The Independent Market Observer

5/21/13 – Higher Costs Equal Slower Growth

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on May 21, 2013 1:03:27 PM

and tagged Market Updates

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This is a follow-up of sorts on yesterday’s post, in which I talked about resource constraints. Today, I want to take another look at that topic—specifically, how resource constraints will negatively affect growth going forward.

I’m writing this from Chicago, at the Commonwealth Retirement Symposium. My talk tomorrow, titled “The New New Normal,” will focus on how growth is expected to be lower in the future than it has been historically. I have written about this before—and am in good company with Grantham and Arnott, among others—but there’s a different way to look at the problem that may add to the discussion.

The idea I’m thinking of is the marginal productivity of capital, as applied to resource problems. This is econo-geek speak for “bang for the buck.” In the early stages of a process, a small investment can make a big difference. With oil, for example, the first wells were shallow and gushed forth oil on their own. As resources get more developed, it takes greater investment to get a similar improvement—the wells are deeper, for example, and the oil has to be pumped out, giving you less bang for the buck. Eventually, when the costs of further improvements exceed the benefits, you max out.

This is a general problem, one that can be seen very clearly in Chinese economic growth. Early in the process, small investments resulted in large profits, which were then reinvested into growing the business in a virtuous circle. Now, though, we’re seeing that the benefits of further investment are rapidly approaching the costs, indicating that the current model is maxed out. Development economics has a name for this—the middle-income trap—and Chinese leaders are now working to avoid it.

The same problem exists with natural resources. Returning to my earlier example, there’s no shortage of oil, but there is a shortage of cheap oil. Oil is available today, but at higher costs from sources that would not have been considered before. With production from nontraditional sources coming on line, from fracking or deepwater fields, the costs are much higher than when gushers squirted from the ground on their own.

In short, higher costs mean less bang for the buck. The more we spend on oil, the less we can spend on other things. This will slow growth, all else being equal.

Oil is one of the most obvious examples of rising costs slowing growth, but water—as I mentioned yesterday—is another, as it affects food costs. Beyond energy and food, the costs of manufactured goods will also start rising faster as the supply of cheap labor starts to decline. We are seeing this in China already.

Regardless of whether the shortage camp is right about how we’re running out of resources in absolute terms—peak oil, for example—there’s no doubt that we are running out of cheap resources, and that this will raise costs and lower growth across the board.

As a result, natural resources remain a good long-term play. There are few alternatives to oil at this point, and no alternatives at all to food or water. The U.S. is very well positioned in this regard, but the limits are starting to hit hard in other countries. Again, China is the poster child. Stories about thousands of dead pigs contaminating the water supply, air pollution at double-digit multiples of U.S. standards, and, most recently, rice contaminated with heavy metals from the soil show that environmental limits are affecting food and water directly.

This headwind will continue to get worse and, in my opinion, is already a contributing factor in the slow growth around the world. Labor is the headline component, with the aging of the West, but rising scarcities in other areas will inevitably reduce growth below what it was in a less limited time.

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