Future Economic Landscape

I believe that the world is heading to an inflationary regime (which can last decades). But that doesn’t mean it will be inflationary throughout, there will be periods of disinflation, deflation, and reinflation peppered within this inflationary regime, just like how we had a deflationary regime over the last four decades that was peppered with periods of disinflation, deflation, and reinflation.

So why are we heading to an inflationary regime?

Let us begin by quickly summarizing the deflationary drivers of the last four decades –

1.China – managed to bring over 600 million people into the workforce and out of poverty. This helped improve their lives but also provided cheap labor to the global economy. At the same time, China laid the massive manufacturing and logistics infrastructure which has made it the manufacturing powerhouse that it is today.

2.Collapse of USSR – led to the migration of cheap labor from Eastern Europe to Mainland Europe.

3.Outsourcing – exasperated with high inflation from the mid 1960’s to the mid 1980’s, developed economies willingly accepted the idea to outsource or offshore their manufacturing to China.

4.Female Labor Force Participation – increased participation of women in the labor force, especially in China.

5.Immigration – the same reason stated in point 3 led to developed economies opening up to immigration from developing economies which led to wages being driven down.

6.Debt – Increase in debt (through monetary policy) led to businesses running on the loss-making model whilst increasing revenues. It also led to increased competition and the emergence of massively disruptive startups.

7.Technology – the ultimate deflationary driver which made the world smaller, expedited exchange and execution of ideas, boosted innovation, and increased efficiency exponentially.

Now let us understand which of the above deflationary drivers can slow down or turn inflationary –

1.China – demography is getting older and wealthier. Cheap labor-intensive industries such as apparel and footwear are already moving to Vietnam and Bangladesh, as China isn’t feasible for cheap labor anymore.

2.Outsourcing – many developed countries have elected or are electing governments that promise to bring back the jobs by reshoring their industries. Also, Covid lockdowns and the Russian – Ukraine conflict has shown governments how globalized supply chains are vulnerable and de-risking supply chains to some extent by localizing them would be a strategic necessity. Reshoring of jobs and supply chains will be inflationary.

3.Immigration – again, many developed countries have elected or are electing governments that promise or have mandates in place that caps immigration which would cut off access to foreign cheap labor and talent.

4.Debt – many developed countries are running debt to GDP ratios in excess of 100% and any increase in debt through monetary policy would be a very unpopular opinion among the electorate, leading to more fiscal policy solutions, which makes the economy inflationary.

Apart from the drivers listed above which can turn from deflationary to inflationary, a new set of inflationary drivers can also be witnessed.

The new drivers of an Inflationary Regime

1.ESG – The transition to Net Zero involves a large negative supply shock for existing sources of energy as enough new investments weren’t being made. This leads to higher prices for existing sources of energy. New ESG projects require mega capex. Without public investment in ESG, private investment would not be enough to scale or bring down the costs to the end consumer. This either means that private investment bears the loss, increase prices, or the governments subsidize the private investment to bring down the costs to the end user. If private investments have to bear a loss, then investing in ESG wouldn’t be attractive to them, if ESG projects have to increase prices to be profitable, then they may not be feasible to consumers, and if the governments introduce subsidies for private ESG investments, then they would exacerbate the debt problem.

2.Inequality – the deflationary regime of the last 40 years worked in favor of the capitalists against the labor, and the monetary policies in place since 2008 exacerbated this inequality. The current inflationary period will put pressure on governments to work on closing the gap in inequality, which will further increase pressures on inflation.

3.Fiscal Policy – governments are already putting money in the hands of the people so that they can weather the inflation or are providing subsidies. Fiscal policy along with monetary policy is proven to be inflationary.

But because I have a view on an inflationary regime that doesn’t mean it will actually play out. There are still factors that would be a risk to an inflationary regime and lead to the deflationary regime from the last 4 decades to continue for another few decades.

The risks to the drivers of an Inflationary Regime

1. Technology – it could continue to be a deflationary driver and would be enough to replace the labor force exiting the market. These technologies could be AI, robotics, 3D printing, etc.

2. India & Africa – although they lack the administrative infrastructure present in China to develop a similar market scale, they could still be a new source for cheap labor.

3. Female Labor Force Participation – in countries such as India where the female labor force participation is low, an increase in the participation rate can be a deflationary driver.

4. Weakening JPY – the continued weakening of the JPY against the USD can make Japan more competitive in the export market, making it a serious competitor to China. However, to stay relevant, China will be forced to devalue its currency, exporting deflation to the world in the process. Although, the BoJ can stop the JPY from weakening further, but that would mean giving up the YCC, which seems difficult as of now because that would lead to a lot of their domestic institutions and funds failing as they own a lot of the JGB’s. Apart from that, increasing yields in Japan would mean lesser liquidity in the global markets, which could possibly lead to higher yields worldwide. Considering these risks, it seems more likely that Japan would let the JPY weaken as per market forces, which in turn would force the hand of China.

5. Underestimating China - having a tight grip over the country, establishing policies and new laws to make sure prices stay low, won’t be difficult for China. Apart from that, the costs involved in building new supply chains and infrastructure to move away from China, may prove difficult to the world, considering this would require new investments, which would mean a higher debt burden than already exists.

A few other thoughts on the Future Economic Landscape

1. Governments would be more focused on spending to reduce inequality rather than investing in alternative energy because fiscal stimulus would win votes as that’s money directly in the hands of people.

2. Monetary policy alone would be frowned upon by the electorate and hence fiscal policy would also be required. Monetary and fiscal policy together, are known to be inflationary.

3. PE, VC, and other alternative investments can become risky as liquidity moves out. Liquidity is moving out because treasury yields worldwide are rising and institutional investors who moved to alternative assets in search of yields, are moving out. Treasury yields move higher when inflation moves higher. Not to forget that if JPY keeps going higher, the BoJ will have to give up on the YCC, thus increasing JGB yields, and taking away liquidity from international markets, which in turn can hurt alternative investments all the more. Alternative investments already are under pressure because of lower valuations due to higher interest rates or discount rates, and taking away liquidity means difficulty in finding buyers for existing investors or lower exit valuations. Keeping this in mind, investors should be more stringent with investments in startups or loss making entities.

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Would appreciate further discussion, comments, dissents on any of the points. Hope this helps!

Cheers!