15 Aug 2019
From Brexit to Donald Trump and the rise of inequality to a backlash against power, my thoughts on globalization and why it's no longer considered a one-way bet...
Globalization is a subject that most market commentators viewed as a given until the Brexit vote and the election of Donald Trump. This has now been called into question and there has been a significant amount of analysis on the subject. Stephen King from HSBC has produced some incredibly useful research and data on the topic.
Up until the financial crisis from the post WW2 period, globalization had been regarded as a one-way bet in which everybody benefitted. Whilst some parts of globalization existed in the pre-war period and indeed even earlier in history, it accelerated dramatically as the US moved away from its pre-world war II isolationism. Modern globalization has been founded on a rules-based international system, primarily sponsored by the United States.
Globalization has always been associated with cross border population flows, starting with the exodus of Europe for the New World, the movement of people from crisis-hit European nations in the GFC and more recently the surge of migrants from Africa to Europe.
Globalization also encompasses the most recent advances in technology, allowing people to connect rapidly and inexpensively through channels such as Facetime, WhatsApp, Twitter and Facebook. Lower production costs (primarily labour) in the emerging world has also had an impact as the cost of tradable goods has reduced, benefitting Western consumers.
After the first world war early attempts at a more globally integrated approach to problem solving, such as the League of Nations, fell apart in the 1930s depression in which some countries such as the United States experienced deflation, whilst the Weimar Germany saw hyperinflation. In 1944 the Allies, or to be more specific the Americans and British, began to think about the post war economic and financial order. After the sacrifices at home, neither country wanted to go back to the chaos of the 1930’s, a decade of depression, devaluation and default. There was recognition that to impose huge costs on a defeated Germany, previously tried with the Versailles Treaty post WW1, would ultimately end in failure.
Thus, the Americans and British looked to create a system that would move away from the “beggar-thy-neighbour” behaviours of the 1930s, whilst settlement treaties on the vanquished of WW2 steered clear of a focus on revenge. Arguably, the Americans also had another subtle agenda which was to get rid of the 19th Century empires and to ensure that the United States was the sole country with super power status in the West. It is now widely recognised that the conditions laid down by the US for its assistance to Britain during WW2 were notably tough.
The Bretton Woods Conference of 1944 looked to rid the world of protectionist practices which had so damaged it in the 1930s. Americans were the front runners in terms of pro globalisation arguments and were behind the creation of three institutions; the International Monetary Fund (IMF), the World Bank, and within a few years, the General Agreement on Tariffs and Trade (GATT) and later the World Trade Organisation (WTO). With Europe struggling under the costs of the war effort, the US Secretary of State put in place the eponymous Marshall Plan to provide a buttress against the threat from the East and to ensure Europe could remain outside Soviet influence. The European Recovery Plan ran for four years from April 1948. The numbers were huge with the US providing $13bn in aid which was almost 5% of US national income in 1948 and around $130bn in 2018 terms. The quid pro quo was that European countries were encouraged to embrace free market principles, abolishing price controls, supporting free trade and re-building Europe in a way that was consistent with Washington’s strategic ambitions. The US did not want to see a return to sovereign rivalries and economic interdependency which had occurred in the first half of the Century. Those who were war time allies received no favourable treatment. You could conclude that the Marshall Plan was behind the huge gains in living standards in Europe delivered during the 1950s and 1960s. A second driver of growth in Europe was the original European Coal and Steel Community and the 1951 Treaty of Paris which later evolved into the Treaty of Rome and the European Economic Community.
Isolationist American foreign policy had resulted in Britain and other advocates of democracy standing alone in both WW1 and WW2 and the formation of NATO (North Atlantic Treaty Organisation) in 1949 saw a break in American isolationism with the 12 founding nations adopting a three musketeers’ approach to their collective defence. NATO was of course designed to provide a bulwark against the perceived Soviet and Communist threat, but also to promote deeper European integration and to ensure that nationalist militarism would not return to the Continent. This worked well as the US wanted to have a permanent military presence in Europe but it is now questioned by the US President.
The end of WW2 saw a huge change in that America moved away from its position of splendid isolationism which had dominated US foreign policy ever since the ‘Munroe Doctrine’. US President James Monroe had promoted non-interference in other countries’ affairs in around 1850 and the US had few serious military ambitions following the American Civil War. You could comment that the League of Nations was doomed to failure when the US Senate voted against membership in 1919. The US had initially been unwilling to get involved in WW2 but eventually took the opportunity to re-write the world order and America’s role within it. In the immediate aftermath of WW2, the US believed it had a moral purpose to demonstrate the values of freedom and democracy to countries far and wide, returning to the Jeffersonian doctrine of an “empire for liberty”. For this to work the US could not return to its insular policies. Money provided through the Marshall Plan and the creation of institutions such as the IMF, World Bank and NATO helped to shape the democratic world in the post war period.
At this time all the countries in what can be described as the free world seemed to prosper, so it was hardly surprising that globalization was an idea which proved popular. The US helped to fund many of the institutions that set the framework for a rules-based trading system and provided significant aid money at a time which saw its per capita GDP more or less double between 1950 and 1980. As a result there was no internal backlash against this act of ‘generosity’. Germany, left ravaged by the war, had an average income of a mere 41% of those in the US in 1950 but this had risen to 76% by 1980. In the same period French per capita incomes grew from 54% to 79% and Italy’s from 33% to 70% when compared to the US. Japan’s ‘economic miracle’ saw a move from a mere 20% to 72%. Countries that had experienced the worst destruction and needed to rebuild without vested interests from existing institutions or organisations such as trade unions or sunset industries blocking reform or restructuring, saw the most rapid recovery from admittedly very depressed levels. This is in line with the Olson Theory, a Norwegian Professor of Economics and Nobel Prize winner.
In contrast countries behind the Iron Curtain, where globalization was rejected, had a far less satisfactory experience with only modest improvements in real incomes. Latin America also suffered over the period and Chinese and Indian citizens remained extremely poor, with China rejecting any attempt to integrate with the West. Europe undoubtedly benefitted from a half century where economic and military conflict was avoided.
As brands became global the US was in a dominant position. Disney and Coca Cola featured among the top global brands for many years. US dominance of the world order was also helped by its military strength and by the collapse of the old Soviet Union. Today this position is challenged from a revitalised China and the strong man leadership of Russia under Putin. China, in particular, has reason to believe that the post 1945 ‘World Order’, imposed after a century of foreign humiliation of the Middle Kingdom, does not apply today. The last great empire to come under challenge was Britain’s and this came at a time of prolonged economic and social conflict. The existing ‘World Order’ clearly seems to be under challenge by emerging or re-emerging superpowers, namely China and Russia, looking for spheres of influence at a time when a trend towards isolationism in the States is providing a vacuum.
The accepted wisdom that globalisation was to the benefit of everyone was not significantly challenged until the GFC. There was a growing belief that free market capitalism was the way forward for every country and China’s reforms under Deng Xiao Ping only reinforced this point. As Western and Japanese capital poured into the country, living standards improved markedly. Over 50 conflict free years in Europe allowed the single market to develop based on the free movement of goods, services, capital and labour, the so-called four freedoms, first established in the 1957 Treaty of Rome. UK Chancellor, Gordon Brown, famously claimed he had abolished boom and bust. Fiscal orthodoxy and free market capitalism were perceived to be the way to the ‘promised land’ for everyone, everywhere.
Keynes wrote in the General Theory of Employment, Interest and Money in 1936 that “if enough people believe that the world’s fundamental economic problems have been solved, they will begin to take risks that collectively will make the world a much more dangerous place”. This proved to be particularly applicable in 2007 when the US credit crunch started and the whole global financial system was thrust into chaos. Whilst the exact causes of the financial crisis have been well discussed, the result was that there was a realisation that low and stable inflation and free market policies provided no guarantees of longer and smoother economic cycles. In the post GFC period, it has been questioned whether increasingly internationalised markets generate outcomes in everybody’s self-interest. Whilst it can be argued that globalization has and will continue to benefit society as a whole, different collective interests within this have been winners and losers and the differences and distinctions between the ‘have yachts and the have nots’ have become glaringly apparent.
In the US living standards have risen since 1980 but the distribution of gains has been skewed far more heavily in favour of the already well off. The median weekly salary for full time employees has barely budged, in real inflation adjusted terms, since 1979 according to the US Bureau of Labour Statistics. For the male population, salaries in real terms have actually fallen. The share of income going to the top 1% of earners rose from 8% in 1979 to over 22% in 2017 and the top 0.1% did even better make 188x as much as bottom 90%. Beyond the top 20% of income earners in the post 1980 period there have been no gains to speak of.
Post crisis policies of low interest rates and quantitative easing have favoured the wealthy as they are the owners of financial assets, which explains why we have referred, in previous outlooks, to QE as “welfare for the wealthy”. Post crisis policies are seen to have provided a financial uplift for the well-off but have not delivered broader economic gains that would have benefitted society in the wider context. Labour has seen a significant decline in its share of GDP with wages remaining subdued thanks to a combination of weak demand, technological change and the ability to relocate to areas with cheaper labour. Even if this has not actually occurred, the threat of it remains ever present for many workforces today. As a result, gains in sales revenues feed through in a much stronger fashion to the bottom line, with higher profits further fuelling stock market advances. With the rise in income inequality it was not surprising that Thomas Piketty’s Capital in the 21st Century became a New York Times Best Seller. Whilst academics have, in many cases, strongly contested the claims of this book, it did seem at first sight, that the owners of capital were becoming richer at the expense of the less well off.
The mystery behind anaemic US wage growth at a time of relatively full employment has attracted much debate. US corporations have continued to enjoy unusually high margins and one of the factors behind this is likely the consolidation of market power within a few names, a subject touched on by Jeremy Grantham of GMO. A period of record high profit margins has coincided with low worker pay. Traditionally economists would expect companies to be forced to raise wages and for there to be a reduction in profit margins when an economy heats up and demand for workers increases. This may not necessarily equate to a fall in profits though as volume growth may outweigh the margin erosion.
The post crisis recovery in the US has not followed the traditional script. The most recent employment numbers for July showed a US unemployment rate of only 3.7% which is actually lower than it was before the financial crisis – but wage growth of under 4% remains low looking at most recovery periods. US company profit margins, despite this now being an expansion of around 9 years, remain at or close to highs, aided admittedly by a cut in the US tax rate. Labour’s share of the economic pie has been shrinking for about 30 years and there is evidence that globalisation is impacting negatively on wage growth. The ability of companies to relocate operations internationally has meant that a workforce is not just competing in its domestic pool of labour, but rather within a global pool of available workers. Not surprisingly rising educational standards and skill sets in the developing world are impacting negatively in the West, especially on lower skilled jobs. Robotics and automation have enabled some jobs to be re-shored home, but here the threat of automation will clearly cap the ability of the labour force to increase wages. In fact, higher levels of wages are often a driving force behind moves to automate.
Whilst in the short-term a combination of high margins and low wages is good for corporate profitability, longer-term challenges with increases in inequality can easily result in either social unrest or levels of discontent amongst the workforce. Both Brexit and the election of Trump showed that voter disillusionment can result in disruptive political outcomes which could, over the longer term, be negative for equity markets. Goldman Sachs has estimated that one third of the overall increase in corporate profit margins between 1997 and 2014 is attributed to rising corporate market power, which has meant wage and salary income has languished near historic lows, even as corporate profits remain near a record high as a percentage of GDP. Work by David Autor, an economics professor at the Massachusetts Institute of Technology, believes that this occurs to a greater extent when there are just a few major players in an industry. This is clearly true of the IT and internet industry where the winner takes all outcome means that there are levels of sector dominance by unknown firms. Looking at search the market is dominated by Google, in social media terms by Facebook and in retail by Amazon.
To date many of these internet-related businesses have had relatively low levels of profitability but have taken a share of what is often a shrinking profit pool in the sector in which they operate. This clearly would argue in favour of a negative impact on wage growth in industries such as retail and travel. Certainly, mark ups in retail have declined as there is now price transparency through Internet comparisons sites and the new disrupters have significantly lowered margins for established players. Today globalization may be helping wages in the developing world, but it is holding back wage growth in developed world labour markets.
Populism is a movement that flourished in the post financial crisis period. Historians look back at the 1930s and see a period when populist politicians also thrived due to the belief that policies enacted during difficult times had what was perceived to be unfair effects on large proportions of society. Today banks are vilified for having enjoyed the profits from the debt driven expansion of the noughties but have succeeded in socialising their losses in the post crisis period. Financial crises often boost political populism with a lurch to what is described as the extreme right but could also accurately be described as ‘national socialism’. In other words, a combination of nationalist behaviour, combined with policies ostensibly to protect the less well off in society. Whilst both Hitler and Mussolini were elected, Fascism as a movement was popular in the 1930s in many European countries, not least in the UK where Oswald Mosley attracted a large following. The sense that society is not working for everyone as it did has seen the two main political parties see a significant drop in their combined level of support to only 67% in the 2017 general election in contrast to 1979 when Margaret Thatcher came to power and the combined vote for the two main parties was over 80%. Labour’s losing share of the vote then was actually higher than the Tory’s win at the last general election. Populist politicians have pushed the line that globalization only benefits the elites, arguably encouraged by Theresa May who, at the 2016 UK conservative party conference stated “if you believe you are a citizen of the world, you are a citizen of nowhere”. This labelling of elites as those who see themselves as global citizens can only encourage xenophobic tendencies in countries and has arguably been seen in post Brexit Britain.
In the post financial crisis world, the well off in most countries have done far better than the average citizen. This has threatened the democratic legitimacy of globalisation and it is clearly true that the rich have more in common with each other, whatever their nationality, than they have with anyone else. Looking at major global cities, residential property prices have been driven ever higher by international buyers, many of whom are not even looking to make this dwelling a permanent place of residence. While at the total level globalization has benefitted the world, it has also created big winners and losers. The winners include countries in Asia such as China, India, Vietnam and Indonesia, not just the already rich, but the relative losers have been those who are in the bottom half of incomes in North America, Western Europe and Japan. Whilst by global standards these workers remain relatively well off, within their own countries they have lost ground. This has resulted in a sense of resentment and a breakdown in trust between what are perceived as the ruling elite who have rigged the system in their favour and a large part of the population for which the current status quo does not seem to be working. The 2016 Brexit referendum showed the unwillingness of electorates to trust so-called experts, preferring to rely instead on their own ‘common sense’. Electorates were no doubt also influenced by campaign promises (some would say lies). Donald Trump’s success in the 2016 election reflected his ability to distance himself from the so-called elite with Hillary Clinton struggling to convince people she understood their concerns. Donald Trump was far more adept at presenting himself as an ordinary person with the common touch, something behind the success of every populist politician in history.
Thus, the belief that globalization is good for everyone, has refined itself into a view that, whilst it may be a good thing in aggregate, there will be significant losers and the established political elite cannot be relied upon to address this as they represent vested interests unwilling to change. A message from both Brexit and the US election is that, unless losers are compensated, populism will remain a political force for many years to come.
The mobility of capital in a globalized world has reduced the bargaining power of Western labour. The high echelons of the workforce have not seen the same pressure on salaries and have also frequently benefited from shares or options in the places they work. If readers are surprised why this challenge did not emerge earlier, it is perhaps partly explained by the fact that, historically, the rich are generally more willing to vote than the poor. This has now begun to change and the success of the Labour Party in the 2016 election ahead of expectations was primarily due to a significant increase in the number of young people voting that hadn’t been the case in recent elections.
With living standards challenged at home, many electorates have focused first and foremost on domestic rather than international issues. President Putin had already seen America under Obama signal a pivot to Asia and the ‘America First’ policies of Donald Trump and his repeated criticism of other NATO members’ level of defence spending has undoubtedly encouraged a more assertive Russia on the world stage.
Globalization in the 21st Century has been challenged politically by a backlash against the elite and those in power. There are other disruptive elements concerning people, technology and money. Early globalization in the 1800s was not driven by trade but rather by the flow of people. The majority of immigrants to the New World before 1820 came unwillingly as slaves and unusually Australia saw its first export success in the form of a tertiary good- ‘jail services’ in the late 1700’s and early 1800’s. As transport costs declined and living standards improved, voluntary migration accelerated significantly. Emigrants left Europe in search of a better life, first of all to the New World and then to the Australasian Continent. The immediate post WW2 period saw developed countries using immigrants as a way to gain a demographic boost and in Europe in particular the working age population wasn’t large enough to support the process of post war reconstruction. At the time European countries, including the UK, welcomed immigrants as an answer to labour shortages.
An important factor behind immigration is the necessity for there to be a significant income gap between the country being left and the country being entered. This unfortunately argues in favour of Europe facing a migration crisis from Africa for many years to come. Unlike the early migrants to the New World, today there has been a huge increase in state provision of goods and services, which has made immigration more politically controversial. Populations are increasingly questioning whether immigrants should be allowed to enjoy the fruits of a ‘benefits club’ they have not contributed to. The ending of colonialism has meant that Europeans have no longer had the right to travel the world in search of a new home. The challenges to globalization have been exposed as populist politicians have argued that an increased pool of cheap labour benefits owners of capital and exerts downward pressure on the wages of the lower skilled members of the indigenous population. Academic evidence also suggests that migration is out of the reach of the extremely poor and an increase in living standards in Africa’s poorest countries such as the DRC could actually trigger an increase in the level of migrants attempting to enter Europe. Interestingly, improved and cheaper technological communication has arguably made it easier for migrants to make an informed decision on where to go but has also allowed those opposed to immigration to readily gain air time for their policies.
Technological developments since the 1980s initially fuelled globalization. Production coordination problems were removed facilitating production in many different countries. Technology and automation are allowing some companies to go down the route of re-shoring. A concern would be that this could encourage countries to turn themselves into self-contained communities, perhaps something Donald Trump favours.
The existence of social media could mean that similar views may not face challenge. Disruptive politicians can quickly establish a meaningful voice and are no longer forced to go to ‘Speakers Corner’ in Hyde Park to air their views to the population. A common thread amongst the most disruptive political parties, be they on the left or right, is the opposition to globalization. This includes Syriza in Greece, Italy’s Five Star Movement and Donald Trump. Controversially a focus of news feeds on social media, reinforcing the existing ideas and preferences, can also encourage narrow-mindedness. Technology has also facilitated a greater understanding of the divide in living standards between the elites and the remainder of the population. With populist politicians arguing that protectionism is the economic extension of nationalism and that these measures will redress the relative loss suffered by the less prosperous parts of the population, this is a real threat.
The international institutions created at the end of the Second World War and in the years after were ultimately united by the Cold War. Following the collapse of the Soviet Union, there was a general belief that the West’s model of liberal democracy and free market capitalism would expand eastwards and that this was the only model for future prosperity. The relative economic decline of the States has helped legitimise the rise of populist politicians, arguing that the US has been cheated out of its position of unquestioned dominance of the global stage. Even though the global economic pie has increased in size, the way it has been distributed in the post crisis period has played into the hands of populist political leaders. Whilst workers initially enjoyed the fruits of globalisation as the cost of tradable goods fell markedly (consider the cost of a TV in terms of monthly income back in the 1970s), it can be argued that globalization has now come back to bite the hand that fed it. Americans have long favoured Walmart as a source of cheap goods, ignoring the fact that off shoring production to China meant not just less jobs at home, but in a globalised labour market, the workers’ bargaining power fell significantly. It could be argued that, in a protectionist world with tariffs, one consequence for global profitability would be a decrease in margins as companies would no longer be able to contain wage growth in the way that occurred in a world with few trade barriers.
Contemporary globalization has allowed the free movement of capital and labour which, whilst benefitting the global population as a whole, has created sharp divides between winners and losers in developed and developing economies. Corporates have undoubtedly been significant beneficiaries of a globalized economy and globalization will now need to recognise that there are differences between free trade and fair trade. Globalization today is driven by flows of capital and people and aided by the technological revolution which has left many people uncomfortable with how they see the world going. These people have always had a vote, but now they are more inclined to use it and to elect disruptive politicians in the hope that the deterioration in their relative living standards will come to an end. Whilst many readers may be abhorred by the policies of Trump, all the evidence suggests that his popularity amongst his core voter base has actually increased. Arguments in favour of nationalism and its economic extension protectionism, have now been entwined.
Globalization was such a driving force in the post WW2 period because America championed it through both free trade and the multi-lateral organisations supported a liberal rules-bound trading system. It has delivered a benign environment for the owners of capital and allowed corporate profit share as a percentage of GDP to reach new highs and to date shows few signs of mean reversion in the post crisis global economy. This has clearly been a factor behind some of the equity markets’ strong returns. Any push back to globalization from less business-friendly policies would clearly impact negatively on markets, as valuations are not especially cheap.
Trump’s ‘America First’ policies have resulted in the S&P500 being ‘first’ amongst major markets. The US is now better placed with a relatively closed economy, suffering less damage (I am loath to say do better) from trade tensions than many overseas markets. The US typically has defensive qualities in more difficult times, even when it is lacking valuation support. For Asia and emerging markets in general, a full-blown trade war would not be positive, but even now investors cannot be sure whether Trump is serious in his threats, or merely using these and tweets to bring what he regards as ‘competitor’ countries to make further concessions. Valuations in EM and Asia have pulled back, partly to reflect this, and these markets now look more attractively valued than most areas in the developed world, assuming a trade crisis can be averted. Investors continue to face a dilemma, as the most defensive major stock market, the United States, remains on a higher valuation than others but has been and is likely to remain a clear beneficiary in relative terms at least of further trade tensions. Furthermore Trump appears to have pushed the Fed into a position of cutting US interest rates if the economy weakens on the back of trade tensions. Globalization remains a subject investors need to keep a watching brief on as it has been a major boost to overall levels of global growth and productivity in the post war period.
Graham O’Neill, Senior Investment Consultant, RSMR
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