The Daily Update - Part III: Regime Change: Inflation

Extract from Bob Gay’s piece ‘Regime Change: Inflation’

One of the most striking yet unsung by-products of globalisation and technology has been the rise of monopolistic industries that has shifted bargaining power from workers to employers. Since the heyday of union power in the early 1970s, which coincided with the coming of age of the postwar baby boom generation, labor’s share has declined from highs around 58% to 53% today. The erosion in workers’ bargaining power has been even more noticeable since the onset of the Great Financial Crisis. Information and communications technology have enabled scale economies that were inconceivable just 25 years ago. Likewise, most of the technology giants are near-monopolies themselves. They all fit Warren Buffett’s ideal investment opportunity, namely, companies that have potential to scale up operations without spending a lot of money on plant and equipment that would eat into profit margins. Technology coupled with globalised production and supply chains made that business model a reality for a wider range of companies. Near-monopolies now dominate telecom, internet, pharmaceuticals, global finance and a host of other less visible industries, notably in services that have become a growing portion of households’ budgets. Until this tide turns, this feature of regime change will limit potential growth and core inflation for years to come.

Market consequences of monopoly. High-cost services have become the new ‘necessities’ for middle income families. Even during hard times, providers of tech services have little incentive to discount prices. Recessions, however, do preclude the introduction of new marvels of technology with yet higher margins. Product cycles slow, and profit margins rather than prices take the hit. Barclays Research estimates of net profit margin for S&P 500 companies dating back to the 1970s show increasing volatility of net margins during recessions. Consider, for example, the mild recession of the early 1990s, which was not especially harsh but did leave the economy muddling along for several years, and net margins fell in half. By contrast, in the sharp and steep recessions of 1974-75 and the early 1980s, millions of workers lost their jobs and output fell about 5%, yet net margins fell only about two percentage points over the course of several years.

During the two recessions of this century, net margins have been volatile in the extreme, both in the barely noticeable recession of the early 2000s when companies were forced to de-lever quickly and in the GFC when both financing and sales were hit hard. This year, net margins have returned to record levels, and have taken market valuations to new records as well. I wonder, however, if financial markets have considered the extreme sensitivity of net margins during recessions that delay the introduction of new high-margin products and may be an unavoidable feature of monopoly-driven regime change. When markets offer, ignore or underprice volatility, there are bound to be big surprises.

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