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June 2017 | Macro Insights

The Longer-Term View - Secular Reflation

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We believe the balance of secular drivers over the next several years is inflationary, as a range of factors that have suppressed prices over the past decade are reaching inflection points. However, Portfolio Managers Alex Stiles and Steve Becker see two exceptions that are relevant to our investment strategies: deflationary pressure will linger as the workforce in services expands and as technological disruptions spur competition

Which structural factors do you see transitioning from deflationary to inflationary drivers?

Stiles: Several factors that have helped contain price pressures over the past decade or longer may be starting to reverse, in our view. We would highlight three that are at, or getting closer to, inflection points: labor supply, income distribution between capital and labor, and globalization.

What are the catalysts for transition?

Stiles: One key inflection point is full employment. As oversupply in the labor market is absorbed, workers have more bargaining power and wages should rise, boosting inflation. The current slow evolution of wage growth despite the tightness of labor markets challenges this view (see Focus, p.4-5), but we believe the relationship is intact and will assert itself first in the US. In turn, rising wages should start to correct the skew of income distribution from holders of capital—investors and savers—in favor of workers, who have a higher propensity to spend.

As for globalization, we believe this trend has already peaked. The global spread of supply chains over recent decades has been a powerful disinflationary force, but companies are no longer pushing as aggressively offshore to rationalize costs. The rise of protectionist policies in the US and the potential knock-on effects could catalyze onshoring, and drive up production costs and prices of imported goods.

How are labor markets reinforcing your expectation for continued policy easing and low rates in Europe?

Stiles: One of the biggest long-term drags on wage growth is the skew in job creation from manufacturing to the lower-paid services sector. The momentum behind the expansion of the services sector may be past its peak, but the deflationary effects will persist as manufacturing workers retire over the next decade. These effects are particularly pronounced in the euro area where unemployment remains high, but even in Germany’s tight labor markets we see headwinds to wage growth, as a function of both demographics and geography (see Roundtable).

German Job Creation is Skewed To Services

German-job-creation-is-skewed-to-services

Source: Destatis, Haver Analytics, as of 2016.


Turning to Steve, how do you see technological disruption exerting deflationary pressure over the longer term?

Becker: Today’s technological advances are putting power in the hands of consumers. A key component of pricing power is price transparency, and shoppers can now compare prices of just about any goods and services in real time. Stores are incentivized to price competitively because they know their consumers are not only price-conscious, but price-aware. Moreover, more brands are using technology to sell directly to consumers, which takes out a layer of mark-ups.

Which sectors do you think are most exposed to technological disruption?

Becker: The power of the online model and the risks posed by insurgent companies are most obvious in the retail and media sectors. For instance, the rise of online shaving clubs has forced the world’s largest consumer product company to cut prices on some of its products by more than 10%. Meanwhile, cord cutting poses a threat to the cable giants, as media companies can assemble a good portfolio of channels in over-the-top bundles at substantial discounts.

The next frontier for disruption is food. Retailers are vying with internet giants to create 'smart' grocery stores, allowing customers to buy online or simply 'grab and go' in stores, bypassing the checkout. This technology could drive grocery prices down, and would be a major advantage in the competition for share of a huge market.

How does this evolution affect your investment strategy?

We take a two-sided approach. On the defensive side, we avoid exposure to legacy players who may be targets for emerging disruptors. Ultimately we expect the retail sector will navigate this transition as business models will adapt, but some attrition and consolidation is likely—this year has already seen nine retail bankruptcies in the US.

On the offense, we see more dispersion of performance as business models and supply chains will have to change, increasing the range of outcomes. This is a stock picker’s environment. We look for companies that are leading in or adapting quickly to the online space, as marketing directly to consumers can enhance margins. The disruptors themselves can thrive in this deflationary habitat, as online companies with lower overheads are proving their ability to undercut more-established brands and capture market share.

About the Authors

Steve Becker

Steve Becker

Large-Cap Growth Equity Strategies
Alex Stiles

Alex Stiles

Portfolio Manager, Fixed Income Duration and Country Strategies, Goldman Sachs Asset Management

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