Second Quarter Equity Outlook

Globalization in Retreat

The first quarter of 2022 was a particularly volatile period for the stock market. Uncertainties about the pandemic led investors to rush into ‘re-opening’ plays one day only to reverse course the next as reports of a new, more virulent strain created fears of another shutdown. Russia’s invasion of Ukraine added a whole new layer of uncertainty as investors tried to fathom the effects of sanctions and disrupted trade. Oil prices surged, as did prices of other commodities, leading to significant short-term inflationary pressures on top of those stemming from Covid-related supply chain disruptions.

In response to these inflationary pressures, the Fed began its much-anticipated move toward tighter monetary policy and higher interest rates. This in turn created yet another layer of uncertainty for equity investors, as higher interest rates ultimately lead to lower equity valuations.

Underneath the short- or immediate-term concerns, we believe there is a longer term, potentially much more persistent issue, namely a reversal of the benign effects of globalization. As our clients know, we have written for years about the combined effect of globalization and technology in taming inflation and bringing it down below 2%. Globalization – especially the opening of China and Eastern Europe – afforded the world a vast supply of cheap labor and enabled companies to move manufacturing offshore to produce goods more cheaply. Labor unions were also weakened as a direct consequence of cheap labor from globalization, leading to a multi-decade collapse in unionization in the U.S. from 20% in 1983 to 10% in 2021.

In addition, technology in all its myriad forms enabled businesses to streamline processes and become more efficient (i.e., operate at lower cost), while also affording consumers unprecedented price-discovery power. This too kept the lid on inflation. While globalization destroyed labor’s ability to demand higher wages, technology destroyed some businesses’ power to raise prices at will and structurally lowered input costs.

We contend that globalization is now in retreat, and that after three decades of falling inflation we are entering a multi-decade period of rising inflation. We do not expect annual inflation growth to remain at 6.4% – its latest reading excluding food and energy – but to settle in at a rate above 2% and probably trend higher from there. The temporary pressures from Covid-related supply chain disruptions and the Ukraine invasion/Russian sanctions will eventually abate. But the reversal of globalization will have a persistent impact on labor costs and long-run inflation.

To better understand these long-term trends, we quote liberally from an exceptionally well-researched book on this subject: The Great Demographic Reversal by Charles Goodhart and Manoj Pradhan (pages 2-3):

"The single most important economic development over the years from 1990 to 2018 has  been the rise of China and its integration into the global trading economy…. [This] and the return of Eastern Europe to the world trading system provided an enormous positive supply shock to the available labour force in the world’s trading system.... The effective labour  supply force for the world’s advanced trading system more than doubled…from 1991 to 2018…. Such a positive supply shock to labour [results in] a weakening in the bargaining power of the labor force.”

As lower labor costs worked their way through the economy, inflation fell, causing interest rates to fall as well. From a high of 14% in 1983, the U.S. Treasury bond yield fell to a low of 0.50% in 2021. Yields in other countries also dropped. Falling interest rates led to rising asset prices, especially for equities and houses. While low-skilled labor wages stagnated, the wealthy benefited from rising asset prices. But according to Goodhart and Pradhan, at least part of this picture is reversing. As a result of the steady decline in birth rates in Europe and the effect of China’s one child policy, there will be a sharp reduction in the growth of the global labor force.

"There will be an absolute decline in the labour force in several countries – in the key economies of Japan, China and most of North Asia as well as several in continental Europe, such as Germany, Italy, Spain and Poland.” (page 9)

Labor may also become more powerful, leading to higher unionization — a trend we already see taking place at some of the largest U.S. companies. In the rest of their book, the authors discuss the various ramifications of the great reversal – most importantly the implications of resurgent inflation. It is a fascinating read.

We would add that beside the demographic causes of a declining labor force, we believe Covid has pushed many U.S. workers out of the workforce. Older workers decided to retire rather than risk infection in the workplace, and younger workers needed to stay home to care for children or aging parents. Whether this represents a permanent decline in the labor participation rate remains to be seen.

Further, Covid and geopolitical concerns have sparked a desire for simpler, shorter, more domestic supply chains (i.e., a trend toward reshoring manufacturing processes). This will bring jobs back to the U.S., increasing demand for labor at the same time supply is constrained. As a result, we are experiencing strong job growth, significant unfilled job openings, and marked upward pressure on wages as employers scramble to hire needed workers. As Goodhart and Pradhan discuss, this upward pressure on wage rates is secular, not cyclical.

Despite all these inflationary pressures, it is worth remembering that technology-led deflation persists, and there is no reason to think this trend will change. Technology, therefore, remains a deflationary force, partially offsetting the impact of the reversal in globalization.

So, what does all this mean? Simply put, we expect inflation will be higher than the Fed’s 2% target, interest rates will gradually move higher, and asset valuations will move lower. Should we therefore panic and sell all our stocks? Of course not!

The economy is still expanding, and many companies are growing. Over time, owning growing companies, which typically pay growing dividends, should prove very rewarding even if valuations come down. And to the extent we can identify companies experiencing temporary headwinds that are therefore selling too cheaply, we could benefit from both rising earnings and higher valuations.

In this new environment of rising inflation, it is important to invest in companies with some combination of pricing power and the ability to offset higher labor costs with productivity gains. These tend to be market-leading competitors that have higher profits to re-invest in their business and who provide better products or services that can command premium pricing.

From an industry perspective we think there will be several obvious areas of focus. Because labor costs will be rising, companies that provide labor-saving equipment or processes should do well. Because inflation will hurt workers whose wages do not keep up with rising costs, companies that offer consumers less expensive options should benefit. We also think companies benefitting from reshoring should do well, as they enable supply chains closer to home. And technology companies that disintermediate old industries at lower costs should continue to thrive. Importantly, though, it appears that the days of speculative excess with regards to valuation are behind us—a change we welcome, as it appeals to our valuation-sensitive approach to investing.

This is clearly a time of great uncertainty – rising inflation, higher interest rates, pandemic, war, and geopolitical tensions – but there are still great and rapidly improving companies that can be purchased at attractive valuations. Broad market drawdowns like we saw in the first quarter (S&P 500 declined almost 13%, and the Nasdaq nearly 20%) frequently lead to many proverbial babies being thrown out with the bathwater. Economic and market conditions come and go but buying growing business at attractive valuations has a way of working out over time.

Please reach out if you have any questions. We genuinely appreciate the trust you have placed in us, and we look forward to serving you for many years to come.

John Osterweis

Founder, Chairman & Co-Chief Investment Officer – Core Equity