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Globalisation: From tail wind to headwind
AN ACCELERATED brand of globalisation, labelled by some as hyper-globalisation, has been under way for the better part of a generation.
Spurred in part by the North American Free Trade Agreement (Nafta), the inception of the euro and China's acceptance into the World Trade Organization (WTO), multinational companies have ridden the globalisation wave along with its secular tailwind to margins. But with growing concern that globalisation may have reached its limits, are margins at risk?
In the post-global financial crisis era, chief financial officers have become extremely adept at employing all manner of financial engineering in order to increase margins, earnings and stock prices.
They've adopted capital-light strategies, increased leverage, engaged in debt-financed mergers and acquisitions and bought back stock. Companies have also become proficient in driving down costs by managing global value chains, sourcing intermediate goods and services from around the world and assembling them in low-cost countries.
At the same time, they've engaged in international regulatory and tax arbitrage. But as we've globalised more and more, the marginal benefits of additional globalisation have decreased. The value-added resulting from Nafta, the formation of the eurozone and offshoring appears to be at an end.
As good as it gets?
While globalisation has ebbed and flowed for thousands of years, the post-Bretton Woods order that gave rise to today's global value chain has been underpinned by the central role of the US dollar as the world's reserve currency, institutions such as WTO and the International Monetary Fund (IMF) and the United States acting as the world's enforcer.
Against that backdrop, the global value chain has been predicated on a relentless decline in tariffs. But there are growing signs that globalisation may have reached its limits, with rising income inequality and a concurrent increase in populism among the symptoms.
The US-China trade war calls into question the viability of the global value chain in a world where tariff rates may be reversing their decades-long fall. If the US were to apply 25 per cent tariffs on all imported goods from China, overall tariff levels would rise towards heights not seen since the 1960s.
However, global value chains weren't designed for 1960s-style tariffs. At those heights, value chains would likely fray.
At the same time, non-tariff barriers are seemingly on the rise everywhere. The global value chain was built for a world of low tariffs in which free trade is seen as a public good. But recent events call that view into question, putting the multi-trillion dollar global value chain at risk.
No levers left to pull
In an environment where CFOs have already pulled all the available levers, is there any margin for error from an asset price perspective? We'd argue there isn't much.
If globalisation is reversing and global value chains are undermined or forced to make expensive adjustments, gross margins are likely to be negatively impacted.
Companies that generated above-average margins, profits and equity performance - not because they produced superior products but because they effectively managed global supply chains - may find themselves in unsustainable positions, no longer surrounded by an economic moat.
And in an environment where management has few cards left to play and margins are at risk due to supply chain disruptions, companies with truly differentiated business models, unique intellectual property and strong brand equity are likely to be better positioned to deal with the shifting global conditions.
Companies that are unable to quickly move production to avoid the impacts of tariffs and those without pricing power could be at risk.
This potential dislocation makes security selection increasingly important as market dispersion reasserts itself after a decade of monolithic index-driven price action.
In essence, late in the business cycle, investors have become much choosier, avoiding highly leveraged companies with falling gross margins as well as lower-quality cyclicals.
As is often the case, changing business environments have a way of exposing corporate vulnerabilities, amplifying the importance of selectivity.
Erik Weisman is chief economist and Rob Almeida is global investment strategist at MFS Investment Management.