How Political Systems Shape Inflation and Growth

Witten By: Dan Lavallee

The immense and growing uncertainty around the world driven by conflicts and global trade makes it harder than ever to have a strong opinion about economic growth and inflation.

The pessimistic view is that growth will be slower, and inflation will persist. The IMF, OECD and others project that policy uncertainty, higher tariffs, restrictive trade, and migration changes will slow economic growth in the next few years. Inflation is down from its peak, but tariffs and supply chain disruptions may cause it to remain above central banks’ targets in the medium term.

The optimistic view is that despite all these headwinds, the U.S. economy (which plays an enormous role in the global economy) has shown resilience. The labour market continues to be strong, and business investment and consumer spending are both holding up. Some believe that inflation will subside as supply chain issues ease and monetary policy remains restrictive.

The media tend to tilt more bearish, because that’s what increases readership. I am also fond of the saying that economists have predicted 9 of the past 5 recessions, and as Warren Buffett often says, never bet against the U.S. economy.

So, which view to believe? One of the lessons I learned from Howard Marks many years ago was to never forecast, but only measure, and apply probabilistic thinking in investing.  Pertaining to the question at hand, I am reminded of a geopolitical framework developed by Marko Papic, who wrote “Geopolitical Alpha“:

When considering future global growth and inflation, we can consider two systems that impact growth and inflation. First is the global distribution of political power which could be unipolar, bipolar, or multipolar. Second are the domestic political systems of major countries, which could be laissez-faire, dirigisme, or populism.

Geopolitics

Post-World War II geopolitics have been dominated by the United States, either as a hegemon acting as a unipolar power or as a bipolar power that shared influence with another nation.

• A unipolar macro construct is the simplest and most stable, and it has a mildly positive effect on growth and a relatively negative effect on inflation, driven by high levels of globalization and large-scale capital flows and trade.
• A bipolar distribution with two competing superpowers often leads to greater government involvement in the economy which can drive higher growth but also higher inflation when fiscal policy becomes too great.
• A multipolar distribution of power creates the most uncertainty and often leads to a lot of macroeconomic and investment volatility. Contrary to what you might think, multipolarity tends to foster regionalization and cooperation and is relatively supportive of global growth.

Domestic Politics

When it comes to politics, the impact on growth and inflation is relatively straightforward.

• Populist leaders seek to generate growth at the expense of almost all else, and while they are often successful in the short term, it is often at the cost of future growth.
• A dirigisme involves much greater leadership involvement in the economy through fiscal policy. Often, dirigiste policies include tariffs, other trade barriers, and currency manipulation (sound familiar?). The downside is often high inflation.
• The laissez-faire system has the least involvement of governments, and it was the system adopted by most developed markets between the 1980s and the early 2020s. Generally, laissez-faire economies create higher growth and productivity outcomes, and hence lower inflation.

Conclusion

This all leads to a nice 3×3 matrix with which we can assign probabilities. Arguably, the days of unipolarity are likely over, as ‘American Exceptionalism’ wanes and other superpowers grow in prominence. It also doesn’t feel like we are returning to a laissez-faire political system in any developed market, so that leaves a mix of dirigisme and populism.

Papic suggests that the highest probability of occurrence in the future is a multipolar world with dirigiste governments, similar to the period between 1945 and 1980, but with multiple recessions. This suggests that global growth will be lower than the previous environment although still mildly positive, but inflation will be higher than we saw in the decade prior to COVID.

Source: UpperMark. Study Handbook CAIA Level II, Volume 1. UpperMark 2024.
Using the framework developed by Papic, Marko. Geopolitical Alpha: An Investment Framework for Predicting the Future. Wiley 2020.

So What?

What does this mean for your investments and forward-looking asset allocations? A slow-growth inflationary environment poses unique challenges for investors.

Which asset classes tend to do well? Energy and other commodities and real assets, including real estate and infrastructure. Commodities are a direct component of inflation, so they tend to be both a cause and a hedge against rising prices, and property values and rents usually rise in an inflationary environment. Inflation-linked bonds (TIPS/RRBs) generally offer direct protection against rising prices, although Canadian investors no longer have access to new government-issued inflation-protected bonds.

Which asset classes tend to lag? Nominal bonds typically perform poorly during inflationary periods, although slower growth may be supportive of owning government bonds. Equities have a mixed record. Those that can pass on higher costs to consumers and those that are less economically sensitive will likely do well. U.S. large caps have typically lagged, and growth stocks may also underperform.  Many emerging markets are commodity exporters, so these environments could be beneficial to them.

Nothing is certain, and we can only estimate probabilities for each outcome, but given the high level of uncertainty and incessant short-term noise, it’s good to anchor on these high-level frameworks when making investment decisions, and a thoughtfully diversified portfolio protects us from the volatility.

Disclaimer:

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The information in this article (the “Information”) is the author’s views and opinions and does not necessarily reflect the views of Prime Quadrant. The information also, does not constitute an invitation, inducement, offer or solicitation in any jurisdiction to any person or entity to acquire or dispose of, or deal in, any security, and interest in any fund, or to engage in any investment activity, nor does it constitute any form of investment, tax, legal or other advice.