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Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays), and a new monthly Q&A format called the Confluence Mailbag.
Welcome to the Confluence Investment Management Bi-Weekly Geopolitical Report. I'm Phil Adler. One long trusted economic indicator may no longer reliably indicate a noninflationary environment. Confluence chief market strategist Patrick Fearon Hernandez joins us today to discuss how governments might be misled and what investors should watch for. Patrick, for years, economists have studied capacity utilization data for clues about inflation.
Phil Adler:Now I'm not trained in the field, but I've always looked at capacity utilization in terms of factory activity. If factories are busy, capacity utilization is high, inflation is more likely, and governments should hold back on stimulus plans. If many factories lie dormant, that's called excess capacity, and inflation probably is not a major worry. In that situation, governments may be encouraged to enact economic stimulus. Have I been analyzing this data correctly?
Patrick Fearon-Hernandez:Yes, Phil. I think that's a very fair description of how economists and policymakers traditionally approach the issue. For decades, industrial capacity utilization was one of the classic gauges of whether an economy was overheating or operating below its potential. The idea was fairly straightforward. If factories were running near full tilt, demand was probably pretty strong relative to supply, and companies would gain more pricing power.
Patrick Fearon-Hernandez:That often often translated into rising inflation pressures. On the other hand, if factories were underused and unemployment was high, policymakers assumed there was plenty of slack in the economy, meaning that governments and central banks could stimulate demand without triggering much inflation. Historically, that framework worked reasonably well because manufacturing, mining, utilities, and construction accounted for a much larger share of overall economic activity than they do now. During periods like the Great Depression, for example, industrial capacity utilization collapsed and unemployment surged. So aggressively fiscal stimulus could increase production and employment without causing runway inflation.
Patrick Fearon-Hernandez:The challenge today is that the structure of modern economies has changed dramatically, and that old framework doesn't always capture where the real constraints are anymore.
Phil Adler:Well, let's explore this. Why has this way of measuring capacity utilization become no longer as useful for inflation watchers?
Patrick Fearon-Hernandez:Well, the biggest reason is that the composition of the economy has evolved. In most developed countries, services now dominate economic activity, while manufacturing plays a much smaller role than it did several decades ago. As a result, looking only at factory utilization can create a misleading impression that there's abundant excess capacity when in reality, the broader economy may already be operating close to full utilization. We've also seen a structural decline in measured manufacturing capacity utilization over time. Some of that probably reflects technological improvements that allow companies to produce more with fewer facilities or fewer workers.
Patrick Fearon-Hernandez:Some of it may also reflect measurement problems where old and obsolete industrial facilities are still counted as part of existing capacity. In any case, policymakers who focus too heavily on industrial utilization data may conclude there's enough slack to justify aggressive stimulus policies. But if labor markets are already tight, productivity growth is sluggish, and inflation is elevated, well, that stimulus may simply fuel higher prices instead of stronger real growth. That's essentially what we think has happened in many countries since the pandemic period.
Phil Adler:So because so many developed countries' economies are now service economies, factory activity alone may no longer be the best way to measure capacity utilization.
Patrick Fearon-Hernandez:Exactly. The modern economy is increasingly centered around services, including technology, healthcare, finance, transportation, logistics, professional services, digital industries. Those sectors don't necessarily rely on giant factories running at a visible percentage of maximum output. Instead, their constraints are often tied to labor availability, infrastructure bottlenecks, energy supplies, or productivity growth. So the old manufacturing based utilization metrics no longer tell the whole story.
Patrick Fearon-Hernandez:You can have relatively low factory utilization and still have an economy experiencing wage pressures, labor shortages, elevated housing costs, or rising service sector inflation. In other words, the economy can feel stretched even if the industrial data suggests excess capacity. That's why we believe investors and policymakers need a broader framework that reflects how modern economies actually function.
Phil Adler:Well, what are better ways of measuring capacity utilization?
Patrick Fearon-Hernandez:We think it's important to look at a broader collection of indicators. First, for example, unemployment rates are probably one of the best gauges today because they capture how fully an economy's labor resources are being utilized. In service oriented economies, labor is often the most important productive resource. Historically low unemployment rates across many countries suggest labor markets are already quite tight. Secondly, inflation itself provides evidence about capacity utilization.
Patrick Fearon-Hernandez:If economies truly had abundant slack, firms would struggle to raise prices. But in most developed countries, inflation remains noticeably higher than it was before the pandemic. Third, productivity growth tells us a great deal. If productivity were surging, that would imply economies can produce substantially more output without increasing inflationary pressures. But productivity growth has remained fairly flat in many countries.
Patrick Fearon-Hernandez:That suggests economies may already be closer to their practical limits than traditional industrial data implies. We also monitor measures like corporate profit margins, labor participation, infrastructure strain, housing supply constraints, and even electricity generation capacity because all of those can reveal whether economic systems are truly being stretched.
Phil Adler:Patrick, are governments around the world generally migrating to these new methods of measuring capacity utilization?
Patrick Fearon-Hernandez:Well, some governments and institutions are adapting, but probably not as quickly or as consistently as they should. Major organizations like the International Monetary Fund and central banks increasingly use broader concepts such as the output gap, labor market tightness, wage growth, and financial conditions instead of simply looking at factory utilization. However, policymakers still often rely on older frameworks or politically convenient narratives. One reason is that the old measures are familiar and relatively easy to quantify. Another is that governments often prefer to justify stimulus policies, especially during periods of political pressure.
Patrick Fearon-Hernandez:The challenge is that if policymakers underestimate how constrained their economies really are, well, they may continue applying fiscal and monetary stimulus long after recovery has already taken hold. That can reinforce inflationary pressures and create new financial imbalances. So in our view, there's still a tendency in many countries to overestimate excess capacity and underestimate inflation risk.
Phil Adler:Patrick, using the measurements that you just described a few moments ago, employment levels, consumer prices, productivity. Now what do they reveal about capacity utilization today, not just in America, but in many countries around the world?
Patrick Fearon-Hernandez:Well, collectively, those indicators tell a fairly consistent story across much of the developed world. Unemployment rates are historically low in many major economies, which suggests labor resources are already heavily utilized. Part of that reflects aging populations and the retirement of large post war generations, which has reduced labor force growth. Now at the same time, inflation is still elevated relative to the very subdued pre pandemic environment. Inflation hasn't returned to the extremely high levels we saw in the nineteen seventies, but it is running persist ently above the levels central banks became accustomed to over the last couple of decades.
Patrick Fearon-Hernandez:Productivity growth is also relatively flat, which is important because if economies truly had massive excess capacity, productivity should be accelerating accelerating as firms scale production more efficiently. Instead, productivity trends suggest many economies are struggling to expand output meaningfully without generating price pressures. The major exception remains China, where excess industrial capacity appears genuinely large and inflation remains comparably subdued. But outside China, many economies appear much tighter than traditional industrial utilization metrics would imply.
Phil Adler:Patrick, are are most of these countries which are experiencing high capacity utilization based on these measurements that you just mentioned, are they still stimulating their economies in a way that will ensure high price inflation in the future?
Patrick Fearon-Hernandez:In many cases, yes. Governments in The United States and other major economies still maintain policies that are broadly stimulative. Fiscal deficits remain historically large in many countries, and monetary policy has eased compared to the immediate post pandemic tightening phase. In The US, for example, real interest rates have declined, budget deficits remain elevated, and public spending programs continue at a significant scale. If those policies are applied to economies already operating near capacity constraints, the likely result is more inflation rather than dramatically stronger real growth.
Patrick Fearon-Hernandez:In other words, stimulus has diminishing returns when labor shortages, infrastructure limitations, or weak productivity become binding constraints. That doesn't mean growth disappears entirely, but it does mean the inflationary component of growth becomes larger. Investors and policymakers therefore need to be careful about assuming that additional stimulus can endlessly generate noninflationary expansion.
Phil Adler:Well, you mentioned China before. Is China the one major exception or maybe the only exception to this overall trend?
Patrick Fearon-Hernandez:Yes. China is probably the clearest and most important exception. Unlike many western economies, China still appears to have substantial industrial excess capacity, especially in sectors tied to manufacturing. Chinese inflation remains relatively subdued, and in some cases, price pressures have actually weakened recently. At the same time, China's policymakers have been more cautious than many observers expected in deploying aggressive stimulus.
Patrick Fearon-Hernandez:So while The US and parts of Europe may be dealing with economies that are already operating close to their productive limits, China faces almost the opposite challenge of insufficient domestic demand relative to its industrial base. There can also be temporary exceptions in countries experiencing severe recessions, financial crises, or sharp demographic declines where genuine economic slack reappears. But broadly speaking, much of the developed world currently looks capacity constrained rather than capacity abundant.
Phil Adler:So can you think of, anything that that might reverse this overall trend around the world, which encourages high price inflation?
Patrick Fearon-Hernandez:Yeah, we've thought of that and we've come up with two major possibilities. The first would be a sustained wave of deregulation and structural reform that increases productive efficiency. If governments reduce unnecessary barriers to investment, improve labor force participation rates, streamline infrastructure development, encourage energy production, and enhance business formation, well then economies could expand capacity and generate stronger non inflationary growth. The second possibility is artificial intelligence and related technological advances. If AI meaningfully boosts worker productivity, companies could produce more goods and services with the same labor and capital inputs.
Patrick Fearon-Hernandez:That would effectively expand economic capacity and reduce inflationary pressure over time. Right now, however, AI is producing mixed effects. It's boosting investment spending, but it's also driving up demand for data centers, semiconductors, construction materials, and electricity, which can initially increase inflation pressures. So the long term outcome is still uncertain. There's also the possibility that a severe recession or financial crisis could reduce demand enough to temporarily eliminate inflation pressures.
Patrick Fearon-Hernandez:But that would obviously come with painful economic consequences.
Phil Adler:Patrick, as as we near the end of our discussion today, the obvious question is, what does all this mean for investment strategy?
Patrick Fearon-Hernandez:Well, we think investors need to prepare for a world where inflation remains structurally higher and more volatile than it was during the decade before the pandemic. If inflation stays elevated, it would likely put downward pressure on equity valuations over time because discount rates would remain higher. It would also create a more challenging environment for long duration bonds. In fixed income, shorter duration instruments may perform relatively better because they're less vulnerable to inflation and rising rates. We also think commodities and precious metals could benefit from this environment, particularly gold, given both inflation concerns and heightened geopolitical tensions.
Patrick Fearon-Hernandez:Finally, international equities may also outperform US equities if the dollar weakens due to concerns about US policy. On the positive side, if policymakers manage a combination of moderate fiscal restraint, selective deregulation and productivity enhancing technologies such as AI, that could create a healthier backdrop for risk assets. But overall, we think the low inflation, ultra low interest rate world investors became accustomed to after the global financial crisis is probably behind us.
Phil Adler:Patrick, one more question. It it sounds that this way of measuring and interpreting capacity utilization data fit neatly with investment strategy recommendations that Confluence, investment management, has been promoting for some time. Am I correct?
Patrick Fearon-Hernandez:Yes. I think it does align very closely with the broader themes we've been emphasizing. At Confluence, we've argued that the world is moving away from the unusually disinflationary environment that prevailed from roughly the late nineteen nineties through the pre pandemic era. Globalization, abundant labor, relatively restrained fiscal policy, and favorable demographics all helped to suppress inflation during that period. Today, many of those trends are reversing.
Patrick Fearon-Hernandez:We're seeing greater geopolitical fragmentation, stronger fiscal activism, aging populations, tighter labor markets, and more industrial policy intervention by governments. Our broader investment strategies reflected the expectation that inflation pressures volatility are likely to remain elevated relative to the previous cycle. That's one reason we favor diversification across asset classes. We caution against long duration fixed income, and we have constructive views toward commodities and precious metals. Ultimately, understanding how much true excess capacity exists in an economy is central to understanding how policy changes will affect growth, inflation, markets, and investment opportunities.
Phil Adler:Thank you, Patrick. The title of this week's report is Excess Capacity and Policy Change, and you can find a link to the written report on the Confluence webpage, confluenceinvestment.com. Our discussion today is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.
Phil Adler:Our audio engineer is Dane Stoll. I'm Phil Adler.