Globalization is under siege on several fronts. Two years after the outbreak of the COVID-19 pandemic and amid growing geopolitical turmoil, the disinflationary headwind that had raged for decades has reversed. Many multinationals have taken steps to deal with the disruptions associated with their expansive and hyper-optimized but ultimately fragile global value chains.
These institutions are shifting their focus to prioritize availability over cost optimization. This process manifests itself in three ways:
- Regionalization: bringing supply chains closer to key markets.
- Nearshoring: moving supply chains to neighboring production centers.
- Relocation: reversal, in part, of the economic relocation of previous decades.
Inflation is one of the main consequences of these shifts in priorities. Reorganizing remote global manufacturing centers into redundant regional supply chains requires increased capital investment and resource expenditure in everything from logistics to management. Such improvements cost money, and consumers will ultimately pay higher prices in exchange for more reliable supply chains.
Furthermore, the process of globalization and the increasingly efficient allocation of resources over the past decades depend on post-Cold War geopolitical stability. The collapse of the Soviet Union and China’s entry into the World Trade Organization (WTO) allowed cost convergence between formerly segmented commodity and labor markets. This has created disinflationary pressures in advanced economies. In retrospect, the Iron Curtain was an important barrier that impeded the bountiful grain harvests and energy resources of developed economies.
Nevertheless, as cracks develop along geopolitical fault lines, new obstacles could emerge to disrupt global trade. The “peace dividend” of the past 30 years could erode further: blockades, embargoes and conflicts could create costly detours in the supply chain.
A “paradigm shift” in inflation limits monetary policy
Against the backdrop of the Russian-Ukrainian conflict and protracted pandemic-related disruptions, Agustín Carstens, Managing Director of the Bank for International Settlements (BIS), acknowledged that “the structural factors that have kept inflation low in recent decades may fade as globalization recedes.” He continued:
“Looking even further, some of the structural disinflationary winds that have blown so intensely over the past few decades may also be fading. In particular, there are signs that globalization could be in reverse. The pandemic, along with changes in the geopolitical landscape, have already begun to cause companies to rethink the risks of expanding global value chains. And, be that as it may, the increase in global aggregate supply resulting from the entry of some 1.6 billion workers from the former Soviet bloc, China and other EMEs into the labor force effective global scale may not be repeated on such a massive scale for a long time. If the rollback of globalization accelerates, it could help restore some of the pricing power that companies and workers have lost over the past few decades.
In the Carstens framework, a paradigm shift in inflation is also a paradigm shift in monetary policy. Thanks to the disinflationary effects of globalization, major central banks have been given great operational freedom to engage in unconventional monetary easing – money printing. Renewed inflationary pressures could reverse this dynamic. Rather than applying quantitative easing (QE) in response to virtually all downside shocks, central bankers should calibrate future support to avoid exacerbating price pressure.
Yield curves predict monetary policy rather than recession
Despite these changing circumstances, the European Central Bank (ECB) and the US Federal Reserve maintained policies of interest rate suppression well beyond the supply-driven spike in inflation. The ECB’s monthly bond purchases totaled €52 billion in March 2022, as the harmonized index of consumer prices (HICP) for the euro area reached 7.5% year-on-year (YoY). While the Fed slowed QE flows in February, personal consumption expenditure (PCE) was already at 6.4% year-on-year. Despite QE’s role in suppressing long-term bond yields, ECB purchases in 2022 will fall to 40 billion euros in April, 30 billion euros in May and 20 billion euros in Junebefore stopping “some time” later.
ECB Asset Purchase Program (APP) and Pandemic Emergency Purchase Program (PEPP)
Quantitative easing programs have anchored global long-term interest rates and the co-movement between European and US long-term yields. Lael Brainard of the Fed Board of Governors acknowledged the ability of foreign QE to lower long-term US bond yields. Thus, expectations of short-term Fed rate hikes as part of ongoing foreign QE contributed to the inversion of the 5-30 year US Treasury yield curve.
Vineer Bhansali, CIO of Long tail alpha and author of The Incredible Upside Down Market in Fixed Income, also noted how politics affects the yield curve. Since central banks can influence all points on the curve through QE, the The shape of the yield curve reflects the political outlook rather than the likelihood of a recession. As Bhansali said:
“The first and most important signal that the Fed has distorted is the shape of the yield curve. Yield curve inversions, in particular, are well known to market participants as a reasonably good predictor of recessions. Historically Right now the Fed has so many Treasuries that it has the power to make the yield curve shape whatever it wants it to be.
To add to Bhansali’s framework, an inverted yield curve incorporates the expectation that rate hikes will slow the economy as inflation declines and turbulence subsides, freeing central banks from political constraints – a convergence to the pre-2020 “old normal” – which would lower the hurdle of renewed QE to remove long-dated yields.
Conversely, an inflation regime shift propelled by a more fractured world with scarcity-induced reflation requires a reversal of balance sheet expansion or quantitative tightening. The Fed’s guidance on how it would unwind its balance sheet — at $95 billion a month — exceeded the expectations of many bond brokers.
Fed balance sheet unwinding scenarios, pace instead of change in composition
Expansive supply chains drive inflation (and politics)
As geopolitical instability disrupts the once efficient allocation of resources, the relative peace and prosperity of the past 30 years is reassessed. Could the absence of great power rivalries in recent decades be the exception rather than the rule? And if the atmosphere deteriorates further, what will that mean for today’s globalized value chains?
This framework suggests the potential for supply-driven inflation rather than disinflation. Further unrest could fuel a process of de-globalization of regionalization and supply chain retrenchment that would spur inflation. Still, a less expansive supply chain may benefit from re-expansion once the disruptions end and inflation subsides.
In market terms, current bond yields in developed countries cannot fully compensate investors if markets become more fragmented. Carstens’ theory of a paradigm shift in inflation leading to a paradigm shift in monetary policy implies significant risks for long-dated bonds assuming a deterioration in the geopolitical outlook and further disruptions to the currency chain. supply.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
Image credit: ©Getty Images / Thomas-Soellner
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