No Longer Plain Sailing?
For a number of years, the pillars of globalization – free trade and the free movement of capital, labor and knowledge – have steadily come under increasing pressure. This pressure has been exerted by the electorates of Western countries and from there has come to shape policy. There have always been sceptics, but they have steadily grown in number since the 2008 global financial crisis.
Prior to that crisis, there was a strong consensus that globalization was positive – a rising tide that lifted all boats. In this setting, a mutual desire to perpetuate the status quo meant that disagreements between countries would be resolved with diplomacy, or at the very least they were conveniently parked to be dealt with another day. The boats were lashed together, reflected in a period of geopolitical harmony.
This began to change following the financial crisis. Persistently weak economic growth in the West led to growing skepticism among populations with respect to whether globalization was in their best interests. This skepticism was revealed at the ballot box, with traditional political landscapes of Western democracies increasingly disrupted, most conspicuously in the UK and the US. In 2016, both Americans and Britons participated in divisive votes shaped in part by questions of immigration and global engagement. In the US, voters cast ballots in a presidential election ultimately won by Donald Trump and his ‘America First’ vision. Across the Atlantic, ‘leave’ voters outnumbered ‘remain’ voters in a national referendum on continued European Union (EU) membership, framed by the slogan ‘take back control’.
A similar debate played out across several European countries, albeit with less dramatic outcomes. With the economic pie no longer growing at the rate it had, electorates in the West have become increasingly concerned with national self-interest.
As a result, there has been a tendency for politicians across the political spectrum to take a dimmer view of globalization, while championing their own national interest. It should come as no surprise, therefore, that frictions between nations have been steadily rising. This has been most apparent by way of the increasingly acrimonious relations between the US and China; but by no means have these two countries been the only source. Without a rising tide to lift all boats, keeping the boats lashed together has been increasingly difficult.
No Such Thing as a Free Lunch
A significant change in the globalization narrative has accompanied these increasing frictions. Free trade is no longer beyond reproach. A near myopic focus on the virtues of faster trade-driven growth and ever larger and cheaper flat-screen TVs has broadened to include the moral implications of free trade and issues of national security.
Western liberal democracies are increasingly asking themselves whether they should allow free trade with countries that have weaker workers’ rights and that operate with poorer safety standards. Should they have free-trade agreements with countries that the Chinese historian Qin Hui has referred to as having “the comparative advantage of lower human rights”?
Relatedly, should Western liberal democracies allow trade with countries that invade peaceful democracies, and should their citizens be allowed to buy their domestic assets? Should Western liberal democracies import goods from countries that stole the intellectual property required to produce those goods from the importing country? Furthermore, is it prudent that the West continues to import technology that may have been hacked to serve the interests of the exporting country’s government?
Part of the changing narrative has been a growing concern about the extent to which the West is dependent on China’s advanced manufacturing base for many strategically important components and inputs. This concern gained traction in 2018 with the realization that every advanced weapon in the US arsenal – from Tomahawk missiles to the F-35 fighter jet to Aegis-equipped destroyers and cruisers, and everything in between – is reliant on components made using rare-earth elements, including critical items such as permanent magnets and specialized alloys that are almost exclusively made in China.
The Russian invasion of Ukraine has laid bare the disastrous consequences of three decades of European energy policy. European governments have allowed a deep fragility to emerge in their energy systems. By mandating a move to 40% intermittent renewables by 2030 (from 20% in 2019).1 – at the expense of coal and nuclear – the continent is dependent on Russian gas. Europe’s reliance on Russian gas undoubtedly contributed to Russian President Vladimir Putin’s decision to invade Ukraine, with the assumption that Europeans would not wear the economic cost of higher energy prices. The notion that everybody wins from free trade is ceasing to exist, and the West appears to have woken up to the disadvantages of such an arrangement: free trade is no longer seen as an economic free lunch.
History Rolls On
In his book The End of History and the Last Man, Francis Fukuyama argued that with the ascendency of Western liberal democracy following the end of the Cold War and the dissolution of the Soviet empire in 1991, humanity had reached “not just…the passing of a particular period of post-war history, but the end of history as such: that is, the end-point of mankind’s ideological evolution and the universalization of Western liberal democracy as the final form of human government”. Fukuyama’s predictions reflected a view among Western political and intellectual circles that all the world’s nations would, in time, inevitably adopt Western liberal democracy. In the last decade it has become clear that these expectations were misplaced.
China’s economic strength following the financial crisis burnished the credentials of China’s model of governance as an alternative to Western liberal democracy. This was particularly the case when the US and Europe were reeling from the financial crisis and the European debt crisis. China’s continued economic rise in tandem with the economic and social upheaval in the West led many to conclude that Western liberal democracy itself was under threat.
There is no doubt that perceived weakness was factored into Putin’s decision to invade Ukraine. But just as Putin miscalculated the willingness and ability of the Ukrainian people to resist invasion, he also underestimated the response of the West. While the latter has refrained from sending armed forces into Ukraine, the economic sanctions placed on Russia have been unprecedented, despite the economic self-harm.
The irony is that the invasion of Ukraine has led to a more unified West than we have seen in well over a decade. Europe has closed ranks, with the Visegrád Group states (Czech Republic, Hungary, Poland and Slovakia) putting aside their differences with the EU in the face of a common enemy. By strengthening the emerging narrative that countries such as China, Russia, Iran and Syria pose an ideological threat to Western liberal democracy, Russia’s invasion of Ukraine appears to have strengthened unity in the West, bringing a new dimension to the ongoing divergence. Western governments are likely to chart a course designed to tackle this threat in order to protect their ‘values’ and their ‘way of life’.
These unified nations have been consistent in their approach to cutting off Russia. Economic sanctions and trade controls became the primary tools of retaliation for the West after President Biden said that the US would not send troops to defend Ukraine given the risk of escalating the conflict. The West is moving rapidly to reduce its reliance on and consumption of Russian energy exports. The EU is promising to cut its imports of Russian natural gas by two-thirds by the end of this year, while the UK said it would end Russian oil imports, currently 8% of the nation’s demand, in the same time frame.2 The US has already banned Russian oil imports entirely, and sales of key technologies in areas like aerospace and semiconductors have also been blocked.
Interestingly, iconic Western multinationals, from Ikea and Harley Davidson to Spotify and McDonald’s, have pulled back or curtailed their Russian operations: no doubt sanctions have increased the operational risk of doing business in Russia. The overarching motivation, however, appears to be the desire to avoid the reputational risk of continuing to operate in what is now a pariah state in the eyes of the Western public.
The West’s sanctions have also sought to starve Russia of financial capital. The US and Europe took the unprecedented step of freezing the Russian central bank’s reserve assets. Russian Finance Minister Anton Siluanov said that nearly half of the country’s roughly US$640 billion of gold and foreign-currency reserves have been frozen.3 The US, the EU, the UK and Canada have removed several Russian banks from the SWIFT payments network, hampering their ability to operate globally and facilitate trade. The US Treasury moved to prevent the payment of Russian government debt from accounts at US banks on April 5, pushing the five-year default risk up to 87.7%.4
The sanctions that have been placed on Russia since the invasion of Ukraine are clearly borne out of a unique situation. The invasion of a peaceful democracy and killing of civilians justifies a robust response. However, there are similarities between the measures implemented on Russia and those used to punish Iran between 2000 and 2015, and more recently in hostilities with China. In a sense, the sanctions placed on Russia are a continuation of a trend; a country that was deemed to be a threat to the West has been subject to sanctions that are, whether by accident or design, pushing back on three of the four key pillars of globalization.
The situation in Ukraine is likely to further strengthen the resolve of Western governments to onshore manufacturing and rebuild their industrial base and strategic industries, with energy security forming part of a renewed recognition for national industrial policies. Additionally, we are set to see an increase in spending on defense.
In a sign of the times, Germany has emerged from a 30-year strategic hibernation in terms of defense. In a speech in a special Sunday plenary session of the German Bundestag on February 27, Chancellor Olaf Scholz of the Social Democratic Party (SPD) ushered in the biggest changes in German defense policy in a generation, pledging to dramatically boost spending in this area. Scholz’s announcement could prove to be a watershed for German defense strategy and the armed forces. He unveiled a €100bn (US$121bn) fund to pay for a capable, modern and advanced German military, along with a commitment that Germany would spend a minimum of 2% of GDP on defense from 2022 onwards.5 Based on current growth projections, 2% of GDP would be approximately €75bn (US$91bn) in 2022, or a nominal defense budget uplift of €25bn (US$30bn) over previous budget plans. According to the International Institute for Strategic Studies’ (IISS) Military Balance+ database, it would also make Germany the third-largest defense spender in the world after the US and China.
Navigating Changing Winds
We have argued since the first quarter of 2020 that the Covid-19 crisis ushered in the conditions necessary to bring about an end to the disinflationary period that has been in place since the early 1980s. With Russia’s invasion of Ukraine, the probability of a transition from the disinflationary globalization of the last 40 years to a new fractured inflationary era in the 2020s has increased further. On the supply side, we are seeing the removal of Russian energy and resources from Western markets. On the demand side, there could be fiscal and monetary largesse to fund the investment in realizing national industrial policies and remilitarization of the US and Europe, as well as fiscal largesse that will subsidize Western consumers in the face of energy-price spikes and goods inflation.
A reading of financial history reveals that equity-market returns are strongest in periods of disinflation; and the period from the early 1980s proved to be no different. Over this period both earnings growth and multiple expansion contributed significantly to aggregate equity-market returns. As we head into a fractured inflation era it is highly unlikely that the trick will be repeated.
As barriers to trade came down, in particular with the fall of the Berlin Wall and China’s ascension to the World Trade Organization in 2001, a multi-decade trend of Western companies offshoring production to developing economies began. It enabled these companies to lower their wage costs and increase their profit margins. As Western firms outsource less and produce more domestically, it could raise domestic labor-force demand and erode profit margins.
A number of technological advances enabled companies to adopt the practice of just-in-time inventory pioneered in Japan, despite many companies operating increasingly complex global supply chains. Just-in-time inventory management in combination with the outsourcing of low-value-add, capital-intensive parts of the production process enabled Western companies to lower their physical capital requirements and thus increase returns on assets. As the world becomes more fractured, we believe companies will be incentivized to hold more inventory and vertically integrate rather than outsource in order to reduce the risk of disruption, thus lowering returns on assets.
Additionally, firms took advantage of the structural decline in interest rates to increase debt-to-equity ratios, boosting earnings per share. Without the tailwind of falling interest rates, companies will no longer be incentivized to leverage their balance sheets. In summary, the period of disinflationary globalization between the early 1980s and 2020 was propitious for equity-market returns, particularly from Western equity markets. As free trade, the free movement of financial capital and the free movement of knowledge come under increasing pressure, we think it is highly likely that aggregate equity-market returns will fall short of those enjoyed over the last 40 years. This does not mean that money cannot be made from equity investments. However, in our view it does mean that investment strategies calibrated by the experience of the last 40 years are unlikely to be as successful.
1 Reuters, EU unveils plan to increase renewables share in energy mix to 40% by 2030, July 14, 2021
2 Reuters, Britain to phase out Russian oil imports by end of 2022, March 8, 2022
3 Reuters, Sanctions have frozen around $300 bln of Russian reserves, FinMin says, March 13, 2022
4 Bloomberg, Russia Five-Year Default Risk Jumps to 87.7% After U.S. Ban, April 5, 2022
5 Reuters, Foreign forces could profit from Germany’s $110 billion defence boost, according to draft law, March 27, 2022
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