The government is open again after a temporary and partial shutdown that depressed GDP by a fraction; the economy should now bounce back. The remarkable resilience of the stock market during the shutdown showed that investors expected that it would be short-lived and that the debt ceiling would be lifted. Corporate profits and margins have held up much better than anyone expected as this slow motion recovery drags on.
Deflation remains the larger threat in the battle between inflation and deflation. Governments may be tempted to inflate their way out from under heavy debt loads, but positioning a portfolio for an imminent spike would have been costly in terms of foregone returns over the last several years and will be for the next several as well. All else equal, combining a sizable government deficit with energetic expansion of the monetary base would be expected to yield robust inflation. All is not equal, however, and the still persistent whiff of deleveraging is keeping newly created money safely contained in the banking system, where it is unable to do inflationary harm.
In addition, sustained inflation is also near-impossible without strong wage acceleration. Wages have been stagnant for a dozen years and the deck is stacked against their sudden revival. The current environment is marked by the complete absence of upward labor cost pressures. High unemployment ensures abundant idle capacity to restrain wage increases. The demise of organized labor has eviscerated workers’ bargaining power, as can be seen in the steady erosion of people employed by unions and the plunge in the unionized share of the workforce.
When it comes to inflation, the worry is more about the employability of the mounting ranks of the long-term unemployed than about monetary policy settings. If wide swaths of the prospective labor pool are permanently unemployable, there’s less slack in the economy. In the developed world, since the financial crisis of 2007/08, the odds of deflation remain greater than those of a sustained rise in inflation. The predominant problem for the world economy today is abundant supply and inadequate demand.
A rebound in capital expenditures (capex) is probable and could fill some of the demand void. Indeed, a strong rebound in capex is overdue, but it is too early to tell if a ‘boom’ (such as the 1990s tech cycle) can occur. Long-term capital return expectations have fallen into the low single digits – a phenomenon that may have something to do with the prolonged investment surge around the world over the past twenty to thirty years. This expansion has generated enormous prosperity, especially in the developing world, but it may have also brought about diminishing returns. If so, corporate investment alone will not be able to sustain aggregate demand growth. However, capex adds productive capacity, which will eventually enhance the supply curve.
The pace of growth continues to slide in many emerging economies. Domestic demand within the developing economies is weak, and deflationary forces are gathering momentum. Core inflation in emerging markets (EM), excluding China, is relatively low. Meanwhile, reflecting subdued global trade growth, world manufacturing goods prices are flirting with deflation. Heightening deflationary pressures imply that EM corporate pricing power will likely be further undermined and that their profit and return on capital will suffer. Expect countries like Brazil to enter recession within the next year. Thus, developing countries will continue to export deflation to the US with cheap labor, inexpensive products, and low demand. The bottom line is that conditions are not ripe for supply constrained inflation to take hold in the EM either.
Broad money growth and an expected easing of fiscal conditions in 2014 should allow the economy to finally grow at an above-trend pace, which will help support stocks and other risk assets. With US bank balance sheets largely cleansed, and bank credit readily available, monetary conditions should remain supportive. A budget compromise is all that stands between the US economy and a bright medium-term future.
Michael Ashley Schulman, CFA