THE UNDERESTIMATED PERILS OF DEGLOBALISATION · 05/05/2011 · say, creating a product made by an...

THE UNDERESTIMATED PERILS OF DEGLOBALISATION

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The underestimated perils of deglobalisation

THE UNDERESTIMATED PERILS OF DEGLOBALISATION

Globalisation is often blamed for the world economy’s ills. Many commentators attribute rising populism in the West to years of wage stagnation attributed to globalisation. But, in our view, deglobalisation would be costly and disruptive for all regions of the world.

Globalisation’s achievements, and the degree to which we rely on them, are underestimated. What would happen to people, companies and financial markets, if modern globalisation was dismantled, as populist politicians in both the US and Europe have threatened?

Such a situation would lower the speed limit at which economies could grow without hitting inflationary roadblocks – shortening and localising economic cycles. From an investment perspective, it could prove the catalyst that halted the 35-year bond market rally, challenging valuations across asset classes.

nn Protectionism threatens to unravel the model of ‘new globalisation’ that sources cheap labour from around the world, enabling companies to increase profit margins through efficiency savings.

nn If globalisation is stopped, the forces of disinflation that supported the 35-year bond bull market would be undermined, threatening the valuations of all financial assets.

nn In such a scenario, stock picking would become more important as the dispersal of outcomes at the stock level is significant.

Toby NangleGlobal Co-Head of Asset Allocation and Head of Multi-Asset, EMEA

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‘OLD’ VERSUS ‘NEW’ GLOBALISATIONTo understand what the consequences of deglobalisation might be for financial markets, it is important to understand what is unique about today’s form of globalisation. In distinguishing old globalisation from new, we are indebted to the economist Richard Baldwin’s masterly analysis, from which we draw heavily.1 Under ‘old globalisation’, international trade rose considerably but companies’ supply chains tended to be geographically attached to their end products. In other words, the entire process of, say, creating a product made by an American company largely took place within the United States itself. That is not the case for large multinational firms operating within the framework of ‘new globalisation’ today.

Under new globalisation, not only supply chains, but stages of production that might in yesteryear all have been the domain of individual firms, have become tradable as businesses have increasingly focused on their specific area of added value – be it their branding, distribution, design, manufacturing, logistics etc. Figure 1 describes the process by which a single firm’s proposition is first fractionalised (outsourcing often employment-rich aspects of a production process to third parties), and then dispersed (where these outsourced stages of production can be bid for by firms around the world).

Figure 1: Evolution of outsourcing and offshoring

Old Model Fractionalisation Dispersion

Distribute Distribute Distribute

Sell/Export Product Sell/Export Product Sell/Export Product

Design Design Design

ManufactureManufacture Oversight Manufacture Oversight

Source: Columbia Threadneedle Investments, February 2017.

Recognising this shift, where stages of production are outsourced overseas, emerging economies have lowered tariffs to enable employment to flow to their markets. Technological advances and greater harmonisation of institutions globally, including the rule of law and regulations, have made it more attractive for companies to employ cheaper labour abroad than domestically. And so firms have globalised their supply chains, lowering their governance-adjusted unit labour costs (eg, unit labour costs adjusted for an estimation of costs and risks associated with heightened governance issues – managerial, political, environmental, legal, etc – which serve to introduce risks and complexity to a firm).

1 Richard Baldwin, The Great Convergence, Harvard University Press, November 2016.

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At an aggregate economy-wide level, all nations should gain from trade openness, because they can specialise according to their comparative advantage. But the shift to new globalisation has led to developed market workers in stages of production most vulnerable to off-shoring and automation losing bargaining power.

Employment income appears to have been a poor way to distribute the gains of globalisation across members of developed market societies. Unbundling of employment has had two main groups of beneficiaries. The first group are workers in emerging economies, because of the jobs created. Globalisation has allowed China to lift millions of people out of poverty. China’s per capita income increased fivefold between 1990 and 2000, from $200 to $1,000.2 Between 2000 and 2010, per capita income continued to rise at the same rate, from $1,000 to $5,000, moving China into the ranks of middle-income countries.3 The second group are companies whose profits margins improve because of the efficiency of fractionalising their production processes, and whose markets have grown. Whilst (largely developed market based) managers of global firms have seen their fortunes soar, the experience of the median developed market citizen has been mixed.

2 Elizabeth Stuart, research fellow at the Overseas Development institute, ‘China has almost wiped out urban poverty. Now it must tackle inequality,’ The Guardian, 19 August 2015 https://www.theguardian.com/business/economics-blog/2015/aug/19/china-poverty-inequality-development-goals 3 As above.

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CASE STUDY: METTLER-TOLEDO*

Sachee Trivedi Global Equity Analyst

Mettler-Toledo, a firm which produces scales and analytical instruments for laboratories, industry and retail outlets, is a case in point. From the year 2000, the firm decided to go global. The results were staggering: Mettler-Toledo grew its revenue by 75% while almost doubling its operating margin and return on invested capital (ROIC).

Headcount grew with revenue...10.0%

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In practice, the firm achieved this in three ways. First, it moved manufacturing jobs to low-cost countries (LCCs), with c. 40% of its manufacturing based in China as of 2013. While it grew headcount in Asia and other emerging market countries, the share of its workforce in developed markets declined. The reduced costs boosted profit margins.

...but in EM at the cost of DM

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Secondly, Mettler-Toledo began to source raw materials from LCCs. By 2013, 40% of its materials were sourced from these markets.

Lastly, it relocated several operational functions to LCCs. These included back office, accounting, IT and order entry roles, which moved from high-cost Switzerland to India and Poland. The labour cost arbitrage allowed them to hire PhDs to man their call centres.

...expanding margins and benefiting capital owners

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* The mention of any specific shares should not be taken as a recommendation to deal.

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4 Peter Navarro, Death by China: Confronting the Dragon – A Global Call to Action, Pearson FT Press, 5 May 2011. 5 ‘US trade chief seeks to reshore supply chain,’ The Financial Times, 1 February 2017https://www.ft.com/content/8dc63502-e7c7-11e6-893c-082c54a7f539 6 As above.

DEGLOBALISATION ON THE AGENDAPeter Navarro, director of the National Trade Council in Donald Trump’s administration, likes to blame China for the lack of employment and equitable distribution in the US.4 As chief trade adviser, he has pledged that one of the administration’s priorities is to unwind and repatriate the international supply chains on which many US multinational companies rely, taking aim at one of the pillars of the modern global economy.5

“It does the American economy no long-term good to only keep the big box factories where we are now assembling ‘American’ products that are composed primarily of foreign components,” he told the Financial Times.6 “We need to manufacture those components in a robust domestic supply chain that will spur job and wage growth.”

Trump’s administration is just one example of a government seeking some form of deglobalisation, with very real consequences for companies that depend on international supply chains and those who invest in them. In trade policy, we have already seen some of Trump’s campaign trail threats put into action with the early scrapping of the Transatlantic Trade and Investment Partnership (TTIP) and the Trans-Pacific Partnership (TPP). The promised Border Adjustment Taxation regime has substantial implications for multinational firms, as well as being inflationary for households, and potentially destabilising for bond and currency markets.

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CASE STUDY: ASSA ABLOY*

Andrea Carzana European Equity Fund Manager

If the US introduces a new border tax, this would affect companies like Assa Abloy, a multinational Swedish lock manufacturer. The firm has some 7,600 suppliers globally, but always pre-assembles products in a LCC. In 2005, Assa Abloy had 52 factories in America. By 2015, it had just 32. Today, the bulk of pre-assembly for the company’s mechanical and electromechanical locks is carried out in Mexico, with some components coming from China. Only final assembly takes place in the US.

Assa Abloy – Supply chain notes: map of pre-assembly sites

Without imported components, Assa Abloy could not meet US demand for its products. If the US imposes a border tax, the company would need to consider the costs and benefits of moving its entire supply chain to the US. Input costs would rise along with prices for consumers. We estimate that moving pre-assembly out of Mexico could take up to two years. If Assa Abloy chose to not relocate its supply chain jobs, the cost of new tariffs would impact profitability. There is no good outcome for the firm.

Assa Abloy’s outsourced based business model is typical of European industrial companies with high and stable returns.

A US border tax would therefore produce few winners – with the exception, in the short term, of small and medium-sized companies that both sell and produce within the US. Yet even these firms would ultimately find that deglobalisation limited their ability to expand and reap efficiency gains.

Worse still, should the US introduce its threatened border tax, this could result in retaliatory measures from countries. Reciprocal tariffs could also prompt corresponding developments outside of the US.


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CASE STUDY: FUYAO GLASS*

Jin Xu Asia Equity Analyst

China’s largest auto glass manufacturer, Fuyao Glass, is another example of a firm that may have to rethink its business model if new tariffs are introduced.

Although Fuyao Glass still relies on a predominantly export-based model for its US sales, the firm recently completed construction of its first US plant, in Dayton, Ohio. The profitability of the US operation is somewhat lower than the non-US operations.

Should tariffs make exporting more difficult, the firm will have to choose between either moving all its production to the US or absorbing the higher costs of exporting. Scenario analysis conducted by Morgan Stanley suggests that either scenario would reduce the company’s earnings, with the estimated impact on profits ranging by between 1% to 12%. (see tables below).

The extent of the loss would depend on how much the US increased tariffs on Chinese imports. Under these estimates, it would only make sense to shift all production to the US if tariffs were raised from their current level of 3% to around 45%, the highest considered scenario.

Scenario analysis – If move all production to US

Total Revenue Assumption 19,389

Before Tariff Hike – Assumptions

US Export Revenue 1,939

Total Firm Earnings 3,375

After Tariff Hike & Move production to US

Earning Change (271)

Impact on Earnings -8%

If continue exports to US Scenario 1 Scenario 2 Scenario 3

Total Revenue Assumption 19,389 19,389 19,389

After Tariff Hike

Original US Tariffs to China 3% 3% 3%

Proposed US Tariffs to China 5% 20% 45%

% of Extra Cost Passed on to Fuyao 50% 50% 50%

Earnings Change (21) (167) (409)

Impact on Earnings -1% -5% -12%

While the construction of the plant in Ohio may, therefore, fit within the context of ‘Trumponomics’ as it creates US jobs, from a purely financial perspective the prospects for onshoring the rest of US demand appear poor.


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ADVANCING CAPITAL OVER LABOURToday, governance-adjusted unit labour costs are still lower in emerging markets than those in developed markets, but the gap is shrinking fast. Labour is still relatively cheap versus capital/automation in a wide variety of sectors. But deglobalisation could disrupt this calculation. By introducing tariffs or tariff-like policies the relative wages of developed market labour against emerging market labour would narrow. But the gap between automation costs and emerging market labour would also narrow. Rather than competing against developed market labour, emerging market labour are in many cases competing against expensive robots. Protectionist policies that make emerging market workers more expensive to developed market firms appear likely in many cases to accelerate the process of automation over the rehiring of developed market manufacturing workers. But insofar as firms are today allocating away from developed market manufacturing bases and towards emerging market manufacturing bases on cost grounds, increasing emerging market manufacturing costs through tariff and non-tariff barriers will likely nonetheless enhance developed market bargaining power at the margin.

Demographic dynamics will influence what choice companies make, depending on whether more protectionism is introduced. China’s working population may already have peaked. Yet in other less developed regions, the working-age population is expected to continue to rise significantly until at least 2040. Were globalisation to continue unchecked, this growing population represents to companies a set of new workers, and new markets. At a human level it represents a billion people who would otherwise be denied the opportunity to trade out of poverty on terms overtly rigged against them.

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PROTECTIONISM PRODUCES FEW WINNERS*

David Dudding Global Equity Portfolio Manager

Firms operating within other sectors are also at risk under a US-led deglobalisation scenario. For example, if Mexico chose to retaliate against unlawful tariff measures by rejecting the validity of US patents, the pharmaceutical industry’s profits would be put at risk. This would reduce the incentive for US multinational firms to innovate and create potentially life-saving medicines.

There are other types of companies that could be affected if their intellectual property rights were no longer respected, as agreed previously within the framework of the World Trade Organisation (WTO), including IT firms.

Some firms which have a high proportion of their value-add based in the US but which sell outside of the US would also suffer in the event of counter measures. These include Boeing, the leading aircraft manufacturer, which is a major US employer.

Furthermore, industries where domestic substitutes for raw materials do not exist and which already have low margins would suffer. These include the refinery and apparel sectors.

Other firms that have exposure to end-demand in regions geared to trade growth, or non-domestic government spending, could also see their current business models under threat.

Companies that sell in the US but create most of the value within their production processes elsewhere might also suffer, especially if they face competition from within the US. These include firms such as French wine and spirits producer Pernod Ricard. Brown-Forman, a US wine and spirits company, which both sells and produces a reasonable amount of its beverages within the US, would meanwhile benefit to a degree – though the firm also exports outside of the US.

The few possible winners from US-led deglobalisation include companies with a low proportion of US sales and low US value-add that compete with US firms. Such companies – operating in Europe, Australasia and the Far East – could gain from lower competition. This is only in the event of reciprocal tariffs being erected.


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CONCLUSION: A NEW WORLD (INVESTMENT) ORDERToday globalisation is far from complete. Tariff and non-tariff barriers still need to be taken down to enable newly emerging populations to participate in the global trading system. Globalisation has been largely paused since the Global Financial Crisis, but attempts to further integrate the global economy in the form of TTP and TTIP have been scuppered since the election of President Trump, and the UK exit from the European Union threatens to alter the character of the world’s largest free-trade zone, giving it a more protectionist attitude. Halting globalisation would fundamentally change the rules of the game for companies, workers and investors alike. Crucially, the 35-year bond bull market has ridden on the coat tails of new globalisation, with the so-called ‘Great Doubling’ of the global labour force playing a key role in creating a disinflationary environment.7 Globalisation has led to falling neutral real interest rates – as labour costs have fallen – in turn lowering bond yields. This has allowed corporate profit margins to rise and asset prices to boom.

A deglobalisation scenario would negatively impact several kinds of firms. Not least because they would need to spend time, and incur costs, working out how to adjust to the new environment. Stock picking would become harder, as the dynamics we have understood to date would change. In such a scenario, likely to produce few winners, rigorous research and regular engagement with companies operating worldwide would be vital to avoid making mistakes based on an approach to investment that only applied in the past.

7 Toby Nangle (2015), ‘Labour sets the neutral real rate’, VoxEU http://voxeu.org/article/labour-power-sets-neutral-real-rate

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THE UNDERESTIMATED PERILS OF DEGLOBALISATION · 05/05/2011 · say, creating a product made by an...

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