Deglobalisation will have ramifications for investment markets.
Deglobalisation will have broad impacts on supply chains, company earnings and markets. All is explained in this article from GSFM’s investment partner Epoch Investment Partners.
Globalisation’s golden age began around 1980 (Figure 1), turbo-charged by three developments:
- The pro-market policies of US presidents from Ronald Reagan through to George W Bush (supported by allies such as UK Prime Ministers Margaret Thatcher and Tony Blair)
- Chinese economic reforms under the leadership of Deng Xiaoping from 1980
The dissolution of the USSR in 1991
Globalisation peaked in 2008 with the Global Financial Crisis (GFC), which led to pushback against hyper-globalisation and the primacy of markets. However, developments in China have been even more important (Figure 2).
President Xi’s first term began in 2012 and, since then, he’s forcefully emphasised national security and self-reliance, especially regarding energy, food, and technology. His foundational policies, particularly “China 2025”, “Dual Circulation” and “Common Prosperity” have collectively forged “Fortress China” and thereby shattered the golden age of globalisation.
Global supply chains are being reinvented because trade with China raises two national security issues for the US.
First, while global supply chains are extremely efficient and much beloved by economists, they are inherently fragile and vulnerable. To illustrate, think of Europe’s dependency on Russian natural gas, challenges obtaining personal protective equipment during the early months of COVID and everyone’s dependency on Taiwan for semiconductors.
Second, many of America’s exports are “dual-use” products; that is, products that can be used for both commercial and military purposes.
This is especially true of Advanced Technology Products (ATP), a classification that includes biotech, chips, robotics, guided missiles, communication satellites and nuclear reactors (Figure 3). Given State Department concerns about Military-Civil Fusion (MCF), Epoch expects the US will continue to tighten controls so that exports of ATP to China fall dramatically over coming years[1].
Elevating national security: after a four-decade hiatus, industrial policy is increasingly de rigueur
One consequence of the rising rift with China is that industrial policy has returned as a bipartisan priority in the US, with three important actions taken in Washington DC during the last few months.
The most recent is the 7 October 2022 announcement of export controls, aimed to choke off China’s access to AI and semiconductors. These controls tightened measures announced previously and will almost certainly be augmented by fresh restrictions in the coming months. US policymakers are determined to cut-off China from the supply of American-made chips and design software to ensure its capabilities remain generations behind[2].
The second action was the bipartisan CHIPs and Science Act, which was signed into law in August 2022, with the primary aim of revitalising US-based semiconductor fabrication (Figure 4).
The Act provides $280 billion over ten years, including $80 billion in subsidies and tax credits to encourage investment in domestic semiconductor manufacturing and equipment. CHIPs also includes $200 billion for tech R&D, which is likely to prove the Act’s most durable and impactful feature.
Reflecting this new emphasis on domestic chip production, during the last year or so there have been numerous announcements to build or expand semiconductor fabrication in at least four states (Arizona, New Mexico, New York and Texas). This is just a start and will require significant government subsidies over the long term.
However, the cost of constructing and operating a fab is much higher in the US than in Taiwan or South Korea. To be more specific, Taiwan Semiconductor Manufacturing Company’s founder, Morris Chang, recently emphasised the costs in the US will be 55% higher than in Taiwan[3].
Similarly, the Boston Consulting Group estimates “a new fab in the US costs approximately 30 percent more to build and operate over 10 years than one in Taiwan, South Korea, or Singapore … As much as 40-70% of that cost differential is directly attributed to government incentives.”[4]
Ramping up US domestic chip production faces two major hurdles (beyond the relative paucity of government subsidies). First, companies looking to build a fab in the US are required to navigate the menacing complexity of local, state, and federal regulations.
Further, a skills gap exists in virtually every job category. Announced plans mean an additional 70,000 to 90,000 fab workers will be needed, commanding a diverse array of highly specialised skills. This includes PhDs in materials sciences and electrical engineering, software and electrical engineers for manufacturing, as well as print technicians and factory machine operators. As one commentator put it, “It’s not like there’s a specific type of person or function missing. It’s across the board.”
The third major industrial policy action out of Washington DC is the poorly named Inflation Reduction Act (IRA), which was also passed in August 2022, but this time on a strictly partisan basis. It includes grants, loans and tax credits tallying $400 billion over the next decade, with the aim of turbo-charging energy capex spending, primarily for green technologies (Figure 5). Daniel Yergin has argued the legislation should really have been called the Industrial Policy Act or Chinese Competition Act. Moreover, regarding the balance between state and market, he emphasises the pendulum has unambiguously swung toward the former.
Cold war II: end of the peace dividend
While a majority of US trade does not raise any national security issues, a significant proportion does, and this has numerous implications for investors.
First, the two biggest beneficiaries of hyper-globalisation have been China and US-based multi-national corporations (MNCs). Focusing on the former for now, as globalisation is unwound, we expect Chinese equities to underperform over the medium- to long-term. In fact, this has already been the case, as China’s stock market has taken a beating over the last decade (Figure 6).
Moreover, there have only been two years since 2010 when a majority of CSI 300 companies outperformed the S&P 500 (Figure 7). On average only 33% produced superior returns, which represents a huge hurdle for portfolio managers and analysts[5].
Further, over the last decade, the best performing sectors, relative to their S&P 500 counterparts, have been consumer staples and health care, both of which are domestically focused. This is likely to remain the case during the next decade as export-oriented sectors take a hit from deglobalisation.
Some commentators take the argument even further, insisting China is uninvestable, especially after the twentieth Congress held in October 2022. President Xi solidified his position and, compared to five or ten years ago, is placing even more emphasis on national security and self-reliance.
However, based on fundamentals such as sustainable free cash flow and return on invested capital, the CSI 300 looks similar to the Tokyo Stock Exchange Index (TOPIX) and the Euro Stoxx Index. That is, markets which should typically be underweight relative to the S&P 500, but where analysts are likely to identify a number of attractive global champions and domestic plays.
“Our fundamental problem is that our number one customer is our number one competitor”[6]
As mentioned earlier, American-based MNCs have been the second biggest winner from the period of hyper-globalisation. However, they are also vulnerable as, in many cases, exports to China have accounted for 40% of their revenue growth over the last decade.
This is also true for ATPs, including chips (Figure 8).
Further, for major US semiconductor companies, China has represented 28%-47% of revenue growth over the last decade. Compulsory decoupling constitutes a major headwind for the sector’s medium-term performance, given its high correlation with global sales (Figure 9).
As a result of the 3Ds – deglobalisation, demographics and decarbonisation – we are not returning to the low inflation, zero real interest rate 2010s. Instead, Epoch forecasts higher macro volatility of growth, inflation, interest rates and foreign exchange.
This brings us to the end of Part I of the analysis of deglobalisation. Part II will demonstrate that deglobalisation, which implies a secular rise in domestic capex and the labour share, constitutes a major headwind for US company margins and free cash flow, and emphasises that we are not returning the macro environment of the 2010s.
Over the next decade, US companies are expected to face a higher cost of capital, which suggests lower multiples and is likely to prove especially challenging for longer duration assets, such as venture capital and speculative tech companies that are years away from producing free cash flow on a sustainable basis.
Read part two: Deglobalisation and its impact on world markets (Part two)
———-
You must be logged in to post or view comments.