Easily Broken
Stephen Hawking famously declared the 21st century as the century of complexity. This complexity can be easily seen and felt through the lens of globalisation. When the idea of globalisation was initially introduced, it promised to grow the pie for everyone –this confident narrative endorsed free trade as a win-win scenario that could create prosperity for all. For the past three decades, globalisation has been an unstoppable force – taking the world economy from connected to hyper-connected and from interconnected to now interdependent.
To specialise and build scale, supply chains have lengthened and have become extremely complex. It is very difficult for a single company to produce all components of a final product by itself. For instance, automakers are not capable of manufacturing touchscreen displays and microprocessors that control the functioning of a car. A more specific example is the business of BHP; which spans across 60 countries and 10,000 partners with an annual spend of $US20 billion. The company sources 215,000 different types of material and equipment for its Australian operations alone.
Modern supply chains are built on the foundations of efficiency and specialisation which has proven to be a fragile model as exposed by the Covid-19 pandemic. Specialisation is more efficient – but also less flexible and open to unforeseen vulnerabilities. For years, industrial production has been outsourced to Asia – particularly China, which is considered as the global factory of the world. Disruption to manufacturing in China is felt throughout the world.
While the concentration of production has its part to play in the supply bottlenecks, there are bigger factors at play here – supply and demand mismatches. In a faster than expected recovery from the pandemic, many producers found themselves flatfooted and unable to meet the pent-up demand.
Production down and demand up is an awful combination as reflected in the parabolic moves in the prices of shipping containers, food, oil, and metals.
The upward tear in commodity prices has caused consumer price inflation to increase rapidly around the world. The elevated inflation is not only a consequence of supply blockages but also the very strong demand outstripping those shortages.
The topic of whether inflation is structural or transitory is being debated relentlessly across the globe. Here’s what International Monetary Fund (IMF) and US federal reserve (Fed) are saying:
“We project, amid high uncertainty, that headline inflation will likely return to pre-pandemic levels by mid-2022 for the group of advanced economies and emerging and developing economies.” – IMF
“Inflation is elevated, largely reflecting factors that are expected to be transitory.” – Fed
We observe that the IMF expects the inflation to persist until next year while the Fed has changed its stance from “transitory” to “expected to be transitory”, emphasising the confidence in transitory inflation has been diminished. The increased uncertainty about the outlook for inflation has led to a significant rise in the risk premium and in the volatility of bonds in the past few months.
Regardless of whether inflation is transitory or not, we believe the portfolios should include some protection against a high inflation scenario; because if inflation were to remain persistent for a long period of time, it would become a headwind for the financial markets – both equity and bond markets. Accordingly, the asset allocation and security selection need to reflect the wide range of possibilities in the year ahead.
