A rising factory tide in US and China won’t lift all boats

A rewiring of the world’s factory supply chain is taking hold as companies contend with sharpened geopolitical fissures, a new era for industrial policy and an increased focus on resiliency. But this revamping is happening against a backdrop of uncertain economic conditions and a surge in the cost of the capital needed to fund such investment. Small and medium-sized manufacturers in the US and China are particularly vulnerable to these growing, divergent pressures and are at risk of becoming collateral damage.

The factory renaissance in North America is real: Melius Research has tabulated some $380 billion of “mega-projects” — defined as an investment greater than $1 billion — with almost 60% of those planned facilities already breaking ground. There’s more to come with a huge influx of US government stimulus aimed at infrastructure, clean energy and semiconductors still filtering its way down to specific projects. China, meanwhile, is pushing billions of dollars of infrastructure investment as companies seek to support a domestic recovery after the end of Covid-Zero policies while grappling with slowing overseas demand and weak balance sheets.

The supply chains need to keep up. The surge of investment in North America often gets termed “reshoring,” but that’s a bit of a misnomer. For the most part, the capacity that industrial manufacturers are adding is meant to bolster their ability to meet demand in that region and add more resiliency to their supply chains; it’s not replacing existing production in Asia. What that means in practice is that the smaller and medium-sized companies that make up the bulk of the world’s factory supply chain actually need to be more globalised and capable of supporting large manufacturers with facilities in multiple regions. In a global supply crunch, it doesn’t do much good to ship goods to Kansas from a factory in Mexico if that facility depends on components or raw materials that need to be shipped from China. The prospect of a shrinking customer base has inspired Asia’s vast base of suppliers to invest in other countries. Air-conditioner maker Carrier Global Corp. has pointed to a supplier that was willing to build an additional facility literally next door to its factory in Monterrey, Mexico, as an example of the kind of “support” its looking for from its parts network. Chinese lithium firm Sichuan Yahua Industrial Group Co. last week announced a tie-up with South Korean battery-maker LG Energy Solution Ltd. to make products in Morocco that can be used in the US and Europe. One of China’s biggest engine makers, Guangxi Yuchai Machinery Group Co., is pushing into Southeast Asia. South Korean manufacturers are looking to the Middle East. Chinese car-parts makers are facing growing pressure from their overseas customers to add factories in other countries, Bloomberg News reported.

“Most manufacturers may have had single source on component products, and they’re now looking for one short and one long supplier,” Kevin Murphy, chief executive officer of Ferguson Plc, a $26 billion distributor of heating, ventilation, plumbing and other industrial supplies, said in an interview. That means one supplier “that is more near shore or North American and one that is more global, likely in Asia.”

The scale of the global investment push begs the stubborn question of supply: Where will the components, raw materials and workers come from to support this building boom, how much will those things cost and what is the return on these projects? These issues are far more existential for smaller companies. New factories aren’t cheap, and investments of this sort are often subject to delays and cost overruns in the best of times. These aren’t the best of times.

The Institute for Supply Management’s gauge of US manufacturing signalled a deepening contraction in March, with the weakest reading since 2009, excluding the pandemic. Supplier-delivery times are improving in China as the era of stringent lockdowns ceases, but businesses aren’t yet willing to build inventories, keeping new order rates and production volumes below pre-pandemic highs. For the rest of Asia, the once reliable and large overseas markets are waning. Japanese manufacturers now say that there’s excess supply and that exports will be subdued, according to the latest Tankan business survey. That sentiment is even more pronounced for small enterprises. In the chip industry that’s meant to power much of the US factory expansion, Taiwan Semiconductor Manufacturing Co. missed sales estimates for the second consecutive quarter and Samsung Electronics Co. said it would curb output of memory chips after reporting its lowest quarterly profit since 2009.

Big companies with ample resources have the ability to look through these trends and plow ahead with long-term investments; small companies with limited budgets may not have that luxury. Banks are tightening commercial and industrial loan standards in the US at rates not seen since the onset of the pandemic and the 2008 financial crisis, according to an analysis from Melius Research analyst Scott Davis citing Federal Reserve data. While the biggest industrial companies feel the impact of higher interest rates when they want to borrow large chunks of money, many are mostly self-funded through free cash flow, which limits the direct effect of tighter lending standards on their operations or capital spending plans. But their suppliers could certainly feel the pinch. A net 9% of small-business owners who borrow frequently said it was harder to get a loan in March than it was three months earlier, the largest percentage since December 2012, according to a survey released this week from the National Federation of Independent Business. Companies surveyed for the National Association of Manufacturers’ first-quarter outlook ranked challenges with access to financing as last among their top concerns; attracting and retaining a high-quality workforce was their chief worry, followed by increased raw material costs and supply-chain challenges. The survey fieldwork was completed on March 7, however, a few days before Silicon Valley Bank collapsed into Federal Deposit Insurance Corp. receivership and triggered fears about a broader banking crisis that were fanned further by the forced merger of Credit Suisse Group AG and UBS Group AG.

“I don’t hear a lot about access to credit in general. But for those companies that it is a big issue, likely smaller manufacturers, it’s a big issue,” Chad Moutray, NAM’s chief economist, said in a phone interview. Small and medium-sized companies are more likely to have relationships with community banks, which could be subject to stiffer regulations in the wake of SVB’s downward spiral. That “begs the question of what access to credit will look like,” Moutray said. Some smaller and medium-sized manufacturers are worried about how a pull-back in lending will affect their ability to expand and hire workers, he said. These companies are already disadvantaged in the labor market relative to bigger manufacturers with more resources and other industries that can offer more flexibility. Smaller industrial companies “have had to raise wages significantly and they’re still having trouble getting people in the door,” Moutray said.

In China, while credit is flowing hard and fast, it’s mostly going toward large state-owned firms. That’s crowding out small and medium-sized manufacturers in the private sector, which account for a significant chunk of China’s industrial might. While the performance of these companies has improved in recent months, they remain on weaker financial footing and their profit margins are getting squeezed as China’s labor cost advantage erodes and larger companies seek to protect their own bottom lines by turning the screws on suppliers.

The era in which end-product manufacturers paid “anything goes” prices for available inputs is ending, and some are getting increasingly aggressive about asking for price cuts as raw material and freight inflation ease. Few have been as publicly blunt about this as Carrier. The air-conditioner maker’s costs ballooned by $500 million in 2021 and $1.5 billion in 2022 because of inflation. It’s the company’s “God-given right” to get that cost back, CEO Dave Gitlin said in February at a Barclays Plc conference. “We have suppliers that are either on this journey with us for the long term or not. And we are going to shift to suppliers that are prepared to support us from a cost perspective, a quality, delivery perspective.”

It’s hard to see how global supply chains will bifurcate without pain, but the brunt of the financial strain may be felt by smaller companies just trying to keep up.