The Dichotomy of Capital & Labour

Published 20th of July 2021

The action once again this week was centred around the bond market, with yields continuing their plunge lower despite a massive CPI print for June coming in at 5.4% YoY. Whilst a vast majority of the CPI increase was caused by sectors which have been heavily impacted by supply chain disruptions, the food price increases amongst other things was a sign that perhaps inflation will be stickier then the Fed is hoping for.

Much has been made of the divergence between yields and inflation, the bond market is usually viewed as being one step ahead so a top level read might assume that the transitory view is correct. Jeffrey Gundlach, CEO of DoubleLine Capital, put forward an alternate view this week. He thought that yields were signalling that the Fed was going to be forced to react to inflation and tighten monetary conditions, which has been reflected in rising short term rates. Doing so would directly hamper growth prospects and likely cause another recession, so the Fed is truly caught between a rock and a hard place as it tries to balance the recovery with inflationary pressures. Of course the emergence of the Delta variant is souring the recovery outlook as well as a slowing Chinese economy.

The idea that cutting rates and printing lots of money will lead to inflation has never really resonated with me, mainly because developed economies have done just that since the GFC and inflation has never taken off. So what would cause this time to be different? Russell Clark from Russell Clark Investment Management did a piece on this recently which highlighted the importance of both politics and wages in driving inflationary outcomes.

Between 1938-1979 the US Federal minimum wage rose over 13 times but has barely budged since 1980. Globalist policies, corporate de-regulation and currency devaluations have all been key drivers and reflect a framework in which institutions have favoured capital over labour. When central banks implement rate cuts & QE, not only does it reduce the real wages of workers, it also has spurred tremendous financial asset price inflation which has seen a lot of millennials and Gen Z’ers feel priced out of the market, particularly in housing. These income inequality pressures have only been growing over the last decade and have been spilling over into greater social unrest which has been visible across much of the globe.   

In terms of global capital flows, Russell highlights an important dynamic that has been at play for much of the last few decades, centred around Japan. Essentially, Japan has substantial amounts of domestic savings which are tied up in their pension fund system. Given the very low level of rates in Japan, this giant pool of capital is invested abroad which pushes up financial asset values in other parts of the world, particularly in emerging markets. When cyclical downturns would occur, and the currency of that country that they had invested in starts to devalue, Japan would accelerate the deprecation by repatriating their capital back, sending Japanese yields lower. This dynamic has played out many times, such as in the US post GFC, during the Eurozone crisis and the mini EM crisis in 2015/16, and those with knowledge of capital flows have been able to profit from it.

Since 2016 however, this dynamic hasn’t held. Japan repatriated capital from China as the Yuan started to devalue, however the Chinese didn’t actually end up devaluing. If they had done so would have benefited from greater export competitiveness, however not de-valuing perhaps signalled that China recognized the need to look out for its labour force. The Brexit vote & Trump election in 2016 also reinforced this idea. The major swing voters in both votes were from the rust belt areas of England & America, citizens who have been left behind by the globalist system which has dominated since 1980.

This notion that institutions and policy shifts ultimately drive where returns are is an interesting framework to think about given the current political landscape. The pandemic may well have been the peak of globalization as it highlighted the vulnerabilities of global supply chains. The political winds seem to be changing as governments globally embark on massive fiscal infrastructure programs and bringing essential industries back onshore, all of which require large amounts of labour. Finally, anti-trust measures are only accelerating and the theme of returning value to shareholders, which has dominated the last 30 years, may be shifting to increasing stakeholder value.

So, if governments are now looking to reduce corporate power, reduce inequality and raise wages, you should see inflation & yields move higher and growth stocks underperform. Of course none of this is conclusive, but there are enough signs that it is beginning to happen so it is worth tracking. Just last week Blackrock CEO Larry Fink increased the base salaries for all staff at the director level and below by 8%. He said ‘Companies are focusing on their employees more, and I do believe you’re going to see more wage growth that will be above trend line’. Blackrock isn’t alone, McDonald’s, Chipotle & Shake Shack all announced last month that they would be raising average raises to $15/hour.

Keep this idea in mind as we move forward, I do not believe in continued inflation without sustained wage increases