The underestimated perils of deglobalisation

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.

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.

‘Old’ versus ‘new’ globalisation
To 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. 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 employmentrich 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).

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).
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. 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. 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.

Deglobalisation on the agenda
Peter 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. 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.
“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. “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.

Advancing capital over labour
Today, 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 workingage 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.

Conclusion: A new world (investment) order
Today 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.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.

Toby Nangle – Global Co-Head of Asset Allocation and Head of Multi-Asset, EMEA – Columbia Threadneedle Investments