Inflation? Blame this guy.

October 15, 2021

So we wanted to begin exploring a topic that’s been percolating in our minds.  Previously it was just a jumble of string diagrams on a wall, but we’re beginning to put things in their place to at least get a mosaic of what we think is going on.  Here goes . . . . inflation? Blame this guy.

Let’s explain.

All Roads Lead to China

As we’re watching commodity and energy prices bound higher like a weightless Capt. Kirk, we’re also seeing commentators argue that this piece of inflation is transitory, that energy prices have climbed too high and too fast for it to be sustainable. What if it’s not? What if it’s just the beginning of a repricing?

What if COVID, instead of the cause for the shortages, was actually the catalyst that sets off a decade of inflation in the making, one that was inevitable to begin with and will be a mirror image of the deflationary decade we’ve had in the 2010s. Why? Because of this.

For nearly a decade, almost 20M Chinese went from the farmlands to the city in search of work every year. The tsunami of urbanization and shift in demographics led to an overwhelming abundance of cheap labor. We all know the story of globalization as the inexpensive and abundant labor attracted multinationals eager to lower their costs and increase profit margins. Businesses cut out the expensive middle-man (i.e., labor) and outsourced then directly to China, and dropped shipped the profits directly back to the US (S&P profit margin).

In turn, the cheap labor and economic development spurred a flywheel of industrial activity in China. Lax enforcement of environmental regulations and higher demand also meant cheap labor could produce cheap energy (via coal mining). In turn, cheap energy led to massive increases in the production of energy intensive commodities (i.e., steel, aluminum, etc.).

Now this flywheel continued to function relatively smoothly until a few years ago when China’s economic development reached a tipping point. First, as the population grew wealthier, it expected more. Rising expectations meant the CCP now needed to “up its game,” as quantity of life shifted to quality of life.

Second, with the explosion of growth, China’s geopolitical and economic clout/ambitions became an increasing threat to the West. No longer a developing country, China had developed, and began asserting itself on the world stage. Kings already sitting on the global stage didn’t take particularly well to the new challenger, so clashing views inevitably led to trade wars and geopolitical friction. Still everyone needed each other, which led to a detente and faux trade agreements. Before any real resolution occurred, however, COVID struck and halted everything. So for a year, the world froze. First China did nothing . . . then the world.

COVID the Catalyst

Now let’s go back to the first point, quality of life. China’s Communist Party receives its legitimacy from the people by delivering two things: 1. economic growth and 2. social stability. Contrary to what most Westerners think, China isn’t a monolithic entity, it’s a smorgasbord of different cultures, ethnicities, dialects and regional/provincial/local interests. From the first emperor of China to Xi Jinping today, ruling China has always involved some form of authoritarianism, a strong central government to control the disparate local interests. Yet as the CCP has delivered on those two things, the population has willingly traded away some social and economic freedoms. If the water in the bathtub rises, so will all the rubber duckies. Hooray for the 1.3B rubber duckies.

It’s not just any water though. It has to be clean water. Inevitably, as the population grew wealthier, they clamored for a cleaner environment, unwilling to pollute their surroundings just to make a yuan. China generates ~70% of its electricity from coal, but the cheap energy and explosive growth of energy intensive industries brought with it poor air quality and pollution. The push to generate more energy also led to unsafe mining conditions and some high profile mining collapses. Eventually the central government instituted a crackdown that forced local officials to pull back on coal production and tighten emissions. Once COVID struck, production fell even further as the miners became idle.

Now this also happened everywhere else in the world. Demand for fossil fuels plummeted. Oil prices went negative for the first time in history, and natural gas prices also plunged. Production for fossil fuels understandably fell as a result, and as we recovered globally, we’re now seeing shortages everywhere.

It’s everywhere because the commodity complex is pretty much globalized. A shortage in one area means the impacts will cascade to others. Many of the metals we produce requires vast amounts of cheap energy (i.e., cheap electricity). So if coal is short, whether to generate electricity for residential heat or industrial production, Chinese producers will grab at liquified natural gas, which drives up natural gas prices globally. In turn, European steelmakers for instance, will suddenly face higher electricity prices (as utilities bid for more expensive gas), which then drives up their steel prices. Round and round and round we go to other fuels and commodities.

As we’ve outsourced our manufacturing activities to China, we’ve effectively enjoyed years of cheap labor and energy, but now we’re seeing those trends reverse. The once abundant/cheap labor force is now aging and the once plentiful and cheap energy sources are now depleted or being more heavily regulated.

Labor Issues

So what happens when the labor pool begins shrinking? When instead of 20M new laborers are added annually to the mix, the trend reverses and it becomes a 3-10M reduction per year? What happens when cheap energy no longer becomes cheap because environmental regulations become stricter and enforced? What happens to the price of commodities that rely on the cheap energy to set their pricing?

It all goes up.

It all goes up because it has to. A globalized, outsourced supply chain that relies on cheap labor for its low costs must face headwinds if that labor pool shrinks. Competition for the remaining workers will inevitably drive up the costs. Moreover, if energy supplies (i.e., coal supplies) are depleted and mining/air quality regulations are tighter, energy prices have to rise to compensate and spur more production/curb demand/fund a shift to cleaner burning, costlier fuels. In turn, commodity prices have to increase because the input costs climb. Steel, aluminum, etc.

Simultaneously, if China is embarking on a path to increase its standard of living, these increased expenses (i.e., the increased “friction/expense” of environmental regulations, health and safety regulations, etc.) will need to be embedded into the costs of everything.

Which is why, this bout of inflation we’re facing? It’s not transitory because it’s not caused by COVID. In a sense, COVID was simply a heart attack that stopped our global economy. Massive and historic amounts of monetary and fiscal stimulus shocked us back from the brink, but after an entire year of sheltering at home and trying to stay healthy, we’ve done little but consume our emergency supplies.

We’ve been eating our winter stores while failing to till the soil or plant the seeds, which is why we’re seeing the shortages now. Nonetheless, had COVID not come to pass, energy, commodity, and the prices of goods would still have risen, albeit more slowly, because the underlying issues that would’ve driven inflation higher to begin with (i.e., an aging Chinese population with higher expectations) still remain. COVID simply accelerated the timing.

None of this can or will be reversed soon. It’s demographics. China’s well aware of this problem because just take a look at its recently adopted 5-Year Plan. The 5-Year Plan emphasizes quality of growth (as opposed to just growth) in 5 categories (economic development, people’s well-being, innovation, resources, and the environment).

Compare the plan to China’s recent regulatory crackdowns and we can see where it’s going: 1. Evergrande’s forced default after regulators instituted higher capital requirements (taming housing speculation/housing prices/excess leverage), 2. banning for profit after school tutoring (education access/affordability), 3. enforcing tighter emission regulations (climate/environment change), 4. limiting play time/media (social impressions/censorship), 5. banning video game playtime during weekdays (social engineering/behavior for youths) and 6. tech crackdown (furthering financial stability, control and national security aims).

Why all this trouble? Partly geopolitics, but partly to make life more livable, more affordable because after all . . . China wants babies. They needs the babies.

They want more rubber duckies.

. . . and they wants them now.

It’s not enough though. Although China’s changing demographics aren’t dissimilar to what’s happening elsewhere in the world, our increasing reliance on the Chinese workforce for globalization means that as this reversal accelerates, the tailwinds of deflation become the headwinds of inflation.

Lifting childbirth restrictions though will prove fruitless unless China can address the underlying social, economic, and environmental pressures Chinese families face today. Hence the push for “common prosperity.” So responsible growth = slower growth, lower productivity, more regulations and care for the environment. All of that coupled with a declining working population = increased costs = inflation.

The tailwinds on everything, from cheap labor, cheap energy, cheap commodities, cheap products, to the cheap life we all live, will now reverse. It’s not COVID that’s causing this, COVID is merely the catalyst that accelerates this.

Sure, monetary and fiscal stimulus will (has?) led to an extraordinary jump in demand, but that will fade. What won’t fade are the increasing headwinds. While energy and commodity prices today are taking a Great Leap Forward because of a confluence of factors (i.e., ESG/climate change movement, underinvestment, COVID aftershocks, etc.), the market is simply repricing today’s inventory level and recognizing a potential shortage. What keeps energy and commodities in a secular bull market, however, could be an aging Chinese population. After nearly a decade of deflation, inflation was bound to creep back towards us as the favorable tailwinds shift, but it’s now sprinting. Once here, it may just linger long after COVID fades. Someone eventually will have to pay for China’s misguided one child policy, and it’s increasingly likely . . . it’s us.