Counter Party Risk In The Supply Chain

We are in the middle of a black swan event.

We have a serious global health risk. The scope and magnitude of the impact is yet to be understood. Unfortunately, we have seen bureaucrats with zero understanding of scientific information making decisions that have put entire countries at risk. For example, the US State Department over-ruled other government departments and put 11 infected passengers from the Diamond Princess in the same aircraft as other passengers who had tested negative for the virus.

The corona virus outbreak, also known as Covid-19 is what I would call a black swan event. The idea of a black swan was coined by  Nissam Taleb. It’s a metaphor used to describe an event that is so rare it is thought not to exist. 

We typically can only see a black swan in hindsight. The collapse of financial markets in 2008 was a black swan event.

A hurricane hitting a major populated area can be a black swan event.

The terrorist attack on the world trade centre on Sept 11, 2001 was a black swan event.

What will be the economic cascade of this situation? We tend to discuss counter-party risk as a financial issue between holders of assets and liabilities.

There is another form of counter party risk that we rarely talk about. That is in the global supply chain.

We don’t understand the complex web of linkages that make up the global supply chain. Economic activity can be disrupted by a drop in demand, or by a drop in supply. We have nearly 3/4 of a billion people in China on lockdown. This will clearly impact both demand and supply.

When Japan experienced the Fukushima nuclear power plant failure, there was a single factory that supplied a critical component for batteries used all over the world. That single factory’s inability to supply for a period of time meant global disruption in the cell phone market. That was a single factory.

Right now we have a situation where 50% of the containership traffic from China has been halted. Even if the products are on the pier ready to depart for North America or Europe, there is no way to get the products to market.

Understand, each one of these container ships are capable of carrying more than 20,000 containers. That’s right, 20,000 20 foot containers. That’s the equivalent of 10,000 trucks on the highway for each ship. There are over 96 of these ships plying the ocean waters right now and a large number of them are stuck in port.

We are going to experience supply chain disruptions on a scale we have not seen since the Great Depression. If companies can’t deliver their products, they can’t collect revenue. It doesn’t matter if there is demand. They simply can’t deliver because they can’t get the product to market. All it takes is a critical component to be missing in the manufacturing process. Some companies will be able to survive a number of weeks, or perhaps even a few months with their current inventory. In the world of Just-In-Time manufacturing, the most efficient companies focus on minimizing that inventory. Ironically, it’s the most efficient companies in the world that will experience the most acute pain in their supply chain. Finding an alternate sources of supply for a product is never quick, nor easy. Component substitutions and supplier substitutions take months or longer to implement.

We have a number of companies that have massive corporate debt, much of it in the way of bonds. A large number of companies will have a very hard time withstanding a precipitous drop in business lasting more than a few months. The debt obligations of those companies assumes that growth will continue without interruption.

I’m predicting a wave of corporate debt defaults over the next 90 days as a direct result of the supply chain disruptions. Those defaults will have a cascade effect due to counter-party risk on the paper.