In November 2021, I argued that supply chain issues should ease by August 2022. Given that August is next month, it’s time to check to see if I might be right. Not because I want to be scored, but because if I was right, then we could get a sense of whether inflation has peaked. And if inflation has peaked, the Federal Reserve doesn’t need to be more aggressive, which helps me determine the asset allocation of investment portfolios. To figure this out, let’s play the Beer Game.
No, no. Not beer pong, flip cup, or wizard staff. I am talking about MIT Sloan’s “Beer Distribution Game” (originally called The Refrigerator Game, but apparently, college students paid more attention when the product was beer).
MIT describes the Beer Game as “one of the oldest and most widely used management simulations…[which] provides an opportunity for participants to play the role of managers in a complex dynamic system, specifically, managers in a supply chain representing the production and distribution of beer.” (Emphasis added.)
The Beer Game is a role-playing simulation with several participants. The players in the Beer Game work their way through a four-stage supply chain—from the factory to the distributor, to the wholesaler, and finally to the retailer.
The goal of the Beer Game is to keep inventories, and thus carrying costs, as low as possible.
The Beer Game reflects what happens in actual companies. Suppose there is a short-term spike in demand for Allen’s Awesome Ale at the retail store. Because there is a delay in delivery, the retailer is soon out of supply. When a new shipment arrives, it’s sold out almost immediately. The retailer is losing out by missing additional sales, so they order larger quantities.
And then the Bullwhip Effect occurs. The Bullwhip Effect refers to how an increase in orders amplifies as it moves upstream in the supply chain, from the consumer toward production. In other words, unexpected large orders from end users trigger a wave of panic orders and inventory building.
The retailer is discouraged because she is missing sales. Then the wholesaler is frustrated because they can’t fill the retailer’s orders. The wholesaler starts ordering more from the distributor. The distributor sees the increased demand and orders more from the factory, so the factory ramps up production.
When the game is completed, everyone ends up with excess inventory, which all started from a small spike in consumer demand. When MIT interviewed the players, everyone blamed the other person. They failed to see how ordering more inventory than was needed magnified the problem.
The supply chain in the Beer Game is idealized for the purpose of the game. Imagine how challenging the game could be if playing with more sophisticated and sensitive supply chains. In real life, we’ve been experiencing just that and retailers are now gagging on inventory.
Gagging on Inventories
“Look at the inventory issues…The thing you never want to be as a retailer is out of stock of what your customer wants to buy…so here’s this great shortage on the one hand, tremendous demand on the other. You can go right down the list (of retailers); they’re all gagging on inventory for one reason—they wanted to be in stock…so they’re digging out right now and will be fine. But there’s a good example of biting the bullet—not wishing the inventory out but being aggressive by marking it down to get it out. Get ready for next spring. Have your shelves ready to bring in next spring’s fashion, or whatever it is.” – Ken Langone, billionaire businessman, investor, and author of “I Love Capitalism! An American Story” during a June 27, 2022, CNBC interview.
What we saw in real life was the Beer Game on steroids. Reopening the global economy spiked demand while consumers were well funded and capable of buying things despite rising prices. The result was product hoarding along all lines of the supply chain. The hoarding exacerbated existing COVID-related supply chain issues, aggravating the Bullwhip Effect.
The good news is that high inventories drive down inflation as sellers discount prices to move old products as demand normalizes.
I am not trying to get ahead of the situation; there’s still a lot of work to be done. Nonetheless, there have been positive signs. Falling prices are an indication that supply imbalances are working themselves out. Since mid-June, there have been double-digit price declines in things like iron ore, natural gas, copper, wheat, and oil. Additionally, the automotive industry had significant supply issues as nearly-completed cars and trucks awaited microchip delivery. Global shipments of automotive microchips have returned to 95% of pre-pandemic levels, up from 56% in 2020, according to Goldman Sachs.
A reassessment of the supply chain issues seems timely, given that it has driven inflation so high. The Federal Reserve has begun aggressively raising the federal funds interest rate to combat higher prices. This has shaken confidence in the economy and the stock market.
Fed Chairman Jerome Powell said, “ultimately, we need to see progress on the supply side, but we’re not waiting for it.” Progress on the supply side has diminished the risk of even higher inflation. Consequently, the risk that the Fed might raise rates higher than the consensus has come down. All other things considered, that’s less of a headwind for stock investors.
Allen Harris is the owner of Berkshire Money Management in Dalton, MA, managing more than $700 million of investments. Unless specifically identified as original research or data gathering, some or all of the data cited is attributable to third-party sources. Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Adviser’s clients may or may not hold the securities discussed in their portfolios. Adviser makes no representations that any of the securities discussed have been or will be profitable. Full disclosures: https://berkshiremm.com/capital-ideas-disclosures/ Direct inquiries to Allen at AHarris@BerkshireMM.com.
