The age of policy divergence

After the fall of the Soviet Union, the world breathed a profound sigh of relief. Humanity had come close to self-annihilation in 1962, when the US and the Soviet Union threatened to deploy their nuclear arsenal on one another, destroying life on the planet in exchange for control of Cuban airspace.

At the beginning of the Cold War, such a notion might have even made sense. Destroying all life for the sake of principle was acceptable. But as years passed, the absurdity became obvious. Is there anything worth destroying all life for? The winds of change blew down the Berlin Wall in 1989, but the post-Soviet world remained a dangerous place. The USSR had the world’s largest nuclear arsenal, and corruption was rampant. Its conventional arsenal was being sold off piece by piece to profiteers, like the notorious Viktor Bout, with Kalashnikovs ending up in the hands of child soldiers in Africa. The US couldn’t allow for errand nuclear weapons to suffer the same fate. Even one would be enough. It was very important to bring not only Russia, but its cohorts into the Western fold as soon as possible before a dirty bomb found its way into New York Harbour or a warlord took control of a Russian nuclear silo. The way they would do this was through trade. Trade would make everyone wealthier and reduce the need for corruption. 

A world separated by an Iron Curtain opened up. Geopolitical concerns revolved not around Red Buttons and Footballs (the case with the nuclear launch codes) but around global value chains. Energy and materials markets would now drive global cooperation. Technology would facilitate a world set on improving communication. Tourists would get to experience other cultures and enrich their own.  As goods traversed, spurred on by favourable trade terms, a once fragmented world entered a new era: Globalisation. Russia re-introduced itself to the West as the purveyor of energy and raw materials, which Red China would proceed to manufacture turn into cheap goods and export to consumers across the globe.

One of the unintended benefits of Globalisation was economic synchronisation. The more synchronised economic cycles became, the more seamless the trade across the world. If the US was growing, China would produce more goods to sell to them. If the US didn’t grow, Chinese factories would have to operate below capacity. Conversely, if Chinese factories couldn’t keep up with demand, this would cause inflation in the US. Every economy became linked. The more complex the products, the greater the need for economic synchronisation.

Benefits of synchronisation

An iPhone 14 is comprised of 34 parts and roughly 80-100 sub-parts. Eight countries - the US, China, Taiwan, South Korea, Japan, Germany, the Netherlands and the UK - are directly involved with the majority of its production, and even more, if we consider the origin of the raw materials. The more synchronised the global economy, the faster the iPhone will reach consumers. But de-synchronisation can cause delays, cancellations, the use of alternative products and, more likely than not, higher prices.

Global economic synchronisation can facilitate the coordination of monetary and fiscal policies between trading partners, which can enhance the credibility and effectiveness of these policies. If the US raises interest rates, but the EU chooses to live with higher inflation, the Euro is likely to depreciate against the Dollar. This means more output from European countries, but less demand for it from the US.

Eventually, European production will be reduced to meet the lower US demand and money will flee Europe to go to the US (which will offer a higher interest rate). Meanwhile, the American economy will see lower output than its peers, possibly losing its workforce and productivity to Europe. When two economies don’t move in sync, they exchange weaknesses. When they do, they can tackle common problems.

Economic synchronisation can reduce exchange rate volatility and uncertainty lowers the cost of capital and promotes investment and trade. It also boosts productivity and competitiveness, as well as fostering social and political cohesion. Desynchronisation can greatly boost inflation.

Economic desynchronization

The post-Soviet era ended slightly after the 2008 Global Financial Crisis. In response to the crisis, countries initially adopted different measures. However, when it became apparent that the crisis would have widespread global economic repercussions, central banks agreed to cooperate. It was unfathomable that one would print a lot of money, staking its reputation and possibly causing inflation, while others would sit on the side lines. Still, loss of capital on all sides put a stop to increasing trade liberalisation, and thus to globalisation and economic synchronisation.

Around 2014, globalisation slowed further. China’s new leader, Xi Jinping, wanted to move the country away from its role as a global producer and look inwards towards its domestic consumer. He felt that it was time to lift the living standards of his country. Moving from the secondary (manufacturing) sector to the tertiary (services) sector is the ultimate goal of all manufacturers. But when China, the world’s factory, does it, the global impact can be significant.

Also in 2014, Russia unilaterally decided to attack and annex Crimea, a strategic peninsula in the Black Sea, south of Ukraine. The move was widely frowned upon by Western powers, who decided to impose severe economic sanctions on Russia.

The post-Soviet era of open trade had officially come to an end.

In 2017, the election of Donald Trump further stressed trade relations between China and the US. Sanctions began to mount, especially around technology and raw materials. China responded in kind.

In 2020, the pandemic delivered a very powerful shock to the global trade system. Countries, once again, decided unilaterally on their healthcare, fiscal and monetary responses to the crisis. The US decided to allow high unemployment, and directly subsidised consumption. This led to an explosion in money supply. Quantitative Easing became, for the first time, inflationary. Meanwhile, Europe and the US preferred to subsidise employment. Initially, inflation was lower, but ultimately it led to services hiking prices rising more than in the US. The global economy diverged more than it had at any time since the fall of the Berlin Wall.

Meanwhile, trade tensions between the US and China continued. The nail in the coffin of global economic convergence and the post-Soviet unipolar world was dealt when Russia attacked Ukraine in February 2022. Fresh sanctions were imposed, exacerbating an inflationary undercurrent already present due to the previous economic desynchronisation.

As a result, Western economies are now facing the worst inflation in forty years. As with the early stages of the Global Financial Crisis and the whole of the pandemic, responses are desynchronised. The US and the UK attacked the problem head-on, while Europe waited until it had evidence that its less flexible labour market was tightening enough to trigger a wage-price spiral. Interest rates are at their highest levels in decades. However, the UK had already de-coupled with from the world, after its decision to leave the EU. Meanwhile, the EU faces its own centrifugal forces. Manufacturing is sluggish, as the German auto industry has fallen behind in designing and selling Eelectric vehicles. Parts of the EU have inflation but other parts don’t. With one a single interest rate between diverging economies, it is very difficult to bringing down inflation and fostering growth is very difficult. So each country adapts differently, designing its own fiscal response to rising prices.

China is stimulating its economy, which is ailing, at the same time as the West is tightening the cost of money. Russia has completely decoupled from Western economies, selling solely to the East, who then re-sells some of that production back to Western economies, for a profit. This causes further inflation (and does very little to stop the war in Ukraine).

At the time of writing (July 2023), the inflation and growth forecasts have diverged significantly amongst Western economies. The US, which has tightened monetary conditions significantly, is seeing the end of rate hikes. It is projected to grow 1.3% in 2023, with CPI currently around 3% and a projected 2.5%-3.5% until the end of the year.

The EU is facing more sluggish growth and higher inflation. It is projected to grow at half the pace, 0.6%, with inflation currently around 5.5%, possibly falling further to 3% at the end of the year. It is also facing two rate hikes.

The UK is not projected to grow in 2023 (but neither to contract). Inflation currently stands above 8.5% and could end the year near 6%. It has a steep rate hike path ahead, with six hikes priced in.

The headline numbers are not the only ones where major economies diverge.  Manufacturing is expanding in Emerging Market economies, while it is contracting in Developed Markets. Within all economies, the services sector has diverged from manufacturing (although this could just be cyclical).

As inflation diverges, so do interest rates, and subsequently growth, between trading blocs, similar economies, even between sectors. The unipolar world is now multipolar, and the tectonic plates of finance and the global economy remain in motion. This is not the result of the pandemic. It is a consequence of geopolitical shifts (China’s turn to consumption, US becoming antagonistic about technology, trade wars) a decade in the making. The pandemic catalysed these changes, but it did not cause them. That is why they didn’t go away with Covid, and why they continue to play out, with increasing force no less.

What economic de-synchronisation means for asset prices and portfolios

The main consequence is the decorrelation of equity assets. Equity prices are, by and large, driven by three factors: fundamentals, heuristics (biases) and speculation. The latter two are based on historical movements and expert judgement and are largely independent from economic performance. Fundamentals though, have a basis on the real economy. Demand affects earnings growth. Taxation affects the bottom line. Unemployment and inflation affect the cost of goods sold. Interest rates affect the discount rate and thus equity risk premiums and ultimately leading to lower valuations. The wider and more persistent the economic divergence, the wider the gap between equity and corporate bond valuations.

The longer the divergence persists, the more we should see asset returns decorrelate. We are already seeing the lowest equity correlations in twenty years.

Sovereign bonds, on the other hand, are seeing the highest levels of correlation between regions, since 2007. As long as all three major Developed Market economies are on rate hike paths, we should expect the bond market securities to remain largely correlated. But once they start to drop off that path, one after another, those correlations should also fall. 

Decorrelation of assets is something that should be factored in by fund managers when considering their strategic positioning.

What economic de-synchronisation means for businesses?

Uncertainty over value chains. Apart from the aforementioned effect on the valuations of listed equity and corporate bond assets, the more globalised the nature of the trade, the more uncertain business models become. Manufacturers especially could be quite exposed to the global economic realignment. The more sophisticated the product, the more likely disruptions could occur.

Uncertainty over demand. Even domestically focused businesses have reasons to be worried about de-synchronisation. Uncertainty over inflation and interest rates can seriously hamper business planning, which is usually based on evidence of historic demand. Central banks are adamant in their desire to bring down levels of consumption and business investment for the time being.

Capital expenditure. Uncertain managers are unlikely to proceed with capital expenditure if they feel that central banks will hike the cost of borrowing. Even if an expansion is paid for from own capital or retained earnings, and not the product of leverage, uncertainty over demand should, all other things being equal, defer capital decisions.   

Business leaders need to take a step back, see the world anew, and make sure their business strategy reflects reality and not the past.

The current strategic backdrop, the current political backdrop, the current economic backdrop, the current technological backdrop. First and foremost, they need to understand where they are, and they can make no assumptions.

Sometimes things get to a point where you simply cannot turn things around. Business leaders need to make sure they've asked the right questions early enough. If they haven't, there is a possibility that it’s already too late.

George Lagarias, Chief Economist

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