The new higher-cost paradigm

Many investors have enjoyed a remarkable period of wealth accumulation since the end of the global financial crisis. In general, companies across the globe have experienced significant net income growth, regardless of region or style. Returns on capital and stock prices have been relatively high and faced minimal interruption.

Despite years of economic stagnation that weighed on corporate revenues, many businesses were able to generate these remarkable return rates, thanks in part to falling capital and operating costs. However, capital and operating costs have been on the rise since 2022 — and we don’t expect them to revert to prior lows.

As the world shifts away from one of artificially suppressed interest rates and cheap manufacturing, investors will need to carefully consider how companies are positioned to navigate this new environment.

Here’s what the new higher-cost paradigm may mean for risk assets:

Unrealistic interest rate expectations

The year 2021 marked the all-time low for interest rates, according to a Bank of England review that looked at 5,000 years of historical rates. To put that into perspective, for those born before the early 1980s, their lifetimes comprise a period when interest rates hit both 5,000-year highs and lows.

Three years later, and despite a tight labor market and a quarter-million new jobs being added monthly, market participants continue to discount a loosening of global monetary policy. And while overnight and short rates have begun to fall, too many investors seem to be counting on a collapse in long rates and a resurgence in cheap capital costs. In our view, any reduction in short rates is more likely to result in more positively sloped yield curves than in precipitous declines in long-end borrowing costs. More important, we think borrowing costs — whether for the consumer, enterprises or government entities — are unlikely to revisit all-time lows because aggregate demand is too high, labor too scarce and the need for capital investment too strong.

Why costs are likely to remain high

There are two key dynamic changes that have contributed to this higher-cost paradigm:

• Household savings are now being spent on food, shelter and energy; and companies are spending to shorten supply chains at a time when labor is expensive and in short supply. All this spending is growth- and inflation-accretive. Inflation today isn’t only higher but more volatile than in the slow growth, low-inflation paradigm, while budget deficits are far larger than in the recent past. This has led to policy constraint being dictated by the bond market, as we saw in the United Kingdom during the liability-driven investments (LDI) crisis in 2022. This matters for risk assets because the hurdle rate to generating positive net income has gotten a lot higher.
• Globalization and “just-in-time” inventorying were tremendous catalysts for profit growth because warehousing goods is costly. Less inventory on hand means more working capital and higher operating and profit efficiencies. Low-cost manufacturing, particularly in Asia, meant many western conglomerates could slash labor expenses. The outsourcing of manufacturing meant that multinationals could decrease tangible fixed investment. All else equal, when capital intensity declines, profits rise. But when globalization allowed developed market companies to become asset-light businesses, it also ushered in a decade of economic stagnation in the 2010s. Thus, globalization isn’t without risks, and more of those risks have been exposed during the pandemic and the ongoing Russia-Ukraine war and conflicts in the Middle East.

Why cheap manufacturing may be a relic of the past

A prerequisite for “just-in-time” inventorying and globalization was global peace. Ships got bigger and could hold more containers because the oceans were made safe by post-World War II alliances. Corporations needed to be sure goods would arrive exactly on time, and they were. As that confidence grew, and the benefits of economies of scale accrued, the percentage of the world’s traded goods via the seas more than doubled. At the same time, shipping costs deflated, and profits soared.

Shipping is still cheap, but its cost is rising. More concerning, a global pandemic, two hot wars and a cold one have reduced the certainty that a critical part will arrive just in time. Meanwhile, labor arbitrage with Asia has ended because manufacturing in Asia is no longer cheap and hiring people is difficult almost everywhere.

Globalization isn’t over and neither is “just-in-time” inventorying. But supply chains will likely become less stretched, cost more or both.

What does this mean for investors?

In our view, the policy response to the global financial crisis and the pandemic purposely created a soft- business operating environment that produced high returns for many owners of capital. As a result, investing was recently made relatively easy by the overwhelming policy response.

But that relatively easy investing environment was driven by falling costs, in our view. Costs are now rising, and growth isn’t keeping pace. As such, portfolio returns may likely become more leveraged to business fundamentals as these dynamics play out. We believe securities of companies positioned to successfully navigate the new higher-cost paradigm should comfortably outperform those who aren’t ready.

Bottom line: The current soft business operating environment will likely give way to a new higher cost paradigm, which is a decidedly more challenging environment for policymakers to address. And that’s why we believe discretion is needed when investing.

Contact your Ameriprise financial advisor for help creating an investment portfolio that’s tailored to your individual needs, financial goals, risk tolerance and time horizon.