We’re at an inflection point today. The relative macroeconomic stability of the Great Moderation – which spanned the past four decades from 1980 to 2020 – is over and the years ahead are set to look very different.
We see four megatrends as shaping the next decade and beyond: shifting demographics, changing world order, energy transition, and technological revolution.
Focusing on the second of these megatrends, Rob Clarry, Investment Strategist at wealth manager Evelyn Partners, says: ‘The world order that has governed internal relations for the last 70 years is under threat. New powers are emerging across the global economy — and they want a say in how things are run. Investors will need to factor these growing geopolitical risks into their thinking.’
In 1944, in the midst of the Second World War, 730 delegates from the 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods to thrash out a new monetary order, designed to govern financial relationships between independent states. This paved the way for the start of a new world order.
In 1948, the General Agreement on Tariffs and Trade (GATT) established the rules governing the global trading system. The foundations of the North Atlantic Treaty Organization (NATO) were laid down in 1949, reaffirming the inherent right of independent member states to individual or collective defence. Then in 1951, the European Coal and Steel Community was founded, marking the beginnings of the European Union ─ a crucial step in securing peace on the European continent.
This international order has remained in existence, with only gradual modifications, ever since.
Figure 1: The foundations of the current world order were established after WW2:
Mounting challenges to today’s world order
It is easy to forget that much of the world did not sign up for these rules and may now want the world’s economy to work differently. While the US remained the undisputed global economic power, its vision prevailed, but as China’s presence on the world stage expands, the challenge to the existing world order has become more insistent.
- This tension is likely to lead to a long-term realignment of the global economy, with new rules and new thinking
- This will have implications for financial markets over the next decade and beyond, particularly the US dollar, government bond, energy and commodity markets
- It may shift power from consumers (and the US) to producers, particularly on commodities, and will change the balance of geopolitical power
Increasingly, countries with new-found economic might are demanding a say in how the world is run and the rules that govern international relations. They want to reduce the power of the US dollar and reshape the world to their own vision, rather than the one laid out for them. They want recognition for their population size and economic growth. The ultimate shape of this new world order is subject to debate. Michael O’Sullivan, a leading academic, argues that the emerging multipolar world will be dominated by at least three large regions: America, the European Union and a China-centric Asia.
Another school of thought posits that the world will coalesce into two blocs: China and the US, each with a competing vision of the world and how its economy should operate.
However as the new world order emerges, tensions between its key players will shape the next decade in financial markets and there will be multiple pressure points. Technology, supply chains and commodities may be the most important.
What are the pressure points as countries realign?
Technology
Most national governments increasingly recognise that technology brings economic and political power. Technology has been the public face of mounting geopolitical tensions between Beijing and Washington. In 2019, China ordered its public institutions and government agencies to stop using foreign-made computers and software[2] while this year the US has enacted a flurry of legislation designed to eliminate China from its technology supply chain.
Nowhere is this more evident than in semiconductors. These chips are used in almost every electrical device and are the backbone of emerging technologies, such as artificial intelligence. Increasingly, the sector is seen as essential to defence and national security.
Consequently, US policymakers have taken several steps to boost domestic production and protect intellectual property in this space:
- The CHIPS and Science Act 2022 assigned over $50 billion dollars to the US semiconductor sector. It also barred companies in receipt of federal funds from making significant transactions that support semiconductor industries in “countries of concern”[3]
- There have been export restrictions for the country’s most sophisticated chips from Nvidia and AMD (Advanced Micro Devices)
- Companies have recognised the direction of travel and acted accordingly. Apple has halted plans to use China’s Yangtze Memory Technologies Corp’s (YTMC) flash chips in its smartphones[4]
The US has identified a number of other key technology areas and these are all likely to see increased protectionism: artificial intelligence, big data, micro-electronics, quantum computing and biotechnology.
Figure 2: CHIPS and Science Act funding over the next ten years, $ billion:
Hoarding technology is likely to be bad for both sides, adding expense through the supply chain, though particularly for China which is still the junior partner on technology innovation. Weaker innovation will hurt productivity and contribute to slower economic growth. Capital Economics estimates that China’s growth rate will slow from 8.1% in 2021 to 2% by the end of this decade as a result.
The rivalry is not confined to the US and China but is likely to be polarising for the world. Japan, for example, has barred Chinese telecoms group Huawei from its national telecom infrastructure and has also banned its Coast Guard from using Chinese-made aerial drones. Countries may increasingly be expected to pick a side in how they access and use technology.
Supply chains
Inevitably, increased mistrust and a desire for self-reliance puts an end to the idea that trade should be conducted freely across borders. Larry Fink, chief executive officer of asset management behemoth BlackRock has said the Ukraine conflict, “put an end to the globalisation we have experienced over the last three decades”[6]. All firms will be operating in a different environment in which political considerations play a greater role in decisions over the allocation of resource.
There has already been some relocation of supply chains, both as a result of geopolitical realignment and the pandemic. For example, Foxconn, a major supplier to Apple, has moved some manufacturing to Vietnam; Samsung has made similar arrangements.
The pandemic exposed the problems of lean supply chains, which pushed manufacturing towards low-cost areas. They may have provided cheap goods, but they proved extremely vulnerable to other countries’ Covid policies when the crisis hit. Companies are re-shoring or near-shoring to ‘friendly’ countries. Some firms are also holding higher inventories to leave themselves less exposed.
Figure 3: % of respondents implementing dual sourcing of raw materials
This has an impact on the inflationary environment. Globalisation has helped keep inflation low: it brought cheap consumer goods from countries such as China and Vietnam, while low-cost immigrant labour helped suppress wage growth. Cheap Russian commodities kept energy costs low for European consumers. These deflationary factors are now reversing. We think that the global economy will be stuck in a period of ‘slowbalisation’ for some time.
Commodities
The Ukraine crisis has put an uncomfortable spotlight on where governments source commodities from. Countries are now scrambling to increase the security of their energy and agricultural supplies. For energy, this means accelerating the move to renewable energy, but this in itself creates competition for raw materials. Lithium is needed for the batteries to power electric cars, while rare earths are needed to manufacture wind turbines. Most major countries are racing to build the necessary infrastructure, creating demand for key metals and cement. There is a danger that countries could struggle to source the materials they need to decarbonise.
China is significantly ahead in areas such as solar panels. China has been the leading global producer of solar energy since 2017[8]. Its cheap solar panels have put many Western rivals out of business. However, there is now a concerted push from Western markets to develop clean energy solutions.
Financial markets
The trend has been towards openness and greater integration in recent decades. Chinese firms have listed in New York using American depository receipts (ADRs), while the Chinese ‘A’ shares market has opened up beyond domestic China investors. However, the trend towards financial market integration was already slowing in the wake of the global financial crisis of 2007-9. The weaponization of the US dollar against Russia is likely to accelerate this further.
Currencies will be a key point of contention. China’s renminbi has been included in the International Monetary Fund’s (IMF) Special Drawing Rights basket of reserve currencies since 2016, but China has subsequently resisted opening up its capital account. This is one of the reasons that the renminbi has insufficient liquidity to rival the dollar as the world’s reserve currency. This may prove important in the power balance between the two countries.
All out war?
The biggest risk is that the tensions between the two (or more) blocs become more than trading spats and supply chain nationalism. In its lukewarm support for Russia’s invasion of Ukraine, China has shown itself reluctant to become embroiled in military conflict even where its allies are under threat. However, it might change its mind if the US were to interfere with its activities in Taiwan. The real risk is if realignment escalates to something more dangerous.
Investment implications
China+1 strategy
Growing geopolitical risks and increasingly fraught economic policies have concerned multinational firms operating in China. We expect to see a larger number of firms pursue a China + 1 strategy, where firms diversify a part of their supply chains away from China to reduce exposure to these risks. This is likely to benefit economies in the East, such as Vietnam, and India, which is seeking to build its manufacturing base. In fact, we have already seen Apple’s suppliers invest in these countries as the US-China relationship becomes more challenging.
Strategic sectors
A wholesale return of manufacturing to Western economies is not going to be feasible from an efficiency perspective. This will benefit the companies operating in industries such as technology and healthcare, but also their suppliers. Having been out of favour with investors over the last decade, industrial firms could benefit as more production returns home.
Greater inflationary pressures
As firms rejig their supply chains in response to geopolitical risk and security concerns, this will push up costs as production moves from cheaper locations to more expensive ones. This will add more inflationary pressures to the global economy.
Defence spending
The world is unquestionably less secure. In response, many countries — including the UK —have committed to doubling defence spending over the next decade. This will provide a tailwind to the established companies in the sector, but also younger firms in the cyber security space.
