Deglobalization Threatens the World Economy and Investors Alike

October 12, 2020

Deglobalization Threatens the World Economy and Investors Alike

10/12/2020

Tom Lee


Tom Lee, CFA

Chief Investment Officer,
Equities and Derivatives

More about this author

History teaches us the value of worldwide trade—but with globalization under fire, it may be time to relearn the lesson.

One of today’s dominant macro-trends is the reversal of globalization, or deglobalization. Globalization is the free flow of people, goods, services, capital, technology, and ideas across national borders. This system has faced numerous threats in 2020, most notably rising nationalism, geopolitical instability, and the COVID-19 pandemic.


In an increasingly deglobalized environment, equity investors may have a harder time finding steady profitability and value. Let’s take a look at how we got here and where we could be going if this trend continues.


How did the world first embrace trade?

We’ve understood for at least two centuries that trade stimulates worldwide economic growth. An 1817 article by British political economist David Ricardo explained that a country is better off when it focuses on producing goods where it has the greatest comparative advantage and trades for other goods where its comparative advantage is less. If every country specializes in this way, he wrote, all countries would be better off—even in scenarios where one country holds no comparative advantage in producing any goods.


The comparative advantage theory has been extended and modified over the years, but Ricardo's basic argument has stood the test of time. Specialization and trade lead to higher levels of economic growth. But while trade benefits society as a whole, the benefits may not be equally distributed. Certain groups in any country may be harmed by trade. The migration of manufacturing abroad benefits Americans who purchase goods at a relatively low cost, but it can hurt those who had worked in factories previously located in the US.

 

After two destructive world wars in the first half of the 20th century, the US and other countries coalesced around the simple idea that more economic integration would promote widespread growth and align national interests, thus reducing the likelihood of another world conflict. The 1948 General Agreement on Tariffs and Trade (GATT) included the US, UK, Europe, and Japan. Trade agreements were later extended to include emerging countries like China, Brazil, and India. The World Trade Organization (WTO) was formed in 1995 to oversee the GATT and provide a forum for individual countries to settle trade disputes.  The result was a sharp increase in bilateral and multilateral trade agreements. There were 50 trade agreements around the world in 1990; today there are 280.

 

World trade as a percentage of global GDP

Deglobalization Threatens the World Economy and Investors AlikeSources: World Bank, OECD, 9/4/2020. For illustrative purposes only.


Global trade increased steadily for several decades before the 2008 financial crisis. The world spent nearly 10 years recovering from the GFC, but we haven’t reached the 2007 peak percentage of global GDP since. The Trump administration hardened existing trade friction in 2017 by deciding to withdraw the US from the Trans-Pacific Partnership (TPP) with 11 countries, including Canada, Japan, and Australia. At the same time, increased tension between the US and China and rising nationalism put global trade under pressure. 

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How has COVID-19 affected globalization?

The global pandemic accelerated the deglobalization trend, with closed borders and economic shutdowns leading to a sharp decline in international trade. International flights in April dropped to levels not seen since the 1970s. Having originated in China, the pandemic blocked supply chain arteries across Asia, laying bare the fragility of those structures. Current projections show the absolute dollar value of world trade falling 13.4% in 2020, the steepest drop in 60 years.


Possibly even more troubling are concerns that the interdependency that results from specialization and trade is a global security risk. Some US political leaders expressed alarm when they discovered a significant amount of personal protective equipment (PPE) and medicinal ingredients are manufactured in Asia. In one of the more public attempts to reverse this trend, the US government extended a $750 million loan to Kodak under the terms of the Defense Production Act in July, with the goal of expediting domestic production of generic drugs. US companies had exited this industry long ago because of compressed margins—an example of low comparative advantage.

 

What does deglobalization mean for equity investors?

History provides us with insight into how trade frictions like tariffs can impact the broader economy. As the US entered the Great Depression in 1930, Congress passed the Smoot-Hawley Tariff Act, which raised tariffs on over 20,000 imported goods and caused a significant drop in US imports and exports. Most economists now recognize that Smoot-Hawley deepened and extended the Depression.

 

A decline in global trade associated with an increase in tariffs and protectionist sentiment presents equity investors with their own challenges. The US lacks the ability in many areas to mass-produce certain goods at a competitive price point. Many of the most successful companies depend on their ability to source goods from lower-cost suppliers to keep margins healthy. Apple, the world's most valuable public company in terms of market value, is a prime example. The company asked two of their Asian manufacturers in 2016 what it would cost to produce 200 million iPhones per year in the US. Taiwan-based Pegatron cited concerns about costs and refused to respond, while China-based Foxconn estimated that manufacturing the iPhone in the US would double the cost. 

 

Deglobalization and a long-term reduction in trade have other implications for investors beyond profitability, including increased inflation pressure, slower innovation cycles, reduced consumer choice, and heightened geopolitical risk. Barriers to the free flow of goods and services across national borders present a headwind for equity investors. The strength of the headwind will directly correlate with the severity of those barriers.  


The bottom line

The COVID-19 pandemic has accelerated deglobalization, threatening to reverse a decades-long expansion in global integration, trade, and economic growth. This trend presents a challenge for equity investors that they must navigate carefully. Parametric stands ready to assist investors through challenging market environments, with solutions customized to every investor’s needs. 



 

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss. Prospective investors should consult with a tax or legal advisor before making any investment decision. Please refer to the Disclosure page on our website for important information about investments and risks.

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