for Apple to move most of its supply chain out of China and into, let's say, a mix of places that include India, Brazil, in Vietnam. Then it is for China to figure out semiconductors, which are the most complex technologies in the world. When I think of something like a semiconductor manufacturing equipment

from a firm like ASML, basically these pieces of machinery are about as large as buses. Each machine costs about $200 million US dollars. And you're really playing with light and physics and math at that point. It's almost like a pure science affair. And the Chinese just have not had enough experience really doing a lot of these things. Now, the question then becomes, when the U.S. exercises these export control actions on China, does it accelerate China's technology development or does it really cripple it? I think over the long term, it should still be accelerating China's technology development. So, right? Right now, the Chinese have always had a program to replace its own internal technologies that it uses with Chinese-made equipment.

Part of that has always been a program that has somewhat accelerated in 2013 after the Stodan revelations of different spying. And I think the Chinese now are, this is the difference in the last two years is that this is no long. a whimsical government effort, which has never really been terribly successful in the past, now this is led much more by private companies, by firms like Alibaba or Tencent or Hyk Vision or Selmy that are asking themselves, can I depend on American supply such that I'm willing to build my technology off in American stack for the next 10 years? And they are becoming a little bit more hesitant to do something like that. And so they are taking the lead in trying to develop.

They're more homegrown, more politically dependent. So, Dan, just to sum it all up, I'm kind of curious to get some of your personal observations about the situation at the moment. What has surprised you about how the coronavirus or the containment efforts around the coronavirus have impacted either the tech industry or the electronics industry? what was most surprising? I think the speed and scale of the payment efforts, I think, after Wuhan was quarantined. First of all, they quarantined Wuhan really quickly. And basically there has been a really enormous demonstration of state power here and state capacity here. And I think we're now trying to figure out, given that,

there are some encouraging signs that the virus is abating. The number of infections ex-Hube has been in the double digits, I think, for the last three days, meaning that the epidemic seems to be mostly contained in Hubei and Wuhan. And the question now is really how to restart the really good at making sure that people are in their place and that the state has the ability to quarantine very many people. now I think there's a lot of these risks. Well, Dan, really appreciate you joining us. Always love chatting with you.

And we should probably, you know, do one again maybe in three months or six months and just sort of reassess where things are on the supply chain and the degree to which the industrial economy has been able to come back. But, Dan, thank you. And hope everything returns to some semblance of normalcy fairly soon. Thanks very much, Joe. Thanks so much, Dan. It was really good. So, Joe, I found that conversation really, really interesting.

It's nice to dig deep into the supply chain issue. And I do think there seems to be a sense out there that they can be very flexible and they can be reoriented as needed. But as Dan pointed out, they're actually quite complex. And it takes time to move these things. No, there are so many things that he pointed out that I hadn't seen anyone described. us before thinking about. So, for example, okay, Christmas shopping or holiday electronic sales, that seems like a long time from now. But if the basic prototyping of the next generation of any products is Q1 and Q1 is looking like for sure a total disaster, then, okay, even if there is a big

economic rebound in Q2, which we don't know for sure yet, but even if there is, there will be inevitably this cascading effect that lasts at least through the year and that to some extent there's no getting back this lost time. Yeah. And the other thing I've been thinking about is we, you know, we were just speaking about the production side of things, but you would think that the coronavirus outbreak is going to end up having a very, very large impact on consumption as well. So China is basically in for both a supply and demand shock to its economy. And I also wonder when it comes to the consumption decline, how long is that going to last? And is it going to be similar like supply chains in that it takes a while to get back to normal? You know, the Chinese government

has spent so long telling people that they really need to make efforts to contain the virus. They have to stay at home. Is it going to be easy for them to lift those and suddenly tell everyone, oh, everything's back to normal, you don't need to worry anymore, to Dan's point in the last question. Yeah, totally, because, you know, there's obviously, there's no cure, there's no vaccine that we have or anything like that yet. So to declare victory over the virus or to declare that it's been eradicated, it seems like an extremely difficult thing. And even after, you know, people start coming back to work, it seems plausible that fear of a new outbreak or fear of just one person having it and spreading into a new super spreader situation could really change.

how people behave, at least for quite some time after, you know, after whatever, that the idea of any sort of imminent resumption of normal life, it kind of seems implausible. There's so much going on. It's such an interesting story and really sort of unprecedented in many ways. So what a fascinating topic to talk about. Hearing Dan talk about how there's someone who checks, checks his temperature literally every three blocks. And as he pointed out, the state capacity required simply to set that up. I mean, it's just extraordinary to think about what has been done already.

Yeah. They're doing it in Hong Kong as well, though not quite on that scale. But certainly to get into the major office buildings at the moment, you have to get your temperature taken. So it's a big change. This has been another episode of the Odd Lots podcast. I'm Tracy Alloway. You can follow me on Twitter. at Tracy Allaway.

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