Globalization is not what it used to be



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The inhabitant of London could order by phone, sipping his morning tea in bed, the various products of the whole earth, in quantities he deemed appropriate, and reasonably expect their prompt delivery to his doorstep. … But, most important of all, he regarded this state of affairs as normal, certain and permanent, except in the sense of further improvement. – John Maynard Keynes

Over the past 30 years, we have grown accustomed to all the benefits of globalization. During this time, not only the prices of the goods became more stable, but the delivery of the goods was fast and reliable. However, this has not been the case in recent months. Since the start of the pandemic, countries that rely heavily on global supply chains have struggled to receive goods from other countries. Supply constraints have made it difficult for companies to meet domestic demand. This dynamic has put the Fed in a certain dilemma as it struggles to determine the course of policy. In this report, we take a look at how supply chain disruptions led to the recent rise in inflation and how the Fed might respond if prices remain high.

A key element of globalization is stability. In a stable world, firms are better placed to absorb supply shocks. When the world is stable, businesses are able to cope with isolated supply disruptions by going to different suppliers of goods or finding cheaper alternatives. For example, when the price of coal increases, companies generally buy more natural gas and vice versa. Additionally, when swine flu caused a shortage of pork products in China, the Chinese began importing pork from the United States. In a stable world, shortages in one part of the world can be offset by increased production in other parts of the world. world. However, the dynamics change when there is a universal shock like a war or a pandemic.

The pandemic has shown that globalization is ill-suited to deal with global supply shocks. The chart above shows that in recent months the US, UK and Eurozone, each of which relies heavily on outsourcing from Asia, have experienced a sharp decline in the performance of delivery from their suppliers. However, Asian countries, where there is less reliance on outsourcing, have seen their supplier delivery performance remain relatively stable. Additionally, there appears to be an inverse correlation between supplier delivery performance and inflation. The United States, the United Kingdom and the Eurozone have all experienced unprecedented increases in inflation in their respective countries for more than a decade. Meanwhile, Asian countries have seen their inflation fall below the standard 2% target. Regional differences in inflation rates highlight the impact of the pandemic on global supply chains.

We believe that as long as supplier delivery performance remains slow, it will be difficult for inflation to come down anytime soon in the US, UK and Eurozone. As a result, the Federal Reserve will face increasing pressure to respond to higher inflation. After all, a failure to respond would threaten its credibility and could undermine its independence. There are elements in the financial markets that would like the central bank to raise rates to contain inflation, while populist politicians would like it to maintain an accommodative monetary policy to ensure wages keep rising and businesses keep rising. to hire. The anger of the former could lead to a loss of investor confidence in the dollar, while the anger of the latter could lead to more political scrutiny.

In addition, there is always a possibility that increasing rates in this environment could lead to undesirable results. While higher rates can reduce inflation by lowering demand, they could also make it more costly for businesses to expand supply and maintain employment. The former may be the expected outcome, but the latter always presents a risk. Given the unpredictability of this pandemic, it is difficult to determine which outcome will prevail. As a result, rising rates can increase the likelihood of a recession. This should prevent the Fed from raising rates sharply.

In conclusion, the marked slowdown in supplier delivery performance suggests that inflation is likely to stay higher for longer. There will be increasing pressure on the Fed to tighten policy or risk undermining the central bank’s credibility on inflation. At the same time, much of the pandemic’s impact on supply chains is temporary, and pricing pressures are expected to be eased as the pandemic is resolved. We expect the Federal Reserve to slow down the expansion of its balance sheet first and take a wait-and-see approach to raising policy rates. The risk of moving too early is that it raises the possibility of unnecessarily delaying improvements in labor markets. The risk of acting too late could undermine confidence in the dollar and raise inflation expectations. The risks of policy error are increasing and we will be monitoring policy developments closely over the coming months.

Past performance is no guarantee of future results. The information provided in this report is for educational and illustrative purposes only and should not be construed as individualized investment advice or a recommendation. The investment or strategy discussed may not be suitable for all investors. Investors must make their own decisions based on their specific investment objectives and financial situation. The opinions expressed are current as of the date indicated and are subject to change.

This report was prepared by Confluence Investment Management LLC and reflects the current opinion of the authors. It is based on sources and data believed to be accurate and reliable. The opinions and forward-looking statements expressed are subject to change. This is not a solicitation or offer to buy or sell securities.



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