Published on April 22, 2022

Concerns about the Ukraine war, inflation, and the Fed were top of mind last quarter, but a lesser appreciated long-tern headwind is the de-globalization of the labor force, which could have profound effects on the economy.

Globalization in Retreat

The first quarter of 2022 was a particularly volatile period in the financial markets. 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 shut down. 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.

In fixed income, we feel it is better to take a more defensive posture and not bet on uncertain outcomes. Before going out on the risk spectrum, we would need to see one of two things happen: either conditions need to settle down so we can begin parsing data and making value calls within a more rational framework, or as happens rarely, asset prices need to get hit so badly that they are at levels that offer enough absolute value that it warrants diving into longer maturities. In the meantime, we have been adding shorter-term debt at yields that are comparable to longer-term debt given the shape of the curve, while we patiently wait to see how the market evolves.

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

Larry Cordisco

Co-Chief Investment Officer – Core Equity & Portfolio Manager

Carl Kaufman

Co-President, Co-Chief Executive Officer, Chief Investment Officer – Strategic Income & Managing Director – Fixed Income

Written by

John Osterweis

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

John Osterweis

John Osterweis

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

After graduating from business school, John Osterweis served as a Senior Analyst concentrating on the forest products and paper industry for several regional brokerage firms and later for E.F. Hutton & Company, Inc. In addition to his activities as an analyst, Mr. Osterweis served as Director of Research for two firms and managed equity portfolios for over ten years.

In late 1982, Mr. Osterweis decided to devote himself full time to his portfolio management activities, and in April of 1983 launched Osterweis Capital Management. Mr. Osterweis has served as Director of the Lucas Museum of Narrative Art, Director on the Stanford Alumni Association Executive Board, Trustee of Bowdoin College, Director and Vice Chairman of Mt. Zion Hospital and Medical Center, and President of the Board of Directors for Summer Search Foundation. He currently serves as a Trustee of the San Francisco Ballet Association, Director of the San Francisco Free Clinic, and President Emeritus of the San Francisco Ballet Endowment Foundation, as well as Trustee Emeritus of Summer Search Foundation and of Bowdoin College.

Mr. Osterweis is a member of the firm’s Management Committee, a principal of the firm, and a co-lead Portfolio Manager for the core equity, growth & income, and flexible balanced strategies.

Mr. Osterweis graduated from Bowdoin College (B.A. in Philosophy, cum laude), and Stanford Graduate School of Business (M.B.A. with top honors in Finance).

Larry Cordisco

Co-Chief Investment Officer – Core Equity & Portfolio Manager

Larry Cordisco

Co-Chief Investment Officer – Core Equity & Portfolio Manager

Before joining Osterweis in 2019, Larry Cordisco was a Co-Portfolio Manager of the Meridian Contrarian Fund at ArrowMark Partners/Meridian Funds. Prior to co-managing the Contrarian Fund, Mr. Cordisco was an equity analyst for 11 years, most recently as Vice President of Investment Research for the Meridian Contrarian Fund. Before that he was an analyst within the technology group at Bank of America Securities. He was also a business and technology consultant for Accenture in San Francisco and began his professional career in the public sector as local staff for a member of Congress.

Mr. Cordisco is a principal of the firm and a co-lead Portfolio Manager for the core equity, growth & income, and flexible balanced strategies.

Mr. Cordisco graduated from the University of California, Santa Barbara (B.A. in Political Science), Georgetown University (M.P.P.), and Columbia Business School (M.B.A.).

Carl Kaufman

Co-President, Co-Chief Executive Officer, Chief Investment Officer – Strategic Income & Managing Director – Fixed Income

Carl Kaufman

Carl Kaufman

Co-President, Co-Chief Executive Officer, Chief Investment Officer – Strategic Income & Managing Director – Fixed Income

Carl Kaufman joined Osterweis Capital Management in 2002 after almost 24 years in various positions at Robertson Stephens and Merrill Lynch. He has managed the Osterweis Strategic Income Fund since its inception in 2002 and is also the Managing Director of Fixed Income and a lead Portfolio Manager for the Osterweis Growth & Income Fund.

In his management role at the firm, he is responsible primarily for investment matters and is a member of the firm’s Management Committee. He is a principal of the firm.

Mr. Kaufman graduated from Harvard University and attended New York University Graduate School of Business Administration.

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Duration measures the sensitivity of a fixed income security’s price (or the aggregate market value of a portfolio of fixed income securities) to changes in interest rates. Fixed income securities with longer durations generally have more volatile prices than those of comparable quality with shorter durations.

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