It’s only May and already it's been a busy year for financial markets and the economy - the biggest items obviously being inflation, the war in Ukraine, and the ongoing COVID pandemic impacting supply chains.
Impacts from the war in Ukraine
When the Russians realized they couldn’t capture Ukraine easily, they pivoted to a civilian infrastructure obliteration strategy. It’s easier to occupy a country when there’s less opposition after the population flees as refugees. This may be an obvious statement, but when you are in a warzone farmers can’t plant. From everything I am reading, this is going to lead to eastern hemisphere food shortages, fertilizer shortages, steel shortages, and more semi-conductor shortages (as of Q4 2021 Ukraine supplied 90% of U.S. semiconductor-grade neon). It seems like it’s just a matter of time before those impacts are really felt. The main thing from this shock is could be an expected 3-4x wheat price increase this fall or winter. As wheat is the main input into bread, we should expect that 3-4x wheat input price change to double the output price of bread. This combined with the fertilizer shortage that we were already in before the war could really impact food costs in Asia, the Middle East, Brazil, and Europe as crop yields suffer1. Abroad, we should expect a lot of political turmoil with the impact of much higher food prices and shortages. The United States is self sufficient for food and energy, but being that these commodities are a world market, we should see price increases here as well. In the U.S. we largely produce our own fertilizer and are a huge net agricultural exporter. The hit here should not be nearly as bad.
Fossil fuel exports from Russia to Germany and the rest of Europe is another big variable to economic activity. Right now, Germany is still funding $1,000,000,000 a day in oil revenue2 via pipelines that go through Ukraine or the Black Sea. If Germany does not stop purchases, Ukraine may destroy that infrastructure to hurt the Russian economy. Consequently, this will also severely impact the German economy with over 40% of their energy is coming from Russia as of now. Besides the human suffering, this is bad for international investment and consumption.
Demographics, Deglobalization, and Inflation
The global demographics have been steadily aging for over 60 years now. This is a byproduct of globalization and industrialization. Once the world became safe and industrialized, people were able to move from the farm to the cities and have less children. On the farm children are needed, while in the city, children are a cost.
One problem with re-industrializing parts of the western hemisphere is that the baby boomers are retiring and the largest concentration of skilled labor in the workforce is going away and will never come back. This will push the price of labor and goods up to meet the demand. This is good for labor in my age cohort, but bad for all consumers wallets. On the bright side, as the baby boomers are leaving the workforce, Generation X and Generation Y (millennials) are in or entering their prime earning years and the world’s largest generation ever, Generation Z, are entering the workforce.3 Most of Generation Z is in emerging markets. If productivity and skill in manufacturing can develop in friendly emerging markets, perhaps a worsening in Chinese relations and demographics can be offset.
Globalization now is reversing. Supply chains are likely going to be reorganized as businesses and nations can’t survive if they are subject to geopolitical machinations that remove crucial elements from their ability to make their products, power their economy, and feed their people. As of May 2022, the Chinese version of the vaccine has proved largely ineffective and China is still practicing a zero-COVID policy. This has brought the world’s biggest manufacturing and shipping centers offline for an undetermined amount of time.4 They may have gotten through the worst of it as authorities in Shanghai have gradually started reopening businesses.5 Nevertheless, there are now whispers of a first time lockdown in the capital of Beijing. This variability makes it tough to participate in a world supply chain. Luckily, the United States got wise to this two years ago and has already started the process of bringing manufacturing back to the western hemisphere. Prepare to see a lot more “made in Mexico” on your goods.
From everything I am reading and listening to, the United States can pull off bringing manufacturing back to the western hemisphere with our NAPFA partners (Canada and Mexico). There should be less disruption in the western hemisphere than the eastern hemisphere for raw materials (which we will be consuming more of the next 5 years). It’s hard to say how long the transition period will be and it will be different sector by sector. Manufacturing will take the longest, but it is also the area that is getting the most prioritization from business and government.
A note on China and Taiwan
Russia’s invasion of Ukraine may have dissuaded China from invading Taiwan. The same sanctions that are only somewhat effective on Russia would decimate China. Russia is energy independent and food independent. On the other hand, China is the world’s largest importer of food and energy. Not only would retaliatory sanctions risk mass starvation in China, the US navy would likely stop all energy shipments from the Middle East and the Chinese economy could be deindustrialized in months. The Chinese Communist Party has a lot to consider if it decided to invade Taiwan now seeing how the world rallied around Ukraine. China thought they could easily take Taiwan and the world would just let it be. Europe’s united front against Russia throws a wrench into over 50 years of Chinese planning.
Long term positives for the United States
- Manufacturing is coming back to North America
- Nothing is threatening the U.S. agricultural system or energy production. The North American economy is writ large self-sufficient.
- The Ukraine war may have dissuaded the Chinese from war with Taiwan.
- The demographics of the United States aren’t amazing for economic growth with an aging population, but automation should pick up the slack production slack. The demographics in the U.S. and Mexico are significantly better than the demographics in rivals Russia and China (remember China old one child policy).
Long term negatives for the United States
- Globalization largely removed military considerations from the table and allowed countries to develop and industrialize in a way the world has never seen before. Deglobalization could reverse some of the peace that globalization brought.
- An aging population/baby boomers retiring means reductions in consumption which will have negative pressure on economic output.
- We now have a top-heavy demography. For the last 10 years this demography has produced a lot of capital as the baby boomers were able to save a lot after their kids have moved out in anticipation of retirement. This means a decline in investment on top of consumption.
With the Fed simultaneously raising interest rates and reducing its balance sheet, we expect volatility to persist in the short to medium term. While the usual ballast in a portfolio, bonds have had a challenging start to the year. This is not all bad, as yields on the aggregate U.S. bond market are about 3.6%, which has doubled since Dec 31.6 Over the medium to long term, opportunity looks immense in the domestic market, and we will continue to be out weighted domestically in our allocations. There has never been a more important time to be looking for value and quality companies to invest in rather than pure indexing.