Bullwhip effect: Should investors be worried?
Big Short investor Michael Burry warned of a “bullwhip effect” that could drastically affect supply chains. But what is the bullwhip effect, and what are its implications for investors?
Bullwhip effect explained
In a since-deleted tweet, Burry said: "This supply glut at retail is the Bullwhip Effect. Google it. Worth understanding for your investing endeavours. Deflationary pulses from this- -> disinflation in CPI later this year --> Fed reverses itself on rates and QT --> Cycles."
Burry’s predictions, particularly that the US Federal Reserve (Fed) will reverse course on an ambitious schedule of tightening monetary policy, are typical of the bold investor. Iif they come to fruition, they could have huge ramifications.
According to the Chartered Institute of Procurement & Supply’s (CIPS) bullwhip effect definition, the term refers to when small changes in demand dramatically affect the supply chain.
Most commonly, this comes from retailers responding to a surge in customer demand by increasing orders, encouraging manufacturers to raise their own production patterns.
Bullwhip effect example
A bullwhip effect example given by the CIPS is of a retailer that usually sells 10 ice creams a day. During a heatwave, demand rises to 30 ice creams a day.
The retailer may decide to increase their demand for units upstream in the supply chain to 40 a day, thereby increasing demand for ingredients used to manufacture ice cream. Each actor in the supply chain increases their forecasts based on minor fluctuations in demand.
When that demand cools, or responses from retailers prove to be otherwise overzealous, it causes a backlog of inventory, forcing a deflationary trend.
It means more spending goes into storage as actors across the supply chain struggle, while retailers are forced to offer steep discounts to offload their excess inventories.
Each of these cut into margins, profitability, and accordingly share prices for publicly traded companies. If as Burry suggests it forces a monetary policy rethink, the effect would extend wider.
If the bullwhip effect were to have a material impact on inflation, it could wreak havoc for investors that have steeled themselves for a prolonged period of high prices and stagflation through the purchase of safe-haven assets.
Are we observing the bullwhip effect now?
There are several causes of the bullwhip effect, and they all may need to occur together to be instigated and offset the multi-decade high inflation rate. Supply has largely struggled to keep up with resurgent demand. Inflation in the US hit 8.6% in May, with price rises being felt across most goods and services.
There are worries that stagflation is imminent as policymakers struggle to pull down prices in the face of large exogenous shocks. The latest efforts have included the Fed raising interest rate by 0.75 percentage points in May – the biggest hike since 1994.
In that vein, there are several early warning signs that the bullwhip effect may be taking hold. A number of retailers have warned of excess inventories, including Walmart (WMT), Target (TGT) and Amazon (AMZN), and they may prove hard to shift while prices are elevated.
According to The Real Economy Blog, there are signs that inventories, including in furniture and apparel, appear too high. Data compiled by Bloomberg in May showed major companies had seen inventory values swell by $44bn.
Overall, these pressures have led retail inventories in the US to rise at their fastest rate on records going back to the 90s.
Some have also been faced with other short-term inflationary pressures, including Walmart (WMT) and Amazon (AMZN) hiring too many workers in anticipation of a wave of the Omicron variant which never came to fruition. These may also have elevated perceptions of the extent of retail price rises.
The current trend of commodity prices may also suggest a comedown in the markets. Prices are easing for previously soaring items like oil, wheat and copper. This may be pointing to a downturn in consumer sentiment that is dwindling and demand is beginning to fall.
According to research by Project 44, there was growing evidence in May that a bullwhip effect in the supply chain could be unavoidable, particularly with China’s economy revving back up.
Factors preventing the bullwhip effect
But there are other, perhaps weaker, counteracting pressures that may keep prices artificially elevated, regardless of the inventory-related effect or demand downturns.
In a research note shared with Bloomberg, JPMorgan analysts said a worst-case scenario of Russia engaging in retaliatory crude output cuts in response to US and European penalties could lead to a “stratospheric” jump in oil prices to $380 a barrel.
And while the Western world may have largely left the threat of Covid-19 in the rearview mirror, China’s pressures are still relatively fresh, recently coming out of a brutal lockdown that stymied production and demand, and caused a big contraction to industry, according to PMI data from Caixin global.
With lockdowns lifted, China is expected to reignite its demand for oil, putting further pressure on supplies, and possibly pushing up prices again.
Note that analyst predictions can be wrong. Forecasts shouldn’t be used as a substitute for your own research. Always conduct your own due diligence before trading. And never invest or trade money you cannot afford to lose.
How does the bullwhip effect affect company stocks?
First and foremost, the bullwhip effect would be expected to have its largest impact on major retail stocks like Amazon (AMZN), Costco (COST), Target (TGT) and Walmart (WMT). Those stocks have already seen big corrections this year, falling by 32%, 11%, 36% and 13% respectively.
Major drops have occurred around earnings season. The bullwhip effect initiate a further sell-off.
But if the effects are as Burry predicts, there could be implications for several other stocks. Renewed monetary stimulus and falling interest rates in the face of a recession and disinflation could be expected to improve risk appetite, particularly in a heavily deflated stock market that has shed a lot of its value this year.
FAQs
How does the bullwhip effect occur?
The bullwhip effect occurs when minor, unsustained changes in demand have long-term effects on supply chains, leading to deflationary pressures.
What is the easiest way to avoid the bullwhip effect?
According to the Chartered Institute of Procurement & Supply (CIPS), the best way to avoid the bullwhip effect is for suppliers to reduce lead times, limit price fluctuations where possible, and other operational changes to improve forecasting.
Who coined the term ‘bullwhip effect’?
According to The European Journal of Operational Research, the term bullwhip effect was first coined by Procter & Gamble (PG) in the 1990s to refer to the order variance amplification phenomenon observed between P&G and its suppliers.
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