By Tim Courtney, Chief Investment Officer
The process of bringing a product from its beginnings to the hands of a consumer is complex, but for many years, the process worked so efficiently that we took it for granted. That is changing as problems have multiplied since the pandemic. The Red Sea, a vital route for international trade, is experiencing disruptions as attacks on shipping companies have affected a major trading artery, putting ships at risk and impacting the flow of goods.1 Simultaneously, on the other side of the world, a severe drought has limited the water supply needed to operate the Panama Canal Authority, causing cargo delays in another one of the world’s leading trading passages.2 These challenges are raising concerns about the reliability and efficiency of global trade routes.
Over the past several decades, the United States has heavily relied on outsourcing for supply chain and production, with the military safeguarding shipping lanes. This model worked well, keeping inflation low (roughly around 1.5% on average)3 and trade flowing smoothly. However, the challenges abroad combined with labor shortages in the United States and a heightened regulatory environment worldwide are making it harder to maintain the status quo. The outsourcing to cheaper countries is facing increasing complexity and unreliability, and companies are reconsidering their supply chain strategies. Many are opting to bring production closer to home in the United States, Mexico or Canada.4
Moving production away from lower-cost areas to higher-cost locations is likely to be inflationary. Further, the market continues to be more heavily focused on solving digital problems over physical ones. Capital has poured into digital assets and solutions while physical infrastructure (i.e., everything that it takes to move energy, goods and agriculture around the world), including roads, bridges, ports and energy, are relatively neglected. This disconnect also raises concerns about potential inflation; the costs associated with upgrading and securing physical infrastructure are inflationary. The transition to electric vehicles, for example, will require the creation of additional physical infrastructure and more labor.
For several decades we got used to inflation at a little under 2%.5 The market today also expects inflation to head in that direction. Based on bond prices, the market is pricing in an inflation expectation of 2.25% over the next decade.6 However there are so many variables changing today it is not at all clear that we’re headed back to what we were, up until recently, so accustomed to. No doubt markets and innovation will work as forces to pull prices lower. But other forces are working in the opposite direction, and it is probably premature to declare victory over inflation as some did in December.7 This risk remains, uncertainty is higher than it was before the pandemic, and portfolios should still be structured to hedge inflation risk. If you have any questions, don’t hesitate to contact your Exencial advisor.
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