Bond Outlook January 3rd

The last months of 2006 saw the beginning of a reversal of a powerful movement evident in most Western economies since 2000, viz., that of higher corporate profits while wages and salaries hardly kept up with the cost of living. This phenomenon of “squeezeflation” is easily explained: competition in manufacture and tradable services from Asia weakened labour’s bargaining power, while companies were able to reduce costs through sub-contracting and “forced” productivity gains. Thus, even though the same Asian competition put a ceiling on selling prices, corporate profits continued to increase.

Slightly more difficult is to explain why the trend should now be reversing. We would see three reasons:

• Sub-contracting may be approaching its limits, not that it will decline, but most of it has already happened
• Asian costs are themselves rising with wage inflation
• The share of services in developed economies is increasing, including untradable services, which cannot be sub-contracted and which are not therefore subject to Asian competition.

Wage inflation frightens central bankers.