Shifting Undercurrents - globalisation to regionalisation and the impact on investments
February 16, 2022
BluOr Bank Investment Portfolio Manager
Two seemingly contradictory facts are true today.
Supply chain disruptions caused by the pandemic have caused whiplash in almost every corner of the global economy. Port shutdowns, container shortages, and a six-day blockage of the Suez Canal dominated the headlines last year. From the relatively benign, such as shortages of the newest gaming consoles over Christmas, to the outright destabilizing, such as dramatic price increases in food and energy commodities that have led to unrest, most recently in Kazakhstan, these disruptions are making waves across the globe with increasing effect.
At the same time, global trade has seemingly never been stronger. After initially cratering at the start of the pandemic, trade in goods bounced back quickly in the middle of 2020, surpassing pre-pandemic levels by the end of the year. Early last year, global trade volumes set new records and forecasts call for trade growth in goods and services to outpace GDP in 2022.
So what is going on here?
Most importantly, we see just how embedded these supply chains are and how much we rely on them. Companies have spent decades investing into the physical capital, labor specialization and logistics arrangements to optimize for just-in-time production, enabling the global economy to run like a well-oiled machine. Moreover, even when things have gone wrong and supply chain disruptions have happened, the system has always bounced back relatively rapidly.
That is until the most recent crisis. It turns out that just-in-time is not necessarily the most optimal solution, a fact being recognized by both corporates and governments.
Two examples in particular drive this point home. The shortage of hospital beds across the Western world has exacerbated the public health crisis and been in large part responsible for the rolling lockdowns of the past two years. Shortages of semiconductors are increasingly being viewed as a national security issue, as the biggest companies commit tens of billions of dollars to building out production capacity closer to home in Europe and the U.S.
This realization is part of the broader political shift that began with the U.S. and China trade war before the pandemic. For the U.S., the complete outsourcing of its manufacturing sector to Southeast Asia has left Middle America hollowed out and let to political consequences. And while China has been a big beneficiary in this relationship, it is overly dependent on exports to the U.S. to drive economic growth, something that its leadership is keen to change. Both countries want to reduce their reliance on the other, and the disruptions caused by the pandemic have only furthered that desire.
At the same time, new technologies that have become widespread in recent years might prove to be more conducive to de-globalisation than the technologies that fuelled the ICT Revolution.
The example of industrial automation and robotics is a case in point. At first glance, automation constitutes an alternative to offshoring for firms in advanced economies seeking to lower their labor costs. Because automation and offshoring appear to be substitutes, one would then expect improvements in automation to lead to an increasing amount of reshoring over time.
Following two decades of supply chain optimization, the pendulum has started to swing in the other direction. So far, the effects are small and only felt on the margins, but it is not beyond imagination that we see a truly mammoth corporate CAPEX spending spree to re-shore production once Covid is truly behind us.
With the increasing likelihood of re-shoring also comes the possibility of the world fracturing along regional lines. Companies have already started to produce goods closer to their destination markets thanks to Covid. As a result, it is plausible that a multipolar world, with fraying relations between the largest economies, could lead to a higher proportion of international flows happening within regions.
Aside from supply chain security, the primary factor behind this trend is the heightened scrutiny of foreign investments on national security grounds, which has gathered momentum since 2018, mainly across the world’s advanced economies. Regulations implementing the EU’s 2019 framework for screening foreign direct investment (FDI) and the U.S.’s 2018 Foreign Investment Risk Review Modernization Act came into effect in 2020.
The impact is already apparent in the data. In 2020, FDI inflows fell 35% to $999 billion, the first time since 2005 that FDI inflows fell below $1 trillion. Even after removing various sources of noise in the FDI data, the underlying FDI trend, as calculated by the UN Conference on Trade and Development, declined 25% in 2020.
But this cumulative measure is not indicative of what is happening on the margins. Here in Latvia, for example, FDI inflows over the first 9 months of the year actually exceeded those of prior years. Tellingly, the majority of these flows were, and have been, from our closest neighbors. One year does not make a trend, but these figures do indicate that FDI on a regional level will likely continue to increase going forward.
This example of geographic distance goes a long way toward explaining the breadth of globalization. For example, if one pair of countries is half as distant as another otherwise similar pair of countries, this greater physical proximity alone would be expected to increase the merchandise trade between the closer pair by more than three times, and to more than double the FDI between them. Cultural and political similarities, which are often correlated with geography, also tend to increase international flows.
Each region’s surging ability to self-finance furthers this process with funding in all regions speeding up the innovation process as more and more ideas get earlier and more substantial funding – sure, some will fail but an accelerated process of discovery and adoption driven by an abundance of capital is part of this new post-Covid era.
Corporates get that each region is increasingly self-sustaining across finance, production and consumption and thus they need to be in each region in order to serve that demand. We appear to be moving from a world of decentralized production and centralized wealth to a more centralized production process and decentralized wealth. The climate focus will accelerate this process – the formation of the International Sustainability Standards Board (ISSB) at COP26 makes it clear that companies will be examined across their supply – value chains.
European integration has been tested several times in recent years: Italy’s populist push, Brexit and the US antipathy under former Pres. Trump all served to remind Europe that it is on its own and needs to speed up its integration. Covid has helped drive that integration through its NextGenerationEU financing as has Climate with the pan-European green bonds providing Europe with a leadership role in Climate finance. How these play out in coming years will say a lot about how Europe advances. There is much that Europe can do and there is a growing awareness of the need for “strategic autonomy”.
Europe occupies an interesting place as the potential swing player should geopolitics continue to develop along the lines of US – China competition. Europe is already the global rule setter in tech, a role it continues to develop. Its green bond financing and carbon emissions trading system (the world’s largest) gives it a similar opportunity to lead the climate transition.
It too is pushing hard for European production of EV batteries and semiconductors. Given that no single European market is big enough to really run and drive these ambitions on its own, it is almost easier in a way for Europe to agree on a regional basis than it is in either the Americas or Asia. This is already visible in recent European semiconductor production agreements, for example.
The new era is likely to reinforce competition between regions as innovation and adoption deepen integration. It is likely to drive faster and deeper integration as a winner take all mentality extends through tech to finance and on to production, distribution and consumption.
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