'Phantom orders', the global chip shortage and the next big recession

An acute global shortage of semiconductor chips has threatened supply chains across multiple industries. The National

Of the countless problems the Covid-19 pandemic has thrown at companies, a global shortage of microchips is one of the most pernicious. Eventually, the supply of chips will recover, but will affected markets then return to normality?

The likely answer is no. In dealing with the scarcity of chips and associated impact on production schedules, markets have helped to seed another crisis in the form of a global economic recession.

The scarcity of chips has hit a wide cross-section of industries, causing backlogs of orders for products including vehicles, consumer electronics and household appliances. Automakers have been severely impacted. According to one estimate by the US-based consulting firm AlixPartners, the global chip shortage cost the auto industry $210 billion in 2021.

The roots of the crisis stretch back to the early days of the pandemic. In the first part of 2020, the arrival of Covid-19 put a brake on economies worldwide. Demand for products and services fell precipitously as consumers stayed at home and governments imposed various restrictions on travel and in-person meetings. The GDP of the world’s largest economy – the US – fell almost 33 per cent in the second quarter of 2020.

As the crisis gained momentum, governments around the globe reacted by injecting huge amounts of money into their economies in various forms such as unemployment benefits, eviction moratoriums and cash grants. Central banks supported these policies in a number of ways, such as keeping a lid on interest rates.

In combination, the above developments laid the groundwork for a jolting increase in demand that was at the heart of the subsequent chip shortage. Governments’ largesse encouraged consumers to start buying again, and demand for products such as home appliances and cars, which are reliant on supplies of microchips, soared. Congestion and reduced capacity of transportation and warehousing afflicted the entire world economy. As consumer spending accelerated, companies struggled to keep up with the sudden turnaround in demand. The abrupt mismatch between supply and demand – and big increases in the cost of transportation and warehousing – dislocated the world’s supply chains, exacerbating product shortages in multiple markets.

Product shortages continue to plague markets today, and it will take some time before the supporting supply chains stabilise. Moreover, the behaviours that underpin the chip shortages are symptomatic of broader market dynamics that are creating conditions conducive to a significant recession.

A key driving force is a well-known supply chain phenomenon called the bullwhip effect. As today’s product manufacturers struggle to keep up with demand as well as unrelenting supply uncertainties, they often over-order, assuming that only a fraction of their orders will actually be fulfilled. They also assume that current demand will continue and grow. The next link in the supply chain, perhaps a parts distributor, receives the inflated order, inflates it further, and passes it to a tier-one supplier. The tier-one supplier does the same, as do all the other suppliers. By the time the order reaches small, sub-tier suppliers deep in the supply chain, it has become grossly proportioned. Orders that are far in excess of what buyers need are sometimes referred to as phantom orders.

No one knows when the shift in demand will occur, or how acute it will be

This scenario is playing out in the semiconductor industry, where over-ordering is widespread. Moreover, there are stories of manufacturers threatening to sue suppliers that do not fulfil their orders. But the same dynamics are at work in most industries, raising the possibility of a broad economic recession.

When demand eases off – as it will at some point in the future – companies will be left with inventories of products they can’t sell and parts they can’t use. The situation will deteriorate further as companies stop ordering. This is especially onerous for smaller suppliers at the end of the supply chain that lack the financial strength to ride out a steep fall off in demand and the cost burden of unsold inventory. In these circumstances, many enterprises will fail, thereby deepening the recession, as happened in the 2007-2008 global financial meltdown.

No one knows when the shift in demand will occur, or how acute it will be. But there are signs that recessionary forces are gaining steam. For example, central banks are expected to start raising interest rates soon in an attempt to curb inflation, actions that could help tip economies into a downturn.

There is also plenty of historical precedent that points the way to bullwhip-related market changes. An example is the 2008 global financial crisis. The bullwhip played out across a broad swathe of industry during that period, and the subsequent downturn caused manufacturers to cut inventories by 15 per cent as their sales declined by some 30 per cent.

As companies today grapple with shortages of parts and components, they should be aware of how the underlying causes of these shortages aided by the bullwhip effect could cause markets to pivot, and prepare for the worst.