Global Rebalancing Will Come, But With Stagflation

by: Arun Motianey

Policies in the emerging world are exerting a more potent influence on developed economies than is commonly understood. In fact, the fate of the latter will be ruled by little else. This may seem a bold - even foolish - assertion at a time when our obsession with fiscal tidiness is all-consuming. Yet unsustainable sovereign debt is just a piece of a much larger tableau. Policymakers will soon need to coordinate their responses to a danger coming from an unusual source. This danger will present more than a quandary for monetary authorities; it threatens severe social and political upheaval in our countries. Yet the major central banks of the world scarcely see it as a threat - let alone have an intellectual framework to address it when it lands on their laps.

The smug self-satisfaction of the U.S. Fed that its aggressively accommodative methods have averted a collapse into deflation while its reputation as an inflation-fighter, painstakingly built up over the last thirty years, has anchored inflation expectations at a comfortable level will be seen to be premature. The conduct of monetary policy in the major emerging economies, too late to be corrected now without a crash landing, has already given goods prices a powerful undertow and this global lift is seeping into the developed economies. For all the talk of slack in labor markets core inflation is on the move and the direction is up.

We do not need to debate here the causes of recent food and energy inflation that have driven up headline inflation around the world. It is indisputable that a combination of zero-cost money and large asset purchase programs in the crisis-afflicted advanced economies, notably the U.S., U.K. and Japan, has radically reshuffled the composition of investor portfolios by soaking up their holdings of government and other risk-free securities, and forcing them further along the risk continuum. Not surprisingly, these policies have played a central role in generating commodity price inflation. It is not the real story though. How the emerging and advanced economies are each responding to rising headline inflation in their different and contradictory ways is where the danger lies.

Rising non-core inflation shrinks real disposable income all else equal. But the developing economies - whatever exchange-rate policies they may have followed, whether flexible like so much of Latin America or less so as in parts of Asia - have accommodated the rise in headline inflation and allowed it to pass into wages. A wage-inflation spiral is now under way as policymakers in these economies fell prey to a we-are-different kind of thinking foisted on them by the usual culprits - bankers and analysts working in financial institutions - whose job it is to conjure up animal spirits.

The story of these economies is little more than a story of capital fleeing the developed world and seeking safe harbor from interventionist western governments. The rest - about their being the new economic supertankers that will not be blown off course as gale force winds whip the advanced economies around - is just the usual drivel, cooked up by the financial markets. The governments of the emerging economies have been taken in by this nonsense. Rising real wages in the emerging economies have thus kept discretionary spending growing at high rates, and have led to a rise in goods inflation and the second-round effects of rising energy prices on transport costs.

The rearguard action mounted by the central banks of Brazil or Chile or India or China (to name just four) will prove to be ineffectual. The fear of dashing expectations of a growing and politically powerful middle class will stay their hand until the problem becomes so intractable that a "Volcker treatment" becomes unavoidable. But that is some distance away.

The advanced economies, such as the U.S. and U.K., brought to their knees by the wrecking ball of the recent financial crisis have despite their unorthodox monetary policies experienced drops in real disposable income. Here rising food and energy prices and stagnant nominal wages of the employed - not to mention the huge armies of the unemployed - exerted a contractionary effect on discretionary spending. Inflation fell rapidly after the crisis. No longer: Core consumer prices have started to rise in these sagging economies and core goods prices even more so. It began in the eurozone in mid-2010 and has appeared in the U.S. economy since the start of this year. Even in the U.K., where the picture is muddied by administered price increases, core goods inflation is now sticking. Goods after all are tradables and their prices respond to global demand.

This is where the two forces collide. The wage-price spiral in the emerging economies is likely to keep commodity and goods prices rising, but weak real labor income in the advanced economies will work in the other direction. If, as I believe is the case, the push-up in the prices of tradables resulting from demand in the emerging economies will prove stronger than the pull-down in the developed world, we should be prepared for a long-drawn out period of stagflation in the latter. Rising goods prices will have to be absorbed by workers in the face of weak bargaining power who will now have to confront falling real wages at a time when they are still deleveraging their balance sheets. The investment implications in this sort of environment fall out cleanly: sharp rallies in hard (ETF: DBB) and soft (DBA, USO) commodities (DBC, DJP) as well as in their equity counterparts, the natural resource sectors (MOO, IGE, XME) and much more upside to that investment of choice, gold (NYSEARCA:GLD).

How will this all end?

Although inflation will rise everywhere, inflation differentials between the two groups of economies (higher in the emerging, lower in developed), adding to the big moves in nominal exchange rates that have already occurred in places like Brazil, Colombia, South Africa and Singapore, - will correct exchange rates in real terms, and this should eventually benefit the stricken advanced economies. But the key word is "eventually"; the process will be slow and painful. The risk that electorates will lack the patience to endure such a gradual rebalancing means that the rise of populist politics in many of these economies leading to widespread protectionism cannot be dismissed. Powerful corporate interests who thrive in an environment where domestic labor costs are repressed and supply chains are global will of course endeavor to neutralize such forces. The recent ructions in Washington are just a hint of the social and political disorder that I expect will engulf much of the global economy in the years to come.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.