Iggo's insight - Global vs local

Global / Local

There are more and more tensions between a “global” economic model and a “local” one. Politics has shifted towards the local and the emergence of the COVID-19 virus has exacerbated it. The reality is that there are challenges to the physical exchange of goods, services and people. These challenges have implications for consumers, businesses and investors. In the short term the retrenchment of normal business activity is already creating victims as well as generating extreme moves in financial markets. We probably don’t quickly return to business as usual – patterns of trade, investment and travel will see more than temporary changes, while the prices to which financial assets will eventually reach could have profound wealth and financing implications. We are all being forced to be very local at the moment. Let’s hope global isn’t permanently damaged.   

 

Globalisation challenged

The physical movement of goods, services and people across international borders is being challenged on a number of fronts. The rise in nationalistic populism has generated a more protectionist and inward-looking approach to trade and economic co-operation. Not to go over old ground but the key examples of this have been the UK decision to leave the European Union and the United States’ determination to re-write trade agreements in its favour. The rise in tariffs between countries means that global businesses have to reconsider their supply chains, their investment locations, strategic alliances and their distribution networks. Tighter controls on immigration into developed economies is also part of this trend. These “political” trends have been building since the Great Financial Crisis and are the reaction to how global capitalism was seen to have exacerbated inequality and economic instability. Now we have a global viral epidemic adding to these challenges. If biological or even climatic events are posing a growing risk to the ability to move goods, services and people around, then business models will change even more. Policy could even exacerbate the movement away from a global model. At the very least we are seeing forced restrictions of business and cultural exchanges (travel for both business and pleasure, conferences, sporting and entertainment events) and the danger is that changes in patterns of travel and business co-operation might become permanent, particularly if public opinion is sufficiently impacted by the extent of the current crisis.  

 

Less trade, less travel 

Global trade volumes have slowed relative to the growth in global GDP growth in recent years. According to World Bank and OECD data, the peak of global trade/GDP ratio was in 2008 and has gone sideways since. The ratio is still very high at close to 60% of global GDP, but the growth rate has slowed to zero in recent years. The current COVID-19 crisis is likely to cause a big hit to global trade volumes because of the impact on supply chains – starting in China in January – and to global consumer and investment demand. Other indicators like airline load factors will show a similar trend. The International Airline Transport Association (IATA) most recent data showed that the global load factor for January 2020 was up just 0.6% year-on-year in January with the Asia Pacific market showing a -1.5% change relative to January 2019. Data for February are likely to be much worse given the anecdotal evidence of massively reduced travel volumes, flight cancellations and, indeed, the market’s judgement on the outlook for airline businesses (S&P airline stocks down almost 25% since the second week of February). Freight rates for shipping fell sharply in January, although they have rallied a little since mid-February, mirroring some of the increase in China specific economic indicators.   

 

Changing trends

The global economy is complex and highly integrated. It is hard to forecast longer-term trends, but investors need to consider how the global economy is evolving – possibly away from the kind of globalisation that characterised the last 3o years, towards more consideration of social and environmental risks, towards how changing human needs can be satisfied using technology and science. One clear theme is that companies will need to establish more secure supply chains in response to the changing global trade environment or in response to the risks posed by environmental or biological events. Countries that act as locations for important parts of that supply chain could suffer. Where possible production might move closer to final consumption or to corporate control. Indeed, the basic driver of protectionism is to produce goods and services in the same geography (sovereign or economic) as where they are consumed in order to boost employment and incomes. Of course, if everyone does that, economic theory tells us that everyone loses. However, “taking back control” is a stronger political emotion than neo-classical economic theory and thus de-globalisation may continue to be a key political theme in coming years. Emerging market economies that have attracted global investment through cost-advantages over several decades may need to change their development models. Arguably, China is already doing this. Recent stories about India, the 10th largest exporter of generic drugs and medicines, considering restricting those exports is both a risk to the supply of drugs to developed economies and to India’s own economy if distributors in export markets don’t want to have that potential disruption. As investors in companies that operate at the global level, we will have to increasingly think about the location of their production and their distribution markets and how changes in these impact on their revenues and costs of sales. 

 

A virtual community

It is human nature to want to have physical contact in social and business relations. However, international travel is being challenged – at the moment by the epidemic but also by the likely acceleration of carbon transition and its impact on demand for and cost of transportation. The demand for more “virtual” relationships will continue to grow at a rapid rate. Communications providers as well as hardware providers for internet-based communications services still have more market share to take from what is currently achieved through physical business and cultural exchange. The robotic and digital themes will dominate as more and more production and exchange is enabled by digitalisation. At the moment it is easy to see how consumer demand might be impacted by concerns about social interaction – home entertainment at the expense of public shows, interactive home gyms instead of going to sweaty studios, food delivery services at the expense of restaurants. None of these are going away. The trends have been evident in retail for many years and will be reinforced by current concerns. Sadly perhaps, at a social level exclusivity might be favoured over openness. Inequality could get worse – the haves will greater choices in their interaction with the rest of society – private services provided online (medical consultations, education) and perhaps even with implications for the physical choice of where people choose to live, reversing the gentrification of some of our city neighbourhoods.

 

Less elastic

Long-term implications on supply curves are also interesting. The current crisis is both a supply and a demand shock. Demand can come back but supply might be permanently changed in line with some of the rambling thoughts above. If there are restrictions on supply – through tariffs, changes in suppliers, immigration controls – then the global supply chain becomes less elastic. That is inflationary and some businesses will struggle with increased costs – just think about a UK firm possibly having to adapt its products to multiple regulatory regimes in the wake of Brexit. There are potential implications for public services too. Restricting the supply of low paid workers in something like the UK’s National Health Service will raise wages and the cost of health provision on the public budget. Increased globalisation has gone hand in hand with lower inflation. What if the reverse were true? Inflation-linked bonds are responding to the current impact of reduced demand on inflationary expectations, helped by the decline in oil prices. If you want to believe that inflation could be higher in the future, think about what happens to relative prices during a more accelerated carbon transition or in a world of less international trade and labour and capital mobility.

 

How much lower

I had to give some thought to what happens to long-term government bond yields from here, with many markets reaching record lows this week. Inflation might go up in the long-term but in the-here-and-now bond yields are still falling. Yields on 30-yr German bonds are currently minus 20bps. That’s 30bps above the ECB’s deposit rate. In the US the spread between the Fed Funds and the 30-yr Treasury yield is 35bps so quite comparable in terms of curve shape. The difference is that the US has a lot more room to reduce the policy rate than the ECB. Imagine the Fed cuts to the 0%-0.25% range that persisted in the 2009-2016 period. 30-year yields at 60bps is possible if the curve doesn’t change shape too much. In Europe, maybe the ECB could reduce rates a little more, but the consensus view is that it really doesn’t want to go further into negative territory. So, 30-year yields at -30bps? Or -10bps if the 30-year minus deposit rate spread goes back to its all-time low. Any lower than that would really require more aggressive monetary easing and a further revision down in long-term growth and equilibrium rate expectations. However, another 20bps decline in yields is not what European defined benefit pension funds want to hear because of the impact it has on their funding ratios (and ultimately their ability to maintain benefits for their members).

 

FX costs

European long-yields may or may not be close to their lows but there is clearly loads of room (ahem) for US yields to fall. One revived dynamic might be that US fixed income looks better to European and Japanese investors on a currency hedged basis than it did a week ago. The USD-EUR 3-month FX hedge cost has come down to below 170bps compared to a peak of over 320bps in 2018. So, the US 30-year hedged into EUR yield is now around -8bps compared to -20bps for the German 30-year bond. Some European or Japanese investors may see value again in the US market which could simultaneously put a floor under European yields and drive US yields lower. While a lot more is already priced in in terms of Fed easing, there is still strong demand for the US Treasury market because of its safe-haven status. Finally, on this, the fact that US high yield spreads have widened, and currency hedging costs have come down makes US high yield the most attractive it has been to European investors since the end of 2018. With the Fed likely to cut rates further, the hedge costs will fall and returns on US investments hedged into Euro and other non-USD currencies will converge on the local USD returns.

 

China sneezed and the world went into recession

There are political, environmental and technological challenges to the globalisation model that has driven economic growth for many decades. Some are good and will allow us to challenge things like climate change, others are not so good and could have unwanted geo-political side effects. There will be investment risks and opportunities created by both. In the very short-term, the global exchange of goods, services and people has taken a body blow from the coronavirus. The continued rise in the number of confirmed cases keeps pushing risk assets lower and government bonds higher. Bond yields are reaching extremes, the move in equities not so much yet. There may come a moment when bond yields stop falling and investors prefer just to hold cash (and some gold) given the longer-term price risks in negative yielding assets, while the equity rout continues. We will look back and see that it was China that sneezed and the rest of the world got a rather bad cold. What we need is better weather and better news on the epidemiological front. Until that comes, good luck and stay healthy.

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