Introduction

Our long-term issuer credit ratings do not have a pre-determined time horizon. However, our rating outcomes typically allocate a higher weight to our expectations over the next several years (including specific financial forecasts for the next two to three years), within which there tends to be a larger amount of certain and actionable information. As projections extend beyond the medium term, judgements about the ability to identify relevant credit drivers, how they will shift, and ultimately their effects on credit quality becomes more challenging.

Nevertheless, we believe it is important to monitor long-dated risks because, while megatrends may be slow moving, they can transform industries, and business processes in fundamental ways.

In this article, we dive into the megatrend of supply chain disruption. (For details on all megatrends we are monitoring, see "Evolving Risks In North American Corporate Ratings: An Overview", published Oct. 29, 2024.)

The objective is to contrast and highlight the different ways that various sectors might be affected by supply chain risk. We elaborate on how we provided an overall view of how the megatrends may influence credit quality on a continuum of positive, neutral, some risk, and more risk below (chart 1).

These risk assessments are largely qualitative and are intended to facilitate cross-sector comparisons within a given risk category. Comparisons across risk categories within the same sector are directional, may differ based on our current forward-looking view of credit transmission channels in North America, and are not meant to capture the absolute level of future ratings risk.

Chart 1

Positive

In this category, we expect credit quality will benefit long term, as disruption and higher costs in some industries deliver above-trend revenue growth and stronger earnings for other sectors with stronger competitive positions.

Neutral

Here we view credit quality as generally insulated against supply chain risks, owing to the simplicity of sourcing, breadth of inputs and substitutes, or range of channels to market.

Some risk

We expect supply chain risks could periodically cause earnings pressure, but these are unlikely to affect many credit ratings because of generally adequate price response for noncontrollable factors. Additionally, we expect supply chain risks will have little impact on the competitive positions of sectors in this category.

More risk

We would expect supply chain risks to have a negative impact on credit ratings by weakening profits and increasing debt levels; or we expect these risks would alter the competitive balance among direct competitors, suppliers, and customers.

In the following sections, we provide background on and our expectations for specific sectors.   We explore every sector that we assessed as positive, some risk, or more risk. In the case of sectors that we assessed as neutral, we may also provide details if we believe there are relevant developments and risks, even if the overall credit impact remains unclear.

Supply Chain Disruption

Why it matters

A supply chain involves processes that connect raw materials, components, and goods and services before their final sale to end consumers. The chain will typically involve logistics operations, IT systems, procurement, distribution, and management functions.

Disruptions to the supply chain can increase business costs and prices for consumers and lengthen the cash flow cycle for corporate entities.

Transmission channels

Shortages of key inputs, transportation bottlenecks, or heavy supplier concentration can increase costs without enough visibility to price in changes. Inputs sometimes hit periods of shortage and price spikes, and capacity solutions emerge from investments in other industries like commodities, technology, or transportation.

Tariffs, non-tariff barriers, sanctions, and conflicts can also restrict access to inputs and increase costs in uneven ways for unpredictable timeframes. The effects of geopolitical risk can range from the imposition of tariffs that shift the economics of established supply chains to sanctions and military action that deny access to supply-chain elements. Such tensions can also come with other supply-chain risks such as asset seizures and sabotage, including through state-backed cyberattacks (see "Cyber Threat Brief: How Worried Should We Be About Cyber Attacks On Ukraine?", Feb. 22, 2022).

Labor availability appears to be constraining output in some sectors, as skilled and experienced workers retire faster than the next generations can replace their productivity.

Potential credit impact

Supply chain disruptions can affect credit quality through missed revenue, higher costs for substitutes and logistics, lower cash flow from a longer cash cycle, more debt to fund working capital, and reduced operating and financial visibility.

At the same time, disruption and higher costs in some industries can deliver above-trend revenue growth and stronger earnings for other companies. These situations test the competitive balance between buyers and suppliers and can affect key rating factors like market position and efficiency.

Aerospace And Defense (some risk)

Background:  The credit profile of the broader aerospace and defense sector has been adversely impacted by ongoing supply-chain constraints that, in our view, are not easily remedied. Certain larger issuers are dependent on thousands of direct and indirect suppliers in their production processes. Disruptions to the flow of parts and services have been significant since the pandemic, with limited evidence of meaningful improvement over the near term.

Program delays and procurement restrictions have led to lower-than-expected revenues and increased costs for both commercial aerospace and defense companies. Those with fixed price contracts face the greatest challenges in this higher-cost environment that has pressured margins.

Our expectations:  Issuers remain focused on minimizing the impact of industry-wide supply-chain challenges, which we expect will gradually ease. These constraints are attributable to a variety of factors that include skilled labor shortages, as well as geopolitical events that are outside of a company's control.

Issuers dependent on sourcing contractually compliant parts have limited flexibility, especially those required to perform remediation work on previously installed and faulty components. At the same time, capacity shortfalls have tightened end-product supply amid generally strong prevailing demand that has benefited pricing.

In our view, enhanced oversight of supplier networks due in part to enhanced quality control and investments in technology will assist in mitigating the impact of future disruptions.

Agribusiness (some risk)

Background:  Successful logistics management and supply chain optimization are critical for agribusinesses to achieve their targeted profit margins. To succeed, companies require timely delivery of commodities that have been strategically sourced from regions where commodity costs are lowest, and logistics economies can be maximized.

Our expectations:  Supply chain disruption can have an immediate and material impact on margins, which are inherently thin for much of the industry. We believe comprehensive enterprise-wide risk management to regularly identify and mitigate emerging risks is a core competency required for companies to be successful.

Risks that could emerge include unforeseen trade restrictions, unanticipated changes in transportation rates (which may or may not be fully hedged), and counterparty defaults on deliveries, among others.

Autos (some risk)

Background:   The semiconductor shortages during the pandemic that severely affected production schedules and raised manufacturing costs through inefficiencies is a recent example of how the complexity and interconnectivity of global automotive supply chains can impact issuers. Depending on the severity of the disruption, supply chain risks can affect auto issuers' business risk profile, financial risk profile, and liquidity.

Our expectations:  Going forward, issuers will need to invest heavily in localized supply chains to secure sustainable electric vehicle (EV) growth globally. The geopolitical frenzy to establish control over both raw materials and refining capacity is systematically challenging the market's development and dynamics, particularly for nickel, graphite, lithium, and cobalt. Southeast Asian countries have advantages including rich mineral resources and low labor costs. Moreover, some of these countries don't want to export their raw resources, but rather develop the entire value chain from raw material extraction and refining to the production of EV batteries and EVs locally.

Countries like China that have more integrated supply chains offer producers cost advantages but also expose these players to higher trade restrictions for their export ambitions. We expect this will fuel further investments to establish local supply chains in markets like North America to avoid tariff related disruption and potentially avail production tax credits. This will lead to lower cash flows for these companies until they achieve economies of scale. As a result, automakers will look to share the burden and pursue partnerships that feature phased investments, as evidenced by the joint venture between General Motors Co. And Lithium Americas.

Capital Goods (some risk)

Background:  U.S. capital goods companies are intensely exposed to changes in supply chains because they manufacture a breadth of intermediate and finished goods from materials and components sourced around the world. At the same time, good pricing power enabled many manufacturers to improve profits when finished goods availability tightened in 2022. Capital goods industry supply chains often include several tiers, meaning that suppliers of their component inputs often have their own suppliers of component inputs, which in turn rely on other manufacturers throughout the supply chain.

The Red Sea conflict and the Panama Canal drought are just two examples of frictions that coincide to disrupt supply chains and extend the corporate cash flow cycle. We believe the strike at eastern U.S. ports would have crimped manufacturing profits within weeks. Furthermore, many companies have added new suppliers in new countries since 2019 when trade tensions flared between the U.S. and China. Each tier or border can add complexity and risk, including lower ability to control and to gain visibility on bottlenecks.

Our expectations:  Larger investments in working capital to protect against supply chain disruptions appear entrenched over the long term. In addition, manufacturers are investing to diversify and strengthen their sources of key inputs, partly because a return to reliable just-in-time inputs from global suppliers appears unlikely in the near term. The onshoring of manufacturing capacity to the U.S. to mitigate potential supply chain disruptions will need access to labor, which has been tight. At the same time, numerous companies indicate that Mexico has ample labor, and Canada has record levels of population growth and immigration.

Capital goods supply chains generally improved in 2024. However, we expect inventories will remain higher for longer as companies keep larger stock levels for safety, in part because the cost of most inputs is 10%-20% higher than in 2019; this causes more inventory dollars at any given level of business activity.

We estimate the industry's inventory-to-sales remains high, running at more than 120% of pre-pandemic levels. Most companies are seeking to reduce inventory, but a range of factors like transportation, tariffs, new suppliers, and even product tweaks could complicate these efforts.

Consumer Products (more risk)

Background:  Consumer products companies import intermediate and finished goods, and have long, complex supply chains. In addition, lean operations and just-in-time inventory management expose the sector to supply chain disruptions. The pandemic revealed the extent of this vulnerability.

Government-mandated plant closures and limited labor availability wreaked havoc on companies' ability to source and deliver products to retailers. Limited supply and strong consumer demand caused input and labor prices to rise. Because price negotiations with retailers typically occur once or twice per year, wholesalers had to absorb the brunt of higher prices until they could gradually be passed on to retailers.

Margin pressure from inflationary costs led to S&P Global Ratings taking many negative rating actions. For instance, nearly every negative rating action for consumer goods companies in September and October of 2022 was partly due to inflation.

Lessons learned from those dramatic disruptions led companies to diversify materials, manufacturing partners, transportation modes, and ports of entry.

Our expectations:  While we believe supply chains have become more agile, risks to the smooth production and movement of goods remain. There are geopolitical risks to the supply chain; reduced traffic through the Suez Canal to avoid rebel attacks on ships in the Red Sea is a recent example that caused increased shipping costs and longer delivery lead times for certain goods. Risks can also come in the form of tariffs.

Additionally, climate change and other unexpected shocks can affect the supply chain. For instance, droughts can affect food commodity inputs and water level in the important supply chain throughway, the Panama Canal.

Health care (some risk)

Background:  The pandemic highlighted the vulnerability of the medical product and pharmaceutical supply chains, given the shortages of personal protective equipment and critical active pharmaceutical ingredients (APIs). Many medical supplies and APIs are manufactured in China and India, and countries reserving critical supplies for their home markets in times of crisis can result in worldwide shortages.

Furthermore, rising geopolitical risk, with increased protectionism, could lead to retaliation from countries that manufacture critical supplies. For example, Chinese manufacturers account for a significant portion of medical glove and face mask production. The Biden Administration is proposing raising U.S. tariffs on Chinese imports of syringes to 50% from 0%; face masks to 25% from 0%-7.5%; and medical gloves to 25% from 7.5% to encourage increased domestic production. This could result in retaliation, such as China restricting the exports of select APIs, especially in categories where China holds increasingly important positions.

The Biden Administration in 2021 listed pharmaceuticals as a critical supply chain, putting it on the same level as semiconductors, batteries, and rare earths. China currently does not have a major hold on the pharmaceutical supply chain; it accounts for only roughly 6% of imported pharmaceuticals and 17% of imported APIs. However, China's percentage of the U.S. market is increasing, and in some therapeutic areas, such as antibiotics and fever reducers, it already has a major presence. While these APIs are more for lower dollar value generic drugs, generics account for over 90% of prescriptions the U.S.

Our expectations:  We note that shortages of critical supplies could result in reduced procedure capacity at health care service providers, such as surgeries being delayed or canceled, limiting revenues. Higher costs, due to tariffs or having to purchase from higher cost suppliers, would also exacerbate inflationary pressures at health care service providers. This could pressure credit metrics at these companies.

Shortages of pharmaceuticals, especially on widely used generics, also create patient safety issues.

Metals and Mining (positive)

Background:  Commodity metals have been one source of supply chain strains and higher manufacturing costs in recent years. A decade of lower capital spending has tightened several metals markets, and U.S. trade barriers have created a moat around North America for steel and aluminum.

Our expectations:  The profitability of most metals and mining companies around the world has been stronger with these disruptions, delivering mostly higher prices at steady volumes and operating rates. Manufacturers have been accustomed to easy access to metals, but lead times and prices jumped after the COVID-19 pandemic and never really recovered given other supply disruptions like the Russia-Ukraine conflict. U.S. trade barriers have held longer than any the past few decades, and customers have generally passed through higher steel costs amid a cyclical profit upswing for manufacturers. Therefore, we believe the overall metals and mining sector could benefit from elevated prices if tight metal availability disrupts supply chains.

Oil and Gas (positive)

Background:  Historically, geopolitical tensions have led to higher hydrocarbon prices. Sometimes these higher prices are short term, based on speculation, but in some cases, prices remain higher in the long term due to a structural shift in policy or supply.

Oil and gas prices typically respond to actual and expected shifts in supply and demand, and any disruption to these variables results in volatile price swings. A recent example is the severe spike in global oil prices and European gas prices in 2022 when Russia reduced supply.

Our expectations:  If countries involved in geopolitical conflict are key producers, the risks to hydrocarbon supply could generate significant upward pressure on prices. Indeed, more than half of the global oil supply comes from emerging markets, including Russia and Venezuela; or it is exposed to numerous risks during sometimes lengthy transportation, such as passage through the Strait of Hormuz adjacent to Iran.

Consequently, disruptions and delays can constrain flows and buyers can respond by paying more to secure adequate and timely deliveries. Market participants can react to actual challenges or the perception of increased supply issues with an implied risk premium and higher prices. This translates into higher revenues per barrel and higher cash flows for oil and gas companies (subject to their contractual and fiscal terms). Therefore, we view supply chain risk as a positive for oil and gas companies.

Retail and Restaurants (more risk)

Background:  Retailers and restaurants are exposed to supply chain risk because many of their products are imported and arrive at a store or distribution center via long and complex supply chains. Lean operations and just-in-time inventory management exacerbate the sector's exposure to supply-chain disruptions.

The pandemic revealed supply chain vulnerabilities. As noted in the consumer products sector, government-mandated plant closures and limited labor availability wreaked havoc on wholesalers' ability to source and deliver products to retailers. Stock-outs led to lost sales. Limited supply and strong consumer demand caused input and labor prices to rise. Retailers were able to raise prices because consumers were aware of scarcity and had excess cash to spend, an offsetting condition that may not repeat in future supply chain disruptions.

Our expectations:  While we believe supply chains have become more agile, risks to the smooth production and movement of goods remain. The recent dockworkers strike at various ports on the East and Gulf Coasts essentially shut down about half of retailers' imports of apparel, footwear, and toys. If the strike had dragged on to two weeks or more, it could have had a major impact on retailers' ability to stock shelves.

Risks can also come in the form of tariffs. The 2018 tariffs on Chinese imports had a meaningful impact on costs for craft retailers. Additionally, climate change and other unexpected shocks can affect the supply chain.

Technology (more risk)

Background:  For decades, companies have heavily relied on the Asia-Pacific region--particularly China--for the manufacturing of semiconductors and assembly of tech products. The region has been a global hub for the tech supply chain to optimize operational efficiencies given the availability of skilled and relatively low-cost labor.

However, increasingly protectionist trade policies are becoming more popular and are causing strain on trade relationships. The deteriorating trade relationship between the U.S. and China in recent years highlights the need for countries to strengthen their domestic manufacturing supply chain and reduce the overreliance on a particular region or business partners within their supply chain, in our view.

The U.S. CHIPS Act passed in August 2022 was a big part of the U.S.' initiative to strengthen its semiconductor manufacturing capacity, which declined to about 12% today from about 37% in the 1990s. Europe, Japan, South Korea, and the U.K. are engaging in similar efforts to support their semiconductor industries.

Our expectations:  Technology supply-chain independence for the U.S. could be decades away. It takes time to reestablish a manufacturing base, accumulate talent and capabilities, and create products at competitive pricing. We believe customers will need to revamp their supply chains to accommodate U.S.-made tech products. Additionally, customers will need to be willing to absorb some, if not all, of the higher costs and take on additional supply chain complexity to improve geographic supplier diversification.

For the semiconductor industry specifically, the U.S. CHIPS Act funding, at $52.8 billion, while significant, will only be sufficient to seed the market for these changes. Although national security concerns are top of mind, it is unclear if further financial incentives will be provided by the U.S. government to help the U.S. tech sector reduce reliance on foreign manufacturing.

However, with the increasing scope and frequency of trade restrictions and threat of retaliatory policies between countries, we expect tech firms will continue to balance their financial targets while managing a more complex regulatory and compliance environment in the U.S. amid the increasing risk of significant supply chain disruptions.

Over the longer term, a more bifurcated global supply chain that prioritizes domestic manufacturing and self-sufficiency could result in increased redundancies and structural cost inflation. Furthermore, trade restrictions, such as those imposed by the U.S. that ban the export of advanced semiconductor chips to China, could hamper market access to the largest global economies.

Transportation Cyclical (some risk)

Background:  The transportation sector faced supply-chain disruptions over the past few years, but not to an extent that has affected credit ratings. For airlines, the impact was mostly indirect and related to new aircraft delivery delays (by The Boeing Co. and, to a lesser extent, Airbus SA) that limited capacity expansion and efficiency gains. The corresponding increase in older aircraft utilization, limitations on parts, and skilled labor shortages also contributed to higher costs.

Rail and truck transportation is critical to the movement of goods and faced high levels of congestion following the outset of the pandemic. For rails, shifts in traffic flow led to network difficulties, reduced velocity, and contributed to lower margins.

Our expectations:  In the case of airlines, we believe that over the next few years, supply constraints directly facing the original equipment manufacturers (OEMs) will be addressed; this will ease some of the issues facing airlines.

Service levels of rails, which lagged that of trucks since the pandemic, have improved. However, we believe increasingly complex supply chains (which includes information technology systems and large share of intermodal transportation) pose a potential future risk to the continuing high levels of railroad profitability over the next several years.

Related Research

• Evolving Risks In North American Corporate Ratings: An Overview, Oct. 29, 2024
• Evolving Risks In North American Corporate Ratings: Artificial Intelligence, Cyberattacks, And Blockchain, Oct. 29, 2024
• Evolving Risks In North American Corporate Ratings: Climate Change, Oct. 29, 2024
• Evolving Risks For Credit Quality In U.S. Capital Goods, June 18, 2024
• White Paper: Assessing How Megatrends May Influence Credit Ratings, April 18, 2024
• Supply-Chain Risks: A Credit Perspective, Oct. 17, 2023

Appendix

Table 1