June 13, 2023 | Podcast
Taking an Economic Pulse

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Every decade brings a different economic environment. What’s set to impact the 2020s? In this episode of The Active Share, join Hugo and Olga Bitel, partner and global strategist for William Blair Investment Management, for a wide-ranging discussion of what’s driving the U.S. and global economies, including inflation, recession risk, productivity, geopolitics, and interest rates.

Comments are edited excerpts from our podcast, which you can listen to in full below.

With recent convulsions in the U.S. banking sector, has the U.S. economy’s credit pulse diminished, or has the Federal Reserve’s (Fed) response been enough to soften the rising risk of recession?

Olga Bitel: The short answer to your question is, yes to both. We’re monitoring what has happened in the banking system, and the impact of it on near-term economic activity in the U.S. and more broadly, in two ways. The first is the weekly change in aggregate bank lending. So, this is the volume of lending and money that goes out to support real economic activity.

We see that has decelerated slightly, but we’re still above pre-COVID trends. The price of that credit has gone up, which is what the Fed would like to happen. They are raising rates. That should dampen economic activity.

The second deals more explicitly with how the Fed is addressing liquidity challenges in the banking sector and has to do with the Fed’s aggregate balance sheet. It’s expanding again. The amount of money available to support economic activity is now growing.

And if that dual policy persists—keeping rates where they are and/or marginally raising them from here, together with providing liquidity to the banking sector—it should see us through with no recession.

But does that cease to be true once the Fed deems this crisis averted? Do they then begin shrinking the balance sheet again?

Olga: We are jumping a little bit ahead of ourselves. We need to navigate the muddy waters until the disinflationary trend that we’re observing is more firmly established.

With less inflationary pressure, there should be more support for incomes, and therefore, more spending and less for the Fed to do—i.e., expanding the balance sheet to support real and financial markets.

However, whether the Fed will choose to continue shrinking its balance sheet remains to be seen. There are multiple ways to do this, and not all these ways are necessarily bad for financial assets.

What do you think is happening with the major drivers of inflation?

Olga: From our vantage point, we’ve separated the overall inflationary pressures into four sources: energy, goods, services, and housing.

I think inflation from energy in the near term was well flagged. This time last year, we were all quite scared by the prospect of an energy availability crisis, particularly in Europe where natural gas prices went up, dragging oil prices up with them.

That created significant inflationary pressure from energy. Energy is critical to everything we produce and consume, and that proliferated throughout our economy in a significant way.

If that dual policy persists—keeping rates where they are and/or marginally raising them from here, together with providing liquidity to the banking sector—it should see us through with no recession.

The second component is goods. Goods prices, because of globalization and some other factors, have been in a long-term deflationary trend for roughly two decades.

But COVID interrupted that trend. We saw significant supply chain pressures, difficulties in procuring goods at almost any price, and increased demand from consumers, all of which pushed up inflationary pressures on goods.

While that part of the story is largely behind us, what is not yet firmly established is the deflationary trend in goods. Year-over-year, goods prices are dis-inflating, but that rate of change is still positive. Consumers are still feeling higher prices, which will hopefully reverse in a sustainable way in the coming months.

Services inflation in the U.S. has run at about a 3% clip for much of the last two to three decades. We expect that trend to persist. Services inflation is significantly higher now, but it is dis-inflating at a much slower pace. We expect services inflation to continue to be positive.

The single biggest component is housing. Post-COVID, many of us rushed to change places of residence, which created a near-term supply shock. Restrictions on rent increases created a double supply shock. Both rent and housing-price inflation in the United States in 2021 and 2022 rose sharply to rates of growth we haven’t seen in a very long time.

Both components have now decelerated to something much more modest, and we expect the disinflationary trend to accelerate as we go into summer.

But in the medium term, there are some inflationary pressures brewing, specifically in energy and the move away from fossil fuels. Are you too sanguine about energy?

Olga: What you’re proposing hinges on the assumption that we’ve underinvested traditional fossil fuel sources in our bid for cleaner energy. And therefore, we’re in this no man’s land during the transition, where clean energy isn’t available at prices we like and lacks abundance.

The thesis of underinvestment in fossil fuels does not hold water up close. If we look at the volume of rigs that are currently opening and operating, we can see that there are about a third fewer rigs today than we averaged between 2012 and 2020.

That suggests a significant decline in our fossil fuel production capacity. But at the same time, both crude and natural gas volumes are higher than their 2019 peak, which suggests that there is a non-negligible productivity gain on a per-rig basis.

I think we can navigate the transition from fossil fuels to cleaner energy with significantly fewer disruptions and impetus for higher inflation from the energy sector.

Across the world, we’ve seen no evidence that there has been a systematic underinvestment in fossil fuel energy to curtail production in a meaningful way. Because of geopolitical tension, we’ve seen the need to transport energy differently.

Europe, for example, will no longer be able to rely on the cheapest form of natural gas, which comes directly via a pipeline. Instead, they’ll have to rely on liquified natural gas, which is transported from places like Qatar and the United States via expensive tankers.

I hear you on the challenges in the energy space. But I think those challenges are overstated. I think we can navigate the transition from fossil fuels to cleaner energy with significantly fewer disruptions and impetus for higher inflation from the energy sector. The politics of this transition are another matter.

You could argue that goods disinflation is gone because geopolitics have changed the world.

Olga: When we talk about goods prices—and specifically goods inflation or disinflation in the medium term—we can’t escape the discussion of potential deglobalization.

I would also like to make a distinction between deglobalization and decoupling. We’re all aware of the political tensions between the United States and China, which arguably will result in some form of decoupling.

I think making our aggregate supply chains more resilient argues for more globalization, rather than less. If you’re a producer of a particular good that’s overly reliant on all your supply, whether it’s because labor costs are cheap or transportation links are excellent, you may choose to diversify and have your supply be spread out across several jurisdictions.

We are witnessing incremental, on-the-margin moves just along those lines. Some companies are choosing to locate their new production in places like India rather than China. That diversification of production centers can go to Mexico or other places in Latin America as well.

Overall, if technology continues to proliferate and make our transport more efficient, our energy cheaper, our products better, those are still overwhelmingly disinflationary, if not outwardly deflationary, trends. In the medium term, I don’t think we’ll see a sharp reversal in those trends.

Are rent and services inflation both wrapped up in demographics?

Olga: Since around 2008, the fertility rate in the United States has plummeted from just north of 2%, which is about the replacement rate, to somewhere south of 1.7%. And around 2011 or 2012, we saw a vast increase in the cohort of the U.S. population that is 65 years of age and older.

We’ve lived with both adverse demographic trends for about 15 years, yet if we look at the inflationary outcome over that period, we have lower inflation, not higher inflation.

If technology continues to proliferate and make our transport more efficient, our energy cheaper, our products better, those are still overwhelmingly disinflationary, if not outwardly deflationary, trends.

Japan is a poster child for the same phenomenon, experiencing a remarkable rise in the aging population with very low fertility rates, and its population is outright declining. But inflationary pressures in Japan over the last decade and a half are nowhere to be seen.

All this is to suggest that I think our understanding of how demographics plays into inflationary outcomes remains rather incomplete for my liking.

In response to the inflation we’ve seen in the last few years, do you think we’ll see an improvement in productivity?

Olga: That’s the multitrillion-dollar question. Productivity is devilishly difficult to measure. We don’t have a good handle on it, and we don’t observe it in real time. I prefer to focus on actual economic growth, which is a good proxy for underlying productivity growth.

The key question from my vantage point is, why has observed growth over the past decade and a half been remarkably low?

I tend to focus on two things, both of which have had a profound impact on overall economic growth.

The first is the change in the interpretation of the antitrust laws in the United States, and more broadly in Organization for Economic Co-operation and Development (OECD) economies, that occurred in the mid-1980s. A pronounced and significant concentration within industries to form monopolistic or oligopolistic structures occurred. And in those structures, there was little need to invest for growth. Dominant firms simply bought out a lot of their competitors.

Dominant firms are of great interest to investors because in the short term, cash-flow generation is extraordinarily strong. Unfortunately, that also comes with meaningful deceleration in economic growth over a longer time horizon.

And so, the willingness and need and ability to innovate economically decreased. This was not just in the United States. It was on both sides of the Atlantic and to a lesser extent in Japan.

Productivity is devilishly difficult to measure.

The second point, which is concurrent with the first, is the fiscal restraint propagated by the Washington Consensus. The prevailing wisdom has been for governments to curtail fiscal spending. Governments are famously imprudent. The downside has not been less imprudent spending but dramatic cuts in public-sector investment.

Public sector investment is critical to creating new technologies, new products, new ways of doing things at the highest risk-taking level where the payouts are very uncertain.

But before the private sector can take a new technology and commercialize it, there’s often decades of scientific rigor. Breakthroughs are required. And that’s the part that we have consistently underinvested in for several decades.

The change in the interpretation of antitrust laws, together with limited or significantly reduced public-sector investment in new endeavors, has really put a damper on the pace with which we can innovate, and therefore ultimately grow.

Does that leave you a little pessimistic about productivity?

Olga: On the contrary. If we identify correctly why we’ve had lackluster growth, we can change the two things I mentioned. These are things that don’t require massive technological breakthroughs.

This is a more optimistic solution or prescription. And to the extent that we as societies can change these things on the margin, that could enable us to have faster growth in the years and decades down the road.

Your overall prognosis for inflation, and therefore interest rates, is quite benign and presents a positive backdrop for equities and similar asset types. Is that a fair summary?

Olga: That’s very much a fair summary, with the caveat being geopolitical developments can completely upset this otherwise rosy forecast.

The other important caveat I would like to throw in there is if we maintain a real rate—an inflation-adjusted interest rate—in developed economies of somewhere between 1% and 1.5%, it could lead to an optimized outcome from an interest-rate-policy perspective.

Olga Bitel, partner, is a global strategist on William Blair’s global equity team.

Hugo ScottGall, partner, is a portfolio manager and co-director of research on William Blair’s global equity team.

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