Some of the deflationary forces associated with globalisation after the end of the Cold War are losing their power, and that means inflation could become more of a force. Investors need to adapt.
Tightening labour markets and pushback against forms of global trade means that inflation is likely to become more visible, forcing wealth managers to adjust asset allocation accordingly, according to Principal Global Investors.
The media’s focus on near-term issues such as central bank comments, trade talks and the Brexit situation may have obscured more fundamental shifts, such as how inflation rather than deflation is likely to become more of an issue, according to Bob Baur, chief economist at the organisation.
In the US, for example, the jobless rate is only 4 per cent and there are rising participation rates in the workforce. Jobless rates are 4.0 per cent, 7.9 per cent and 2.5 per cent in the UK, the eurozone and Japan, respectively.
“Why is this happening? Much of it is because globalisation is fading. Globalisation has always been about utilising low-wage, underemployed workers in newly opening emerging markets, especially China and India,” Baur said. “As trade barriers fell in the 1990s and 2000s, global companies moved in to utilise those newly available workers and make their companies’ products more cheaply. Global profits soared. Those super-low wages became stiff competition for well-paid middle-class workers in developed countries as their jobs moved offshore. As a result, middle class wages stagnated over recent decades, as is well known,” he continued.
“But, low-wage, employed workers don’t stay low-wage forever and wages in China have been rising at high rates for nearly twenty years. As a result, manufacturing in China is not nearly as competitive as a generation ago. So, Chinese manufacturers have been building plants and making their products in the United States in recent years. Some studies show not much manufacturing cost difference between the United States and China when the former’s high productivity is considered,” he said.
The shift means that markets will eventually adjust, he said. “Ten-year US treasury and German Bund yields of 2.7 per cent and 0.25 per cent respectively have little to no such premium currently. Long-term safe-haven yields have to eventually work higher,” he said.
Among other changes, Baur said that out-of-fashion value equities will come back into vogue, reversing recent large underperformance; higher interest rates will boost sectors such as banks. Equity markets may tread water to some extent.
Another result of higher inflation will be weaker corporate margins and earnings – and an impact on equity valuations. A more inflationary environment might also make active investment management more important because the old boost of central bank cheap money is likely to end.
“The current infatuation with passively managed index funds should start to fade. Central bank-sponsored capital subsidisation provided a systematic support under all stocks, making it very difficult for active managers to outperform. With that systemic influence winding down, good active managers should find better opportunities to beat their index,” he said.
“Real assets in general and real estate especially may be the best choices in an environment of faster wage growth and a bit more inflation,” Baur added.