We believe that at least three major disinflationary trends affecting the global investment outlook over the past decade or so are either reversing or beginning to reverse: labour supply, the distribution of income between capital and labour, and globalisation.
The first waning disinflationary trend is labour oversupply, which is correcting in the US and Japan in particular as unemployment rates reach multi-year lows. The relationship between full employment and inflation is a simple one. As workers are more able to find jobs, their bargaining power improves and they can demand higher wages. Higher wages lead to increased consumer demand, which can drive prices higher.
This relationship has been slow to emerge in this recovery—wage growth remains sluggish even in tight labour markets—but we believe the dynamic is intact and will assert itself first in the US.
The second inflection point to higher prices is related to income distribution, which is affected by wage growth over the longer term. Rising wages should help shift the balance of income distribution from the holders of capital—investors and savers—toward workers with a greater propensity to spend.
The third disinflationary force on the decline is globalisation. The global spread of supply chains in search of production cost savings may already have peaked. Companies are no longer pushing as aggressively as they did into offshore markets, in part because labour costs are rising in many emerging markets. Moreover, the potential for protectionist policies in the US could drive up prices of imported goods, and lead to more on-shoring and higher production costs.
While these inflationary factors are coming into play, they are not the whole story. One enduring disinflationary pressure is the drag on wage growth caused by the skew in job creation from manufacturing to the comparatively low-paid services sector.
The momentum behind the expansion of the services sector workforce may also be past its peak, but the disinflationary effects are likely to persist as manufacturing workers retire over the next decade. This effect will be especially pronounced in the euro area—even in tight labour markets such as Germany’s—given the ready availability of migrant labour with little bargaining power on wages.
Technology poses the second longer-term headwind to inflation. Today’s advances are putting more power in the hands of consumers, introducing unprecedented levels of price transparency, as shoppers can compare the prices of just about any goods or services in real time.
As a result more retailers are under pressure to price competitively because they know their consumers are price-aware. Also, more brands are eschewing the traditional retail model and using technology to sell directly to consumers, removing a layer of mark-ups.
The power of the online model is most evident in the retail and media industries. The emergence of small online shaving clubs, for example, forced the world’s largest consumer product company to drop some of its prices more than 10%, while the growing trend of ‘cord-cutting’ and streaming content online poses a threat to the cable giants.
The next frontier for disruption is food. Retailers are vying with internet giants to create ‘smart’ grocery stores, allowing customers to buy online or simply ‘grab and go’ in stores, bypassing the checkout. This technology could drive grocery prices down, and those who harness it well will have a major advantage in the competition for share of this huge market.
All this, of course, has an impact on investment strategies. Our approach to this challenge is two-fold, both offensive and defensive.
On the defensive side, we avoid exposure to legacy players who may be targets for emerging disruptors. Ultimately we expect the retail sector to successfully navigate this transition as business models adapt, but some measure of attrition and consolidation is likely: this year has already seen nine retail bankruptcies in the US.
On the offense, we see more dispersion of performance as business models and supply chains will have to change, increasing the range of outcomes. This is a stock picker’s environment: we look for companies that are leading in or adapting quickly to the online space, as marketing directly to consumers can enhance margins. The disruptors themselves can thrive in this deflationary habitat, as online companies with lower overheads are proving their ability to undercut more established brands and capture market share.
The Great Reflation may be a genuine phenomenon, but these deflationary factors and the specific investment challenges and opportunities they present ensure that investing in this environment is not a one-way bet on rising prices.