The idea to write this post started a few weeks ago in response to several member questions about how the coronavirus – then largely confined to China – would affect supply chains for AC parts and equipment. Unfortunately, this post has since become an exercise in understanding how the global economy responds to a pandemic. The early returns have not been encouraging.
To begin, let’s take stock of the U.S. market for unitary air conditioners. Over the last five years, domestic shipments of A/C equipment have averaged 4.8 million units per year, equaling roughly $8.7 billion in annual sales. During that time period the U.S. imported an average of $1.8 billion per year in unitary A/C equipment, and an average of $282 million per year in parts and intermediate goods for A/C equipment. Since 2014, the 10 largest exporters of A/C equipment and parts to the U.S. by total shipment value have been:
Although there is near unanimous agreement among economists that tariffs hurt the countries they’re enacted to support, the U.S. – China trade war could have inadvertently protected the U.S. market from the COVID-19 outbreak had OEM supply lines shifted from China to avoid tariff penalties. Unfortunately, the evidence suggests that tariffs have had a relatively minor impact on U.S. demand for Chinese-produced unitary equipment and parts, leaving the U.S. market exposed to product shortages caused by widespread factory closures in China. China’s factory closures will affect the supply of A/C equipment. The only question now is, to what extent?
China’s Purchasing Managers’ Index (PMI) – a key indicator for the health of China’s manufacturing sector – dropped to its lowest level in 10 years when it fell from 50 to 35.7 in February (a figure above 50 indicates expansion, and below 50 indicates contraction). The fall in PMI is significant, and U.S. manufacturers have reported receiving force majeure notices from their Chinese suppliers. Nevertheless, U.S. demand for A/C parts and equipment from China typically reaches its highest point during the second quarter, as U.S. suppliers familiar with the Chinese calendar plan their orders around the annual Chinese New Year and its resultant factory closures. Recent commentary from J.P. Morgan analysts at their 2020 Industrials Conference seem to underscore this point, with few HVACR manufacturers reporting any major disruptions or shortages as a result of China’s economic shutdown. With few exceptions, those suppliers are broadly indicating that many of their Chinese factories have reopened and are expected to reach full capacity by the end of March. Those comments largely square with national reports that China’s manufacturing plants have begun to reopen, and that between 65 and 75 percent of all business activities have resumed.
The heatmap above indicates which quarters over the last 5-years have seen greatest export values for A/C parts and equipment, by country. Red indicates the quarter with the lowest value of exports, and green indicates the quarter with the highest value of exports.
An optimist may be inclined to believe that if the overall pace of manufacturing output normalizes, any shortages caused by factory shutdowns in China will be constrained to the order backlogs from January and February. However, China has a dubious track-record of reporting false or misleading economic statistics, and there is already evidence of Chinese factories operating machinery without workers to meet government-imposed power consumption quotas. Given the depth of China’s manufacturing slowdown, a more likely scenario is that factory resumption rates grow at a much slower pace than is currently being reported, with output remaining well below normal levels through the second quarter. Further, given the now worldwide prevalence of COVID-19, there is reason to believe that as normal business and tourist operations resume that China’s rate of infections will spike, and the country will once again be forced to close key manufacturing plants to contain the outbreak.
The story is similarly bleak outside of China, given the virus’ rapid growth in countries the U.S. relies on for A/C parts and equipment. Of the top 15 exporting nations for A/C parts and equipment, 5 have more than 2,000 known cases of COVID-19 (Germany: 4,838; France: 5,423; South Korea: 8,236; Italy: 24,747; China: 80,860). Italy and South Korea are both leading producers of ductless split systems, and South Korean giants LG and Samsung are particularly exposed given their reliance on production facilities in both South Korea and China. Likewise, Italy’s most productive regions – Lombardy and Veneto – have been the most seriously affected by the COVID-19 outbreak, and those northern Italian regions are an important source of highly-engineered parts for HVAC systems.
The map’s shaded regions indicate the largest exporters of A/C parts and equipment to the U.S. The red circles indicate countries with greater than 1,000 COVID-19 infections.
Outside of its effects on international supply chains, the quick expansion of COVID-19 is causing markets to panic - the S&P 500 is down nearly 27 percent since February 19th - and credit conditions have tightened at their fastest pace since the financial crisis. The U.S. has now entered a bear market for the first time since 2009, and the Federal Reserve has cut interest rates and launched a new round of quantitative easing to calm investor fears and stabilize an increasingly shaken economy. Economists at Bloomberg now assess the risk of a recession over the next 12 months at 53 percent, and both Congress and the administration are considering plans for an economic relief package.
What Distributors Should Be Watching
Given the current state of the global economy, as well as the general uncertainty regarding the growth and duration of COVID-19, how should distributors respond? HARDI anticipates consumer demand shocks to the industries most exposed to social distancing practices – travel, tourism, and non-essential retail. While the construction and manufacturing sectors are likely to be more resilient to changes in consumer sentiment, the continued growth of infections in the U.S. could have a serious effect on the availability of healthy workers – an obvious drain on any industry. Likewise, the possibility of slower than projected recovery in China or a second major outbreak could cause product shortages when contractor demand for A/C parts and equipment are traditionally at their highest levels. Rather than tracking Chinese demand for raw materials or regional energy consumption – indicators that are much more easily to manipulate – distributors should begin tracking the volume of shipping containers arriving at U.S. ports from China as a way of assessing the extent of China’s economic normalization. Additional metrics distributors should watch in the weeks ahead include:
- The National Association of Home Builders/Wells Fargo Housing Market Index – The HMI is a monthly index that tracks the state of the single-family housing market. The March report will offer insight into how the single-family market is responding to economic headwinds.
- University of Michigan Consumer Sentiment Index – Like the HMI, the Michigan CSI is a survey-based economic index. However, unlike the HMI (which only describes the state of the housing market), the MCSI reflects the consumer opinions on the state of the overall economy. If the outbreak of COVID-19 is having an impact on consumer buying patterns, the shift in buying patterns will likely be seen first in the MCSI.
- USG Corporation + U.S. Chamber of Commerce Commercial Construction Index – Unlike the monthly HMI and MCSI, the CCI is a quarterly index. If the COVID-19 outbreak is affecting commercial construction, the effects will be visible in the 2020 Q1 report (likely to be released in April).
- Institute for Supply Management Purchasing Managers’ Index – The PMI is a monthly index that measures the health of the U.S. manufacturing sector. Any decline in manufacturing output as a result of the COVID-19 outbreak will be captured in the forthcoming March report.
A Look Ahead
Possible product shortages, higher costs, a construction slowdown, and the growing prospects of a U.S. recession suggest that demand for HVACR materials will be concentrated on the repair-side of things, rather than on new construction or replacement demand. However, distributors should be mindful that even in the leanest years of the Great Recession, replacement demand only dipped to 5 percent of the total installed base. Total replacement demand for A/C equipment, whether in good times or bad, generally remains between 5 and 7 percent of the total installed base, and there is little reason to believe that this time will be different. Thus, the threat of dwindling supply remains the greatest current threat to wholesale distribution, and distributors should take steps to ensure that they have enough inventory to guard against product shortages.
HARDI will continue to monitor the advance of COVID-19, and the Market Intelligence team will be commenting in greater detail on its possible threat to wholesale distribution on both the HARDI blog and in upcoming editions of HARDInomics. If you have any questions or concerns related to this post or the effects of COVID-19 on the HVACR industry, contact Tim Fisher.
Please see our COVID-19 resources page on our website for more assistance on this issue.
Team Leader, Market Intelligence