The supply wobble
The pandemic has disrupted global supply in product and labour markets. This is a shock. The global economy benefitted from plentiful supply of both for the last two decades and now things are disrupted. Inflation is resulting from the disruption. How long inflation stays elevated and how long it takes supply to be restored are key questions for investors. Questions that are likely to remain front and centre for the remainder of 2021.
For the last decade or two, the global economy has been characterised by a situation of over-supply. Savings have been abundant since before the COVID crisis. That and the accelerated creation of central bank reserves extenuated the already well established downtrend in global bond yields. There has been no shortage of consumer goods, thanks to China’s emergence as the pre-eminent global producer and exporter and the broader trend towards globalisation. That also meant labour scarcity was not really an issue either. Cheap labour in the developing world and, until recently, liberal immigration policies in the developed world provided lots of low wage workers for factories, agriculture, high street services, construction and public services like health-care and transport. Combined with digitalisation that cut out many wage paying contributions to the supply chain, it is no wonder that inflation was low and stayed low even as central banks flip-flopped on their historical policy approach by voicing a desire to see inflation higher.
Shake those curves
The emergence from the pandemic forced shutting down of the global economy has challenged this narrative. The global supply curve might not have shifted permanently to the left but it’s like if you had drawn a supply and demand curve on an “Etch A Sketch”1 and then shaken it. Supply and demand has been fragmented by the COVID shock. It’s difficult to see where the equilibrium is. The US markets are challenged by trying to decide whether inflation is rising permanently when the economy has an unemployment rate some 2.3 percentage points higher than where it was at the end of 2019. That means there are five million fewer jobs (people employed) yet today’s commentaries are all about labour shortages and rising wages. Outbreaks of COVID infections continue to disrupt production across global supply chains. In the UK there is a shortage of workers to stack shelves – or theoretically stack shelves if the goods were being delivered to shops and supermarkets. They aren’t because there is a shortage of lorry drivers. COVID and Brexit have combined to disrupt the UK labour market.
Work, the same but different
Labour behaviour might have changed too. In the short-term, parental needs, pandemic unemployment benefits and furlough schemes are cited as reasons why people who previously worked aren’t doing so now. Others might have shifted their work-life preferences, moving out of cities, and potentially moving jobs as a result. Labour shortages don’t exist because there is an absolute shortfall in the number of people that could be employed but are often the result of frictions, changed mobility, institutional factors, and the wage-benefit relationship. It’s interesting that some financial firms have announced big pay increases for younger staff. I wonder if these have been either reactive or preventative decisions when young professionals might not want to come to an office for five days a week and work for twelve hours after the experience of the last seventeen months. My colleague and economist, David Page, refers to an increase in job turnover in the US reflecting how COVID has been disruptive.
Lots of things seem to be hitting the supply of commodities, industrial and consumer goods. Demand has not really been an issue thanks to the COVID emergency liquidity and income support policies put in place since March 2020. It’s not only some UK supermarket shelves that are looking threadbare. The shortage of semi-conductors is impacting on the production of consumer goods and motor vehicles (hence the rise in used car prices). Try to buy a laptop or a second PC monitor at the moment, it’s not easy. Last week’s July ISM report from the US showed customer inventories at a record low and the “backlog of orders” index has been at record highs in recent months.
Demand is strong
In modern history the global economy has never shut down in the way it did in 2020. Re-starting it has not been easy. The pandemic has not gone away and there are all kinds of supply disruptions. These disruptions could show up in some weaker GDP data as declining inventories and production difficulties are picked up in data. They will also keep inflation fears alive for a while. Yet the “glass half full” view of this is that it will sustain stronger growth for some time as production and hiring are ramped up to meet backlogs and strong demand. There should be no concerns on the demand side. Employment is growing, incomes have been sustained (in aggregate) and wages are rising. In addition, fiscal stimulus and the wealth effects from the monetary policy led rise in global asset prices are supporting strong demand.
How soon is now?
It is reasonable to expect that these trends are temporary. Supply will be restored over time; labour markets will settle down when furlough schemes and pandemic benefits come to an end. Whatever drag there is on quarterly GDP numbers from inventory run-downs will be restored by production increases. Backlogs across the supply chain should ease. However, we can’t be sure how long this will last. The delta variable is a major issue globally and could impact supply for a while longer. Consumer businesses are usually ramping up stock in time for the year-end holiday season, but this year will be challenging especially in consumer electronics. Pricing could well be used as the regulating mechanism – meaning inflation might remain high for a while.
For markets the importance of all of this is that global growth is likely to remain strong but with bottlenecks and inflation for some time to come. Companies have more pricing power today than at any time in recent years and that should support healthy profits, as long as higher costs can be passed on. Generally equities should do well, but that doesn’t mean some companies will have issues. On the fixed income side, rates volatility has picked up and yields will get kicked around by inflation and tapering concerns on the one hand, and strong underlying technical demand on the other. Yet there are fewer 2% end-of-year forecasts for 10-yr US bond yields than there were.
Inflation uncertainty for bonds
Equity returns are beating inflation; bond returns are not. That is likely to remain the case in my opinion. Inflation-linked bonds in the US have an expectation of medium-term inflation at 2.4% but it is likely to be well above that for the next several months. I don’t think break-evens are particularly expensive given the uncertainty over how long the inflation hump will last, but that means nominal bonds are expensive.
Supply difficulties for some
Over-supply has been turned into disrupted supply by the pandemic with politically driven issues like protectionism and Brexit adding to the mix. While the emergence of supply concerns is a symptom of the strength of demand and the overall recovery there are problems for some companies. A European wind turbine manufacturer this week said that it missed its earnings target because of rising materials prices, supply-chain constrains and Covid restrictions even with a very strong order book for its equipment. So equity investors have to be focussed on businesses inventory management, labour force issues and cost control. There are some localised concerns as well. The UK’s trade frictions and labour market issues that are Brexit related might persist beyond those that are Covid related. After the strong bounce back that the UK is registering at the moment, there may be some deeper issues to confront in the years ahead.
Savings though, and the need to feed the green
The global supply of available savings is one of the things that has not been disrupted. This continues to enable companies and households to keep their borrowing costs very low and, in real terms, negative. Until this changes we should be confident that the global economy can continue to prosper and be hopeful that a lot of that capital can be channelled even more to combatting climate change. The latest IPCC report and the constant flood of news stories about wildfires underline the urgent need to finance the rapid adoption of clean technology and the decommissioning of activities that generate the most carbon dioxide. The real long-term risks to supply chains comes from climate change and extreme weather and when that forces the supply curve to the left there will be no restoring it.