Asset Allocation Weekly: concern on the supply side of inflation

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Confluence Investment Management offers various asset allocation products which are managed using top down or macro analysis. We post thoughts on asset allocation on a weekly basis in this report, updating the report every Friday, with an accompanying podcast.

In the 1970s, the United States had a serious inflation problem. By the end of the decade, that had become the most critical economic policy issue. While inflation can be a complicated subject, one way to simplify it is to see it through the intersection of aggregate supply and aggregate demand.

On this stylized chart, the price levels are rising. In the short term, the most common way to tackle price levels would be to engage in austerity policies, for example by raising interest rates, raising taxes, cutting spending. However, this result also reduces production, which means that growth decreases.

In the late 1970s, President Carter began to implement deregulation policies. The aim was to affect the supply. By increasing supply, price levels would fall and production would increase.

The policies on the supply side of the Reagan / Thatcher revolution were primarily deregulation and globalization. Deregulation has allowed the rapid introduction of new techniques and technologies. Globalization has naturally widened the available offer. Both have undermined the power of labor to push price increases into the economy.
The recent rise in inflation raises questions about the future development of prices. The FOMC maintains that inflation will be “transient”. While the actual definition of the word, at least in the context of politics, is “fuzzy,” it looks like the price increase will moderate at some point.

Our concerns are twofold. First, using the second graph, we would say that the supply situation has changed from S ‘to S. Supply chains have been disrupted and supply will remain tight until fixed. However, the degree to which inflation is transient may depend on how these supply chains are set. It is important to note that globalization relies on hegemonic power that provides global security and a reserve currency. America’s hegemonic position has become less certain, as Americans seem less willing to make the sacrifices necessary to maintain their role. If so, a return to S ‘is less likely.

Another factor is related to deregulation. In the 1970s there was obvious underinvestment and misinvestment. The “anti-rust belt” happened to reduce the bad investment that had emerged. To make new investments, savings had to increase, and the most effective way to increase savings is to reduce taxes on higher income brackets. While aggregate saving does not necessarily increase, it is concentrated in fewer households, making it easier to concentrate investment in a similar way. However, over time deregulation has tended to create industry concentration. Concentrated industries can hamper the expansion of supply.

Under competitive conditions, extraordinary profits tend to attract new entrants to the industry. As new entrants enter the market, the profits of individual firms eventually decline. In addition, increasing competition makes it difficult to raise prices. Competition acts as a brake on inflation; if higher costs affect the industry, it may simply lead to lower profit margins. But, with concentration, the ability of new competition to enter the market may be thwarted. Therefore, the benefits may persist. An oligopoly or monopolist may not increase its capacity at high prices and may simply accept high profitability.

The economic term for this is “market failure,” when the market fails to deliver the best results for the company. In the 1970s, supply constraints arose from the lack of incentive to invest. Taxes were too high and regulations increased costs and also discouraged investment. Our current situation looks different. As the world deglobalizes, prices will rise as supply tightens. Ideally, this increase in price levels will trigger a supply response; however, if the industry is too concentrated, the answer may not occur to the degree required.

It is too early to tell if this is the situation we are facing, but the higher the transitional price levels remain, we must entertain the idea that a period of higher inflation may be upon us. We still don’t see any signs of a return to the 1970s: the labor force is still too weak and inequalities favor moderate inflation. But just because we don’t see circumstances resembling the 1970s doesn’t mean we’re going to see inflation levels in line with the
last two decades.


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 an offer to buy or sell securities.

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