The End of Globalization

“If they don’t want to trade with us anymore, that would be fine with me.” -President Donald Trump; August 1, 2019

Future historians may well mark the summer of 2019 as the time when a 30-year period of increasing globalization officially came to an end. On August 1, President Trump escalated his trade war with China by extending 10% tariffs to nearly every Chinese import to the US. China quickly retaliated with a suspension of agricultural purchases and by engineering a sharp drop in their currency that could offset the cost of the new tariffs.

Boris Johnson, the United Kingdom’s new Prime Minister, has pledged to rip the U.K. out of the European Union on October 31st without a deal establishing a new trading relationship unless the E.U. agrees to renegotiate the Irish backstop. E.U. leadership have repeatedly refused to even discuss such a renegotiation of the existing Brexit agreement.

Finally, the summer of 2019 witnessed unprecedented use of trade restrictions as a weapon in otherwise unrelated diplomatic disputes. This trend started with President Trump’s use of tariffs to influence Mexico’s policy toward refugees, and has continued with Japan severely restricting trade with South Korea in a dispute over World War II reparations.

Globalization, the interconnection of the global economy through relatively open trading relationships and free flowing investment capital, took off during the 1990s after the fall of the Iron Curtain and the supposed triumph of Western capitalism and democracy. The high water mark of globalization was probably December of 2001, when China entered the World Trading Organization and the euro currency was officially launched.

Business leaders have feared a major reversal in the 30-year trend toward more open trading relationships since 2016 due to the Brexit vote and the election of Donald Trump. This summer’s developments have confirmed those fears, in our view, and resulted in a precipitous drop in business investment spending. The MNI Chicago Business Barometer, one of the best leading indicators of manufacturing activity in the US, dropped sharply in July and was far worse than expected (see chart below).

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IHS Markit is a company that surveys business leaders all over the world for its monthly PMI surveys. Their Chief Business Economist, Chris Williamson, stated on August 1st that

“US manufacturing has entered its sharpest downturn since 2009.” These trends are similarly reflected in forward looking indicators of manufacturing and business investment all over the world. This sharp decline in business investment spending is likely the beginning of a painful series of economic adjustments necessitated by the end of globalization.

The developments of recent days and weeks suggest that, even if Presidents Trump and Xi resolve their current dispute and Parliament prevents a “hard” Brexit in the UK, business confidence is unlikely to be quickly restored.

Crises in the global trading system are erupting with little or no warning (Trump’s new tariffs, Japan’s trade restrictions on South Korea, etc.), undermining confidence in the long-term viability of any dispute resolution. Business leaders and investors are recognizing that a seismic shift has occurred in the political and economic environment in which companies operate.

The political consensus behind globalization that allowed Republican and Democratic Presidents to continue one another’s work on free trade agreements like NAFTA and TPP was shattered by the 2016 elections.

A new political consensus on trade needs to be formed. Prior to recent events, business leaders and investors believed/hoped that the new political consensus would be a straightforward modification of the old (fairer trading relations with China, ‘soft’ Brexit, etc.).

This summer’s developments have revealed that the new trading regime may bear little resemblance to the globalization trends of the past 30-years. Uncertainty over how the new trading regime might operate could depress business investment for an extended period of time.

Economics and Investment Implications

• Depressed business investment is likely to pull the global economy into recession in the next 12 to 18 months. US consumers and the global financial system are in much better shape than in 2008, and any recession will likely be much less severe when compared to the 2008 financial crises. However, interest rates are already low in most economies and budget deficits high. That means stimulus efforts could be less effective in countering the economic slowdown, and a mild but protracted recession could result.

• The collapse of global business investment makes the US economy almost completely dependent upon consumer spending and government stimulus. Low consumer debt burdens and residual momentum in the job market should keep US consumption spending high for the foreseeable future. The new two-year budget deal assures another $300 billion of fiscal stimulus and continued $1 trillion deficits from Washington. The combined impact of these two forces and the relatively low dependence of the US economy on globalization and trade should prevent a US recession for the next 12 to 18 months. This forecast assumes that President Trump continues to build on recent initiatives to improve trading relations with Europe and Japan, and focuses his anti-globalization policies on China.

• The end of globalization will severely impact those economies that became dependent upon increasing integration of the global economy. China is clearly the biggest loser and should continue to see declining business investment as businesses diversify their export production capacity, in our view. Europe and Japan relied on Chinese consumers to provide the dynamism and growth that their demographically challenged economies could not, and they are likely to suffer along with China.

• Despite significant fiscal stimulus from Beijing, Chinese consumer spending appears rather tenuous and continued relocation of export production capacity out of China could further depress consumer sentiment. Beijing recognizes that any economic slump could undermine it political legitimacy and is pulling out all the stops to stimulate its economy. Consumer sentiment is highly dependent upon real estate markets and Beijing is provided significant stimulus to debt driven real estate investments. Chinese growth will slow sharply but remain positive. This forecast assumes that China does not apply a destabilizing use of force in Hong Kong.

• Extraordinary budget deficits and debt dependent consumers in both the US and China are likely to require another extended period of very low interest rates. Both economies are increasingly dependent upon debt and renewed borrowing, and need declining interest rates to keep ever increasing government and consumer debt burdens manageable.

• Although the US economy should escape recession, US corporate earnings growth is likely to be very subdued for the foreseeable future.  US companies within the S&P 500 depend upon overseas sales for about 40% of their earnings, and we believe problems overseas will inevitably depress US earnings growth. Unlike US consumers, US corporations are back to the heavy debt loads that made the 2008 recession so painful for corporate earnings, and debt driven stock buybacks should decline as the global economy slows. The good news for US stocks is that, as shown in the below chart, equity risk premiums (earnings yield relative to bond yields) are a much better predictor of future returns than price/earnings ratios. Risk premiums on the S&P 500 are currently cheap enough that history suggests a 75% chance of positive returns over the next year.

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Investment Strategy

Since the initial Strategic Insight published on April 1, 2019, we have consistently advocated four investment themes:

1. Barbell the Bond Portfolio (buy 30-year Treasuries)

2. Swap US Equities for High Yield (buy $2 of high yield for every $1 of S&P sold)

3. Buy Currency Hedged European Exporters (sell unhedged international equities)

4. Swap Emerging Markets Equities for Japan

We believe that the events of this summer and our much more pessimistic forecast necessitate some adjustments to these 4 strategies.

First, we recommend adding another 5% of the portfolio to the long bond position. We believe that low interest rates are now a global imperative in a post globalization world. The Fed may drag its feet on future rate increases, but the bond market is clearly treating a slow Fed as a long term positive for bonds, and we agree. The additional 5% in 30-year bonds is the equivalent of adding an additional 15% of typical, intermediate maturity bonds to the portfolio.

Second, we recommend cutting positions in hedged European exporters by half and eliminating all Japanese equity investments. Although hedged European exporters have been one of the best performing international investments, the world we envision will be increasingly difficult for global European brands that have flourished in a world of relatively open trade and increasing Chinese affluence.

Japan has also outperformed emerging market equities in recent months, but losing less money is not a satisfactory investment strategy. Furthermore, by using trade as a diplomatic weapon Japan is endangering its inbound tourism business. Attracting Chinese and Korean tourists has been one of the most successful elements of Abenomics, and Japan is undermining this strategy just as its more traditional export and globalization dependent business are suffering.

We continue to like US high yield bonds. We believe that the Fed will be compelled to keep interest rates low and liquidity high to help fund massive US deficits and higher consumer borrowing. That environment will be supportive for high yield debt and could offset the negative effects of a slowing economy.

We would deploy the funds liquidated from hedged European exporters and Japan first to the 5% increased allocation to 30-year treasuries, and we would split the balance of the funds between US high yield and cash. We would wait for the US equity market to find technical support before making these high yield investments.

We maintain a neutral weighting in US equities. Although earnings growth is likely to come under pressure over the coming year, the high risk premium and lack of compelling alternatives for investment capital make US equities the best house in a not very attractive neighborhood.

Conclusion

Equity markets have been in free fall since President Trump’s announcement of the new tariffs on Chinese imports. Investors are  adjusting to the fact that a quick resolution of the current trade dispute is increasingly unlikely. We believe that markets may have to face another unpleasant realization in the coming weeks and months.

Ever since the surprising victories of the Brexit and Trump campaigns, the market consensus (that we shared) was that the populist backlash to trade would be confined to marginal adjustments to the existing trading regime.

By sharply curtailing investment spending, businesses are stating that they are now afraid that something much more profound may be shaking the global trading system. Adjusting to this uncertainty could be a drag on the global economy until clarity emerges about the new trading regime, and that clarity may not be possible until after new elections in the US and the UK. In this environment, the US economy may escape recession but corporate earnings are likely to suffer more than the economy. We expect to keep a cautious portfolio stance until the lows of December 2018 have been successfully tested.

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