What did we learn this week?

Finding the positives

Where could I be wrong? That’s the key question every investor and fiduciary must ask themselves. Whether one is contemplating a stock position or one’s overall market exposure, the discipline to challenge oneself is critical to making better decisions. In that same vein, I constantly ask myself whether I’m too bearish about equity markets and too gloomy about the risk that inflation remains persistent beyond the current economic cycle. So, this week I want to walk through and enumerate the risks to my five-pronged thesis that wage inflation driven by a persistent worker shortage will be a secular driver of long-term inflation.

1. Aging Demographics – If I am going to be wrong about structural inflationary pressure, it is unlikely the developed world’s demographic problem is going to be where the situation turns out to be more benign than I thought. The US, Europe, China, Taiwan, South Korea all have the same issue, which is that we are all in the midst or on the cusp of falling working age populations as our retired populations grow larger. History has been consistent that when countries have high dependency ratios (too many retirees and the very young vs workers). They end up with far more inflationary pressure than normal. We have an acute worker shortage in the US and we aren’t going to simply discover that we have millions of twenty somethings that we didn’t know about ready to fill all those job openings.

2. Deglobalization – The end of global integration is not a theory but something that began over ten years ago. Unlike before the financial crisis of ’08-’09, the US is growing manufacturing jobs again at a steady clip. The emerging geopolitical issues have reinforced the priority companies are making to re-shore or near-shore manufacturing and service functions. The trend is now ingrained. Markets remain hopeful that China’s President Xi will return to a policy focused on economic growth and global integration, but there is little evidence that he is considering such a reversal. That said, I have no idea, nor do the experts closer to the CCP and China’s overall political climate, have any idea if such a turn is still a possibility. So, I remain open to the idea that XI may change his tune but for now, the evidence is that the opposite is occurring.

3. Falling Labor Productivity – Over the last ten years, productivity growth has been about half of what it had been over the first decade of this century. The first half of this year witnessed the weakest two quarters of productivity growth is modern history. That said, the re-emergence of productivity growth will eventually come. The problem is that it’s impossible to say when. We need what economists call multi-factor productivity growth, or in layman’s terms: new innovation. At some point, we will have self-driving cars and trucks but the promises of when have been chronically too optimistic. There is no shortage of investors and technologists who tout the potential of artificial intelligence and machine learning but, as yet the benefits remain unclear in the macro data. Ultimately the catalyst to overcome inflation is inflation. Companies have enjoyed ever cheaper labor for decades and have therefore had little incentive to spend aggressively to reduce labor. That has now changed of course, and I expect we will see greater capital expenditure to drive more innovation and productivity growth, but it will take time.

4. Falling Legal Immigration – This one is already improving. The Biden administration has already taken steps to return legal immigration to its pre-2017 trend. Encouragingly, the idea of increasing legal immigration polls generally well. But we have a long way to go to make up for the last five years of very low legal immigration that has led to a deficit of millions of workers. Additionally, as this economy continues to weaken and unemployment begins to rise cyclically, the political will to make the decidedly non-populist argument that we need more legal immigration is unlikely to hold up as we approach the next election cycle. Call me cynical, but I can’t envision a scenario where either political party attempts to make the sound but nuanced argument that more legal immigration is good for blue-collar workers in the long run when it has proven so much easier to claim immigration and immigrants are a threat to your job.

5. Falling Male Labor Force Participation – Again, there are recent signs of improvement, but when a trend has been in place with metronomic consistency for literally seventy years, calling bottoms is probably a bad idea. Intuitively, it makes sense that in an environment of high inflation and historic wage growth, more men would be pulled into the labor market and perhaps they will, but after a year of a super tight labor markets, we are still not even back to where we were prior to the pandemic. It is important to note that we are talking about tens of millions of healthy men, over 30% of the male working age population who are not in the labor force and aren’t even looking for a job. A meaningful improvement to this statistic could overwhelm the deficits from the factors listed above. There is room for optimism. The rate at which American men are dropping out of high school and the rate at which American men are incarcerated are both declining and those are the factors most determinant of being outside the labor force. With every Non-Farm Payroll report that prints, this is the first statistic I am looking for and hopefully for the sake of the country it has bottomed, but again, I suspect it will take some time.

In every recession, inflation declines, and unemployment rises cyclically and this cycle will be no different. The more important question is what happens to long term inflation and my conclusion remains that after forty years of labor losing out to capital and management, the tide has turned. Higher long-run labor costs equals higher long-run inflation, higher interest rates and lower equity multiples.

For more from Tim, follow his podcast The Weekly Bull and Bear wherever you listen to your podcast or read his weekly blog posts here.

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