Trade wars, cross-border tension and populism were all in the forefront in 2019. Along with that came talk about de-globalization and its potential to reverse the disinflationary environment in which we have been mired. Inflation is a global phenomenon and it will take significant structural shifts for this environment to change.
Fears of rising inflation are once again creeping into markets. At this juncture in the economic cycle, it is not unreasonable to expect inflation to finally turn given that central banks in developed markets have had the monetary spigots open for much of the past decade. We are late in the economic cycle and slack is diminishing; the unemployment rate in the US is at 3.5% and has been below estimates of the non-accelerating inflation rate of unemployment (NAIRU) for a sustained period. Inflation in the service sector has remained firm; tensions in the Middle East are buoying oil prices; and, fiscal largesse around the globe and the associated probability of monetization of increasing deficits all point toward rising prices. In addition to these concerns, the numerous one-off hits to inflation over the last couple of decades have played out to a great extent; these include globalization, fracking, the internet, technology, the Amazon effect and the financial crisis to name a few.
Inflation is difficult to predict and is sticky. Unless we see a shift in some of the structural drivers of inflation we are likely to remain in a low-inflation environment. We believe that for the inflationary dynamic to change in the US we need to see a shift in three related dynamics: 1) a shift in excess supply of labor and capital in the world, 2) a change of the reserve status of the US dollar and 3) an end to US current account deficits. None of these seem likely in the near future.
Excess Supply of Labor and Capital in the World
The global supply-side-driven disinflation is underappreciated. The world has an excess supply of labor and capital. The scale of the excess supply of labor out of the Far East, where there are hundreds of millions of people who still need to be pulled out of poverty, is enormous. Beyond that, you have India, Africa and the Middle East right on their heels. And, the excess savings of current account surplus countries is large (those of Germany, Japan, South Korea and China totaled $590 billion in 2018). The problem of the global savings glut remains entrenched with excessive savings chasing investments in maturing economies that require less and less capital. Until global savings and investments are in balance inflation and interest rates are likely to remain low.
The Reserve Status of the US Dollar
We believe for inflation to rise in the US, the dollar needs to weaken. But, until the reserve currency status of the US dollar changes it is unlikely to depreciate significantly. Global growth differentials will have to shift against the US for the dollar to weaken. And, although the Federal Reserve has more room to cut rates, relative to the European Central Bank and Bank of Japan, this room is small and its need to provide accommodation is less. Beyond interest rate differentials, US financial and real assets have increasingly become the “safe-haven asset” choice of investors worldwide, which keeps the US dollar buoyed.
US Current Account Deficits
The US runs the largest current account deficit in the world ($489 billion in 2018). This trend has persisted for decades, mainly due to the symbiotic trade relationship with China. In our view, China needs to generate growth to keep its population moving out of poverty and it will keep its currency weak to achieve its domestic goals. This dynamic is unlikely to reverse in the near term as evident in the CNH weakening in 2019 in response to tariffs. We think that for the US current account deficit to reverse, the rest of the world has to grow faster than the US and buy more from the US, while the US consumer slows. Given the established global supply chain and cost differentials this seems far out in the future.
The economic psyche has been scarred by devastating episodes of inflation in the past and this fear drives our bias to expect inflation. Inflation is more than a domestic phenomenon. For costs to rise in the US, prices have to rise everywhere outside our borders. We believe the prospects for inflation may be improving, but global structural forces will remain a headwind for inflation.