What the end of Shanghai lockdowns means for global production chains

One wonders whether for one of the first times in its history, China might not have prioritized the health of its people at the expense of its economy. Since mid-March, the Chinese government has implemented the zero-covid policy, to the detriment of the economy, and millions of Chinese citizen have been confined to their home. As a result, logistics operators and exporters are facing great difficulties. The repeated lockdowns are hurting supply chains, the consumption of Chinese products is at its lowest, while the unemployment rate is at its highest.

It is increasingly clear that the Chinese economy is facing major headwinds. A draconian zero-Covid-19 policy has stalled large parts of the economy, severely affected consumer spending and reduced factory output. These new lockdowns in major cities such as Xi'an, Shenzhen and Shanghai have had a huge impact on factories, leading to problems on production and supply chains. Factories supplying the global electronics market such as Apple, Samsung or Huawei have been heavily hit by these closures. At the same time, the lockdown of Shanghai's 25 million citizens who were forbidden to go out - except for a few essential professions - led to a drop in overall demand. At the same time, Russia's invasion of Ukraine is driving up global prices for food, energy and other commodities imported by China. Despite these disruptions, China's GDP for Q1 grew 4.8%.

Source: National Bureau of Statistics of China, Nikkei, Nikkei Quick News

At the same time, the zero-covid policy is having an immense impact on the health and productivity of Chinese workers, who are increasingly looking to move abroad. There is a demographic decline and a continued brain drain (technology sectors) to the US. Despite the higher tariffs imposed during Trump's U.S.-China trade war, Americans continue to consume goods from China at a record pace. Meanwhile, inflation is skyrocketing in the U.S., but China remains essential to the supply chains of U.S. companies. The slowdown in Chinese manufacturing due to Shanghai's pandemic policy will put even more upward pressure on U.S. prices, hitting U.S. consumers and businesses. Meanwhile, the U.S. economy contracted in the first quarter of 2022, and economists are increasingly predicting a U.S. recession within a year or two, even without the added blow of a Chinese implosion.

Although seaports have remained open and road traffic is still available, truck traffic in China dropped by 40% around Shanghai and their movements are only 15% of their usual level.

The congestion of major ports is still going on, although they remain operational, thanks to the implementation of safety bubble; workers have no contact with the general public.

Source: The Economist

A downward trend has been observed for nearly 6 months, and has accelerated for the last 3 months due to lockdowns in China and the war in Ukraine. Some sectors are in the red – such as the luxury, tech and auto sectors - driven by a drop in production, a rise in labor costs and the flight of investors to less volatile stocks. But since Mid-May, when authorities started to lift Covid restrictions, they also implemented financial support. This included tax reductions on car purchases and the speed-up of approval procedures for real estate projects for a total of 100 billion yuan. Investors welcome these changes, leading to a general rise in indexes.

Supply chains will gradually return to "pre-covid" production levels in the most affected sectors and will strengthen in other sectors. We can assume that the luxury sector will be the first to return to the green as shown by LVMH (+ 1.30% last month) and Kering (+ 6.55%). However, the Covid-19 pandemic and the numerous lockdowns have caused shortages that will take time before returning to normal. In this context, the shortage of semiconductors and many components related to the production of technology products will slow supply chain improvements, but we can highlight the upward trend of some car manufacturers such as Volkswagen (+ 5.07%).

Finally, investors should take a look at other sectors such as real estate, energy and healthcare. Despite a debt bubble in the real estate sector that led to spectacular collapses, including the failure of large property developer Evergrande (down 87.86% since last year), China remains very attractive.  And with an increasingly rapid demographic development and support to citizens, this sector should return to the green in the coming months or years. In addition, the energy sector is currently one of the most promising sectors. With the post-lockdown reopening of cryptocurrency mining factories, and the return of oil deals after the European embargo on Russian crude, China is set to expand its dominance.

Another sector to take into consideration is pharma. While the biggest players in the industry are not Chinese, public investments are multiplying after the Covid crisis. China aims to simplify the approval procedures for new drugs and thus become the world's leading laboratory.

Written by Grégoire Legrand