Tuesday, October 16, 2007

A Tectonic Shift?

I mentioned in my notes on "Mosaic" that there was something I wanted to talk more about:

There is currently a broad tectonic shift going on- businesses are profiting while jobs are being outsourced, but white- and blue-collar wages are eroding.

The effects of globalization is something that has been on my mind recently. This is the abstract concept I have come up with so far:

The chart below shows the annual incomes of everyone around the world. The graph is highly skewed to the right, because capital is heavily accumulated in a small proportion of people, and this disproportionately affects their income. In general though, most people rely solely on wages.

Before going on, there are two things which I think people should recognize:
1. People working in areas with more investment have higher productivity and so can be paid higher wages.
2. Even when it comes to businesses such as services which do not need capital investment, people in wealthy areas still have higher incomes because the opportunity cost of time in the region is higher- so saving the time of the people around them is more valuable. To better see this, think of a dry cleaner working in the US and in China. The dry cleaner in the US is saving more time for a wealthier population, which has higher time opportunity costs, and so this dry cleaner is paid a much higher wage than the dry cleaner in China. This is all despite the fact that dry cleaning itself does not require much capital as a business to run and both of them are essentially doing the same amount of work.

Now, what is globalization doing? Pabrai said so far it has increased profits of capital, and it is eroding the value of labor. Long term, I disagree with the first point. The increased profits from capital seem to be a temporary boost, and economic law would suggest that competition would eventually bring these back to normal levels. But globalization and technology is dramatically increasing the supply of labor, and hence competition. As a result, there is overall downward pressure on wages. But it is also balancing, because the demand for the cheapest labor is increasing while demand for rich world labor is decreasing.

All this so far has been pretty well understood in the financial community. But what I haven't heard discussed frequently is what a synchronization of (lower) wages is doing.

1. It doesn't seem unreasonable to think that this synchronization will lead to an increased demand in basic necessities, such as food, oil, energy, water, etc, as more people are able to afford these goods. In fact, this is maybe what we are already seeing here. But, increased demand shouldn't be necessarily confused with higher prices. Many of these commodities have already increased significantly from their lows. What is important besides increased demand is at what price that demand can be fulfilled. For most agricultural goods, that price is low. For oil and some other commodities, it is debatable. (Or rather, I just haven't looked into much specific data and the media never provides good answers to these questions)

2. People in first world countries seem to have maintained our standard of living by mostly saving less and borrowing against our assets. I base this mostly based on what I've seen in the United States and the United Kingdom. This is unsustainable, and eventually we will start seeing declines in our purchasing power due to the pressure on our high wages. Again, we might already be seeing that through the declining US dollar rather than direct wage decreases. This pressure would also affect the gap between service sector jobs in different countries. (think the US/China dry cleaner example again, only now the wealth of both populations are slowly converging, and so are their wages)

3. There might be a decrease in more conspicuous types of consumption, as the average first-world wages which supported this demand would be under pressure. This would also affect business profit margins, and hence investment returns.

This is all mostly abstract so far, but I think these broad trends seem fairly credible. Please do comment if you have any thoughts on the matter. I do plan on looking more into this myself. As to how this will effect investing: well, for myself personally, that would mean increased demand for both oil and pulp, two things I would consider basic necessities. But in general, I would be also worried about the deflationary pressures that this globalization can cause.


Scott R said...

Nice post.

Is your email posted on this site correct?

Nnejad said...

Thank you, and yes.
( mrp8ntball@gmail.com )

Sivaram Velauthapillai said...

Good post. This is all just my opinion and who knows what will happen?

Globalization, and basically free markets, will equalize the wages (same job will pay same wages within reason) and return on capital (capital can easily flow anywhere nowadays). Wages are downward rigid (due to a whole bunch of reasons) so they won't drop in developed countries. Instead, wages in developing countries will rise.

The investment implications are tougher to figure out. I'm in the disinflation/deflation camp because Globalization and technology should weaken any inflationary pressures. For this reason, I am not sure that commodities that you cite (like oil & pulp) will necessarily do well. Certainly given the big run-up in most commodities in the last 5 years, I am not so sure that they will outperform other assets in the future. I have been wrong with my commodity views but it remains to be seen what transpires.

The problem for commodity investors is that even if demand initially increases, prices can drop and cause decline in profit margins eventually. For instance, oil demand actually has grown all throughout the 80's and 90's yet oil prices didn't go anywhere (they actually declined from the 80 peak). This is with demand constantly increasing!

Technology can also cause huge deflations in commodity prices. Sticking with the oil example, one of the reasons China (and others) consumes huge amounts of oil is because they are inefficient. Businesses are literally using diesel generators for their power, poor gasoline-consuming autos, and so forth, because the electricity grid is unreliable, public transport is inefficient, home insulation is not as good, etc. After China increases its efficiency (say via nuclear power, better insulation in factories, etc), I can see oil prices declining.

Obviously investors like Jim Rogers see a continued bull market in commodities but it remains to be seen who is right...

Nnejad said...

I'm going to expand on the first point you made in a post right now. On the difference between increased demand and price, I agree and I thought I was careful to point out that in the article. And I wasn't saying the future prices for oil and pulp would be higher, I said the implications was "increased demand for oil and pulp." I would say though from what I know about the pulp industry that increased demand is what the industry badly needs to begin a cyclical upturn, and that would in fact lead to an increase in prices (See posts on SFK to better understand this). With oil, I am completely ignorant about where the price will be, but I fully appreciate the major headwinds from technological improvements, alternatives, increased efficiency. So, I would frown on any investment which assumes the current $90 barrel price is sustained in the future.