Regime Change: The Rebirth of Inflation
These developments may prove to be historic. We believe last year’s market convulsions probably reflected the birth pangs of a new regime characterized by persistently higher inflation and interest rates, and potentially lower market returns. Investors will need to rethink how to position their portfolios and allocations to generate real returns above the inflation rate.
But how did we get here?
Since the 1980s, the global economy and markets have been defined by falling inflation and real interest rates. These conditions were driven by demographics, accelerated globalization, technological progress and the adoption of pro-shareholder values in developed markets.
China’s growing integration into the world economy fostered globalized supply chains. Companies everywhere tapped China’s cheap labor force and manufacturing prowess, which enabled the cheaper production of goods in many industries. Favorable demographics helped the global workforce expand to record proportions. The technological revolution boosted productivity and supported a leap in corporate profitability. At the same time, Western governments and policymakers became increasingly supportive of shareholder values. Inflation and interest rates gradually fell.
When calamity struck, policy reactions often reinforced these trends. For example, after the global financial crisis in 2008, anemic growth in the US, Europe and Japan led to quantitative easing (QE) and ultralow interest rates. Yet inflation was absent, which fostered a growing belief that it may have been conquered forever.
Pandemic Policies Were a Turning Point
That belief guided policy during the coronavirus pandemic, as central banks pushed interest rates to rock-bottom levels and accelerated QE. Governments delivered mammoth fiscal packages to help keep economies afloat through the massive shock to business activity.
Those days are over. When the economic history of the pandemic is written, it will be seen as the catalyst for changes that were bubbling beneath the surface for years. Populist politics were already threatening globalization and the Chinese workforce was aging. Now, massive capital injections into financial markets and unprecedented supply chain disruptions have pushed inflationary pressures to the boiling point.
Profitability to Come Under Pressure
Changing inflationary forces affect profitability in many ways. Global supply chains allowed companies to maintain smaller inventories. Cheaper labor helped curb expenses, and taxes were low. This was a recipe for companies to boost margins—and returns—often without solid underlying business fundamentals.
Companies will need to learn to live without such support. Expect corporate tax rates to rise as deglobalization hinders companies’ ability to operate in the most tax-efficient locations, and as campaigns for social fairness spread. Deglobalization will require higher inventory levels, which tends to lead to lower profit margins, according to our research. Increased labor power suggests that high wage costs might not come down soon. Meanwhile, the energy transition adds inflationary ingredients that will also erode profitability. The US corporate profit share of GDP was a near record 12.2% in June 2022. That now looks unsustainable.
To be sure, there are strong countervailing winds, most importantly, technology and innovation. Robotics, the Internet of Things and technology-enabled infrastructure will unlock efficiencies to help control costs. Innovative companies that tap into these technologies ahead of competitors will enjoy competitive advantages.
Markets Look Very Different Today
History may not be a good guide to this future. Today’s markets look very different from those of the inflationary 1970s and 1980s. For example, since 1980, technology stocks have more than tripled their weights in the MSCI World, and account for 24% the index, respectively (Display). Many of today’s tech and new media giants didn’t exist the last time we faced inflation, so we don’t know how their businesses will fare. The dominance of energy companies in global and US stock indices has diminished. Just as the corporate powers of yesterday have receded, we believe that tomorrow’s winners could be very different from those in the recent and more distant past.