The inflation we need to have

A shrinking global labour pool will demand better wages and conditions, pushing up prices.

This month I want to address a common question being asked by investors i.e. ‘how long could high and higher prices last’. The short answer is that a very, very long time. But there may be a silver lining here.

Over the past 30 years the world economic system has experienced an unprecedented positive shock to the supply of global labour pool. The effective labour supply for the world’s advanced economy trading system, more than doubled over the 27 years, from 1991 to 2018. But the future is unlikely to be like the past!

So where did this doubling of the labour pool come from and what impact did it have?

Well, there are a few reasons for this doubling, let’s take one at a time. Firstly, the rise of China and its integration into the global economy and global manufacturing complex meant China more than doubled the available labour supply for the production of tradeable products among advanced economies. Supply and demand economics suggest that when supply doubles price is the adjusting factor i.e. prices of products ex China have continued to fall.

China has continued to add new supply of labour and production capacity to the world economy as more and more people from its rural areas got attracted to its urban economic

powerhouses supplying the world’s voracious demand for ever cheaper and wider range of exported products. The impact of excess supply of cheap labour from China can also be read in the US’ labour participation rate which declined by 4% over the past thirty years.

Thus, China has been a deflationary force for a long time and attempts by central banks of advanced economies to push up inflation through very low interest rates failed to inflate the imported prices from China. But these deflationary benefits are set to reverse as China’s labour supply is set to shrink, a reflection of its ageing population.

The second source of increases to the global labour pool was the re-integration of Eastern Europe’s work force into the global economy after the collapse of the USSR in 1989.

However, China and Eastern Europe are not the only factors leading to a dramatic rise in the labour pool. There were other domestic demographic features in advanced economies at play, namely, the dependency ratio (measured as the population of children under 14 plus retirees over 65 divided by working age population of 15-64 years). The dependency ratio declined in Australia from 1960 to 2009, roughly, from 64% to 48%. The dependency ratio bottomed in 2009 and has since been rising and is projected to continue rising for the remainder of this century, not just in Australia but also in all corners of the world except Africa.

Falls in the dependency ratio due to lower birth rates allowed women to enter the work force in greater numbers. As the dependency ratio is now decidedly reversing with retirees and older age population set to rise (baby boomers exiting the workforce), this will subtract from the available labour pool.

The persistent decline in birth rates in advanced economies (due to wealth effect and one child policy in China) is set to bring about a sharp decline in the growth of the labour force in many countries like Japan, China, continental Europe such as Germany, Italy, Spain, and Poland. Meanwhile, dependency ratios are set to increase rapidly in all of these countries and regions. This will likely lead to significant increases in demand for shrinking labour pool and drive up labour’s bargaining power for working conditions and pay increases.

When you combine the crunch in the supply of labour pool while more and more advanced economies pivot to services-based economies (including China), you really have a strong case for wage inflation ahead.

All of this means that higher labour cost will eventually push up general prices in the economy and reverse the long-term deflationary dividend that we have much enjoyed in advanced economies.

Moreover, the political schism currently developing between China, Russia and their allies in the east versus the western economies led by US is also a significant ongoing risk to reversing of the globalisation trend. This will further raise the cost of doing business which will be passed on to consumers through higher inflation.

We may have entered the next long multi-year episode of higher inflation, perhaps 5% p.a. give and take. The period of adjusting to a higher inflation is best played through participating in nominal growth through equities and being underweight the long duration bonds as interest rates rise.

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Max Riaz

Investment Manager at Banyantree Investment Group

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