03.15.2022: War, crude oil price shocks and sharply higher inflation: history appears to be repeating itself or, at the very least, it’s similar. Let’s take a trip in the WABAC Machine to see where we’ve been, examine that sense of déjà vu and consider the possibility of a post-globalization world.
In 1973, a war in the Middle East prompted an oil embargo that sent crude prices skyward. The price for a barrel of crude shot up from just over $2 in January 1973 to $13 a year later, representing a 525 per cent spike. The oil shortage was a body blow to an inflexible US economy. At that time, America relied on imports for more than one-third of its oil supply to fuel automobiles, power generation and manufacturing. Nearly one- third of the country’s private sector workforce was represented by trade unions, many of whose contracts contained cost of living adjustments (COLAs) designed to automatically raise wages in line with inflation. As a result, what should have been a one-off supply and price shock metamorphized into a protracted wage and price inflation spiral. Between 1972 and 1974, inflation rose from 3.4 per cent to 12.3 per cent.
Six years later, the Iranian revolution took a critical crude supplier offline, dealing the US economy its second body blow in less than a decade. Oil prices shot up more than 200 per cent in 1979 to more than $40/bbl. The “misery index,” a blend of the inflation rate and the unemployment rate, spiked to over 20 per cent in 1980. At the same time, “Made in America” meant shoddy quality. Automobiles rolling off assembly lines in the 1970s were modern-day Edsels that were poorly designed and as unreliable as three-card Monte dealers. Americans had enough. High unemployment, stubborn inflation, a war in Afghanistan and the Iran hostages sent President Jimmy Carter packing and ushered in President Ronald Reagan on the promise of free trade, fewer regulations and a challenge to the sclerotic effects of organized labor. The era of globalization began.
Starting in the early 1980s, the United States and other developed countries embarked on a significant policy shift designed to make their economies more efficient and flexible in withstanding supply shocks. President Reagan’s first test against organized labor came in 1981, when over 12,000 members of the Professional Air Traffic Controllers Organization (PATCO) walked off the job after contract negotiations with the Federal Aviation Administration (FAA) broke down. Reagan ordered them to return to work, and after 48 hours fired those who did not. The move set the stage for President Reagan in the US and Prime Minister Thatcher in the UK to usher in an era of free-market capitalism that included deregulation and globalization, prompting developed market multi-nationals to outsource their production in countries where labor was relatively cheap. The promise of globalization was most elegantly articulated by writer and author Tom Friedman of The New York Times, who argued that engaging our allies and enemies in a unified global supply chain would spawn capitalism and reduce hostilities. Friedman asserted that no two countries with McDonald’s have warred since erecting golden arches in their respective lands.
Over time, globalization had a profound effect on the world economy. Finding manufacturing efficiencies in other countries saved consumers trillions of dollars as the cost of goods declined and quality, in many cases, improved. As production shifted from $20/hour locations to $2/hour locations, nearly 2 billion people were lifted out of abject poverty worldwide. Here at home, however, globalization pulled the rug out from under the developed world’s manufacturing workers by eliminating their means to maintain a middle-class lifestyle. More than 8 million US manufacturing jobs were wiped away between 1980 and 2009. The US job market tilted toward services. In the mid-1970s, manufacturing jobs accounted for about 30 per cent of America’s employment; by 2010, that ratio had been cut in half.
Globalization introduced billions of skilled and unskilled workers in the emerging world to the global labor market, at a fraction of the cost of workers in the developed world. Those savings were split between consumers, who enjoyed often higher-quality goods and more attractive prices, and shareholders, who enjoyed skyrocketing profits. The price of a new automobile, adjusted for inflation, is more than 43 per cent cheaper than it was in 1980, according to Bureau of Labor Statistics data. Services costs, for work that generally couldn’t be outsourced, rose more than 26 per cent relative to inflation over the same period. The favorable blend of restrained inflation and higher productivity helped lower America’s inflation rate from a whopping 12.5 per cent at the end of 1980, to a scant 1.4 per cent by 2020. Today’s 7.9 per cent inflation rate is the highest reading since the early 1980s.
Analysts estimate nearly two billion people worldwide were lifted out of abject poverty as a result of globalization. Per capita GDP in the emerging world, particularly in China, grew. China’s per capita income growth has mushroomed 2500 per cent since 1980 to nearly $17,000. As a reference point, US per capita GDP is about $63,000.
The global income shift came at the expense of the middle class, those, often unionized, Americans who lost their high-paying manufacturing jobs. While retraining was discussed among policymakers, it was never implemented. Incomes have risen incrementally over the last 40 years, although the best pay gravitated toward domestic knowledge jobs (often requiring a college degree or higher), widening the income gap between skilled and unskilled workers. Further exacerbating the divide, outsourcing, cost and production efficiencies as well as low interest rates created an ideal backdrop for risk taking, and returns on capital soared. Between 1978 and 2021, household income expanded 320 per cent, outpacing inflation by 40 percentage points. Meanwhile, capital (defined here as the S&P 500) rocketed 10,259 per cent, creating unprecedented wealth inequality between workers and owners. Between 1983 and 2016, the share of US aggregate wealth among upper-income households rose from 60 per cent to nearly 80 per cent, while the middle-income share fell from 32 per cent to 17 per cent, according to the Pew Research Center.
The post-globalization economy
Economics is a social science whose dynamics are driven by greed, fear, complacency and anger. The hollowing out of the US Rust Belt devastated communities and left many blue-collar workers angry and resentful. Opioid usage skyrocketed, as did deaths of despair. The Centers for Disease Control and Prevention (CDC) recently reported more than 100,000 drug overdose deaths occurred during the 12-month period ending in April 2021, a 28.5 per cent year-on-year increase. Most of the deaths were attributed to the use of synthetic opioids by middle-aged white men.
Candidate Donald Trump tapped into their anger and built a base of supporters favoring turning the clock back to the 1970s. He reached the White House backed by a constituency built on reshoring manufacturing, limiting immigration and distrusting the elites. The profit/compensation pendulum appears to have peaked in 2012 and began swinging toward labor, and the pandemic exacerbated that trend. Lockdowns placed stress on the global supply chain, which led to shortages of everything from critical drugs and advanced semiconductors to masks and swabs. Now, the labor market is among the tightest in history, with 1.7 job current openings for every unemployed American. In the early 1980s, coinciding with President Reagan’s policy initiatives to foster outsourcing, corporate profit relative to worker compensation was at an all-time low. By 2012, globalization had helped push corporate profit relative to worker compensation to an all-time high. That trend has reversed.
After 40 years, many of the benefits of globalization have run their course, as multinationals wrung out most of the benefits of ever-cheaper labor. Now, supply chains are kinked, and Tom Friedman needs to be reminded that both Russia and Ukraine have McDonald’s. But will we be making a large-scale about-face on globalization? Unless sufficient incentives or regulations force employers to re-shore their production back to the United States, we believe corporate America will continue to source production from the most cost-effective locations.
Nonetheless, policymakers understand that strategic industries like advanced semiconductor production, critical medical equipment and pharmaceuticals as well as domestic energy production are in our nation’s strategic interest. Maintaining and encouraging domestic production comes at a cost of higher prices and lower productivity than we’ve enjoyed over the last four decades. Reshoring will help narrow the income gap by raising wages for production work, although we expect employers will increasingly turn to automation to meet domestic production goals when possible. Current job market tightness has undoubtedly strengthened the hand of labor, and pro-union sentiment is reaching new highs. A 2021 Gallup poll found that 68 per cent of Americans approve of unions — the highest rate of approval since 1965. Approval was even higher among the youngest generation of workers, with 77 per cent of adults ages 18-34 saying they approve of unions.
Reversing globalization, even partially, doesn’t mean that inflation escalates. Two strong factors push against higher prices: demographics and innovation. The developed world is aging, and retired households spend less and save more than younger, working families, keeping interest rates incrementally lower. Technology has made price discovery virtually transparent – shoppers can comparison shop on their smartphone while standing in a brick-and-mortar store. Other technology enables us to harness the value of our assets, like homes and automobiles, and tap their value through sharing apps like Airbnb or Uber. Technology is a powerful deflationary force that will continue to battle any inflation headwinds resulting from reshoring.
From an investing perspective, notwithstanding the structural impediments to inflation price spirals, the age of ever-disinflation as a byproduct of globalization is probably behind us because most of the cost benefits on the labor side have been wrung out. We suggest investors consider adding a real asset component to their portfolio mix. Real assets – like commodities and commodity businesses, inflation-protected securities, commercial real estate and equities that tend to move in tandem with inflation – are natural inflation hedges. Investors also need to consider revisiting their emerging market holdings. The changing global trade landscape creates winners and losers. As a result, we recommend investors consider emerging markets active management, rather than exchange-traded funds that passively track the emerging markets index.
From an economic and business perspective, globalization drove decades of growth and profitability with low interest rates and little inflation. Like most economic phenomena, that pendulum swung too far. We expect, and must prepare for, a reversal of sorts, one that, given economics and human nature, will likely swing too far the other way as well.