Reply #7: Global: What Could We Be Missing?

[54anickel]

http://www.morganstanley.com/GEFdata/digests/20040524-mon.html#anchor0

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The more this debate goes on, the more it sounds precisely like that of 1994. Back then, the US economy was just coming out of its first jobless recovery, a desperate Fed was attempting to normalize monetary policy after a then extraordinary accommodation, the dollar was falling, and industrial commodity prices were surging at a 30% annual rate. Sound familiar? It should — it fits today’s script to a tee. But here’s where it gets interesting for financial markets: Back then, a full-blown inflation scare — the scenario that some fear we could be missing — also led to the worst carnage in the modern history of the bond market. Yields on 10-year Treasuries soared by nearly 225 bp from 5.75% in January 1994 to 7.96% in November 1994. If that happens again — and the recent back-up in 10-year yields has already matched about half the sell-off that occurred a decade ago — a more broadly based shock in financial markets could be a distinct possibility.

Ironically, of course, it turned out that the inflation scare of a decade ago was a false alarm. The core CPI, which was running at a 2.9% rate in early 1994, ticked up to 3.1% in the spring of 1995 before trending decisively lower toward 2.25% in late 1997. My guess is that’s exactly what’s in the cards again — an inflation scare that might intensify a bit further but one that ultimately turns out to be another false alarm. The reason — a total absence of labor cost pressures. Labor costs basically define inflation in the US. That’s because worker compensation accounts for about 75% of total business production expenses, about ten times the share going to materials, or commodity, inputs. In retrospect, it was the extraordinary containment of labor costs that kept US inflation at bay in the mid-1990s; gains in unit labor costs averaged only about 1% per annum in 1993–95. Today the comparison is even more extraordinary: Unit labor costs have, in fact, been declining on a year-over-year basis since early 2002 — not increasing as was the case a decade ago — and, as of 1Q04, were still falling at a 1.3% Y-o-Y rate.

As I see the world, labor cost control is likely to remain an overriding characteristic of the macro climate for years to come. The reason: Lacking in meaningful pricing leverage, high-cost producers in countries like the US, Japan, and Europe will continue to fixate on cost cutting. The slight uplift in cyclical pricing leverage to a 2.25% core inflation rate that Dick Berner and others envision for the US over the next couple of years hardly doesn’t diminish that pressure at all. It hardly provides companies with the degree of pricing power they have enjoyed at comparable stages of past cycles. It’s a real stretch, in my view, to even call this pricing leverage. For me, that’s the bottom line on the great inflation debate: The imperatives of cost control are likely to remain unrelenting. In the absence of any meaningful build-up in labor cost pressures, inflation scares are likely to come and go, but inflation, itself, is unlikely to budge.

At the end of the day, that takes us to the biggest difference between today and 1994 — the globalization of inflation and cost control. A decade ago, the world economy was not nearly as open and integrated as it is today. Since 1994, world trade volumes have increased by 42%, well in excess of the 29% increase in world output. But those numbers mask the sea-change in the fabric of globalization — highlighted by rapidly expanding outsourcing platforms in tradable goods (i.e., China) and now in what we used to call nontradables (i.e., India). And the Internet has transformed the means of cross-border economic integration — providing an IT-enabled connectivity that truly revolutionizes the logistics of supply-chain management in global manufacturing but, more importantly, offers a new conduit for the dissemination of the knowledge-based output of offshore services workers. As a result, labor cost control is no longer driven by conditions in domestic labor markets, alone. The global labor arbitrage defines a new context for cost control in an increasingly interconnected world.

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