State Of The World

“Inflation is the number one worry in the economy, but the picture about price pressure will be cloudy for most of the year… There are anecdotal reports about supply chain bottle necks and certain prices are rising fast.” St. Louis Federal Reserve President, James Bullard.

“We argued some time ago that globalisation had peaked, but that the jury was still out on what form a subsequent period of deglobalisation might take. Two years and one pandemic later, and it is starting to become clear what to expect. The technological drivers of globalisation have faded. Complex supply chains have reached their limit. At the same time, advanced manufacturing techniques mean that the location of manufacturing no longer hinges on where labour costs are cheapest.” Neil Shearing, Group Chief Economist, Capital Economics.

 

 

State Of The World

“Inflation is the number one worry in the economy, but the picture about price pressure will be cloudy for most of the year… There are anecdotal reports about supply chain bottle necks and certain prices are rising fast.” St. Louis Federal Reserve President, James Bullard.

“We argued some time ago that globalisation had peaked, but that the jury was still out on what form a subsequent period of deglobalisation might take. Two years and one pandemic later, and it is starting to become clear what to expect. The technological drivers of globalisation have faded. Complex supply chains have reached their limit. At the same time, advanced manufacturing techniques mean that the location of manufacturing no longer hinges on where labour costs are cheapest.” Neil Shearing, Group Chief Economist, Capital Economics.

The pandemic has accelerated the premise that peak globalisation is in, and that Governments will look to companies to re-shore production to the US and Europe, building in redundancy at home in what amounts to a regime change after 40 years of offshoring production. This structural alteration to the economy comes with unintended consequences. It is hard for economic models, those used by Central Banks to measure the trajectory of the economy, to cope with these changes.

When an economy goes through a significant alteration, then prior relationships between economic variables will also change. This modelling is attempting to extrapolate trends based on past average correlations, but the outcomes will go awry when the coefficients change. This is of particular significance now when it appears that the US economy is transitioning through an accelerated period of structural change, with many factors altering materially. To the Chairman of the Federal Reserve (Fed), these changes may only cause temporary inflation, but there is a risk the Fed is “flying blind”, as its econometric models fail to incorporate the changes in the underlying economy, which may result in an inflation surprise.

The aforementioned reversal of 40 years of globalisation is a realisation of the point when China presented itself as a geopolitical challenger to US supremacy. From being a source of endless profit margin enhancement, global supply chains turned into potential liabilities, subject to random disruption as they started to fall victim to geopolitical tensions.

There are two significant recent events, which are consistent with a restructuring of global supply chains. The first was the Suez Canal fiasco, and secondly the semiconductor shortage. Add to this other supply chain shocks, including the 2011 Great East Japan Tsunami disruption of the auto sector, the US / China Trade War and the COVID-19 pandemic. Beware those telling you there are winners and losers in supply chain disruptions, Ricardo’s comparative advantage only works if it increases aggregate economic efficiency. It is becoming clear that many global supply chains are now an economic deadweight.

The massive disruption to global trade during the pandemic has emphatically highlighted the weakness and risk of global supply chains. A major change for the World now is that this trend going into reverse; partially, for most global supply chains, but fully for anything deemed of strategic importance. As a result, the medium-term is likely to see a slow decline in the trade share of global Gross Domestic Product (GDP), and for Western economies, the share of manufacturing as a percentage of GDP will increase.

Whilst the World will be dealing with the consequences of deglobalisation, the US initially will be dealing with the ramifications of two other structural changes; firstly, the evolving activist monetary policy undertaken by the Fed and secondly, a seemingly fundamentally new approach to fiscal policy.

Turning to the Fed. Quantitative Easing was expanded in March 2021, beyond the realms of what was previously thought possible. The scale of the Central Bank’s commitment to propping up the US bond market and extending its remit to include corporate bonds ushered in a new era for policy objectives. Although the Fed had previously confirmed last Summer it was adopting an average inflation targeting objective, rather than a fixed level of inflation at any one point in time being the catalyst for a move in US interest rates, the fact it has in recent months explicitly focused on the level of US employment and further breaking it down to levels of unemployment based on race, highlights how full employment has become the dominant objective over inflation to trigger an interest rate move.

Secondly, US fiscal policy since last Summer and the onset of the pandemic, has been of a scale and magnitude unprecedented. A trend that has been facilitated by Quantitative Easing actions on behalf of the Fed. At this stage, there is no way of knowing what the consequences of both the size of the largesse provided to the economy will prove to be, nor what the Fed buying up most of the new debt being issued by the US Treasury will mean.

What does seem apparent is, that by being the buyer of last resort of US Government debt, the Fed has for now removed any constraint on the level of budget deficits or the discipline on Government spending  caused by a material rise in US Treasury bond yields in the near-term. After the muted fiscal response to the 2008 Great Financial Crash, the reaction to the pandemic has shown the almost limitlessness of fiscal policy, when it is funded by the Central Bank.

What we think all of the above means is that we are in a period of flux, as deglobalisation picks up steam against the backdrop of a major shift in fiscal spending and Central Bank policy objectives, which likely crystallises a much more inflationary outlook for the US and other Western economies, as Governments initially seek to prop up and then unleash the full forces of demand in a World economy increasingly showing signs of supply constraints.

Against this backdrop, if market expectations for inflation rise significantly then it might be beyond the abilities even of the Fed to cap the level of US Government bond yields ad infinitum. Economist, Dr Woody Brock, notes that “the late Kenneth Arrow best summarised this whole matter by stating that asset prices (e.g. bond yields) would at any point in time be exactly what investors wanted them to be – not what the authorities [The Federal Reserve] might wish them to be. Today, should World growth recover by 2022, and should inflationary expectations rise from 2% today to 5% by mid-2022, then expect investors to demand a 3% higher long-bond yield (reflecting a higher inflation premium), and expect them to obtain this regardless of whether the Fed likes it or tries to keep rates from rising.” 

Objectively, in such an environment, those investors holding bonds that have a long time horizon until they redeem will suffer heavy losses, as the price of a bond moves inversely to its yield. To that end, for portfolios made up wholly of bonds or a balance between bonds and equities, restricting the time horizon to the redemption date is critical. We have sought to adopt that stance since the start of the year, by repositioning in bonds across our strategies that are short-dated and thus less sensitive to inflation and interest rate changes.

For equities, in a new economic cycle it should not be assumed that the same sectors will provide outsized gains over coming years as they did pre-pandemic, particularly when inflation is higher and pricing power becomes more important to profitability – pity the company reliant on a long and fragile supply chain operating on thin margins – which means previously unfashionable sectors, like consumer staples and financials, should take up the leadership through the balance of this year and into the next.