I was 10 years old when the Berlin War came down. It is a stretch to say my formulative years took place during the cold war. Yet as someone who loves history, I still had a profound appreciation of the significance of standing in Red Square in Moscow during a trip in the early 90s. This sense of appreciation was repeated a few short years later as I stood in Tiananmen Square with the giant portrait of Mao staring down at me from the Forbidden City. From those vantage points it was hard not to sense that the world had changed profoundly. The breakdown of the divide between the ideological camps that had defined the world since the end of the Second World War led to an acceleration of globalisation as Western style capitalism was exported across the world.
This is not a foreign affairs journal, so I will quickly pivot to the implication on investors. The lure of thematic investing is powerful, even if it rarely works. Many investors are focused on narrow themes that they believe will lead to outsized returns over the short run. What many investors tend to miss is the impact that longer term multi-decade themes have on investor portfolios. The age of globalisation after the end of the Cold War was an underappreciated boon for investors. Offshore manufacturing accelerated as China became the factory of the world. Services followed manufacturing as technology advanced. Call centres were followed by back-office operations and soon x-rays were being read in India.
The benefit for companies was immense as many of the cost savings flowed directly to the bottom line. The margin represents the difference between revenue and profits (the difference between the goods and services that a company sells and how much they get to keep after all the expenses come out). In 2000, the margin on the S&P 500 was 6.2%. Prior to COVID, it had increased to 13.6%. Globalisation was not the only thing that caused this dramatic margin expansion. Technology made delivering goods and services more efficient, corporate taxes were lowered, and the bargaining power of union workers continually declined. Yet globalisation had an outsized impact.
There was another big benefit for investors during the period between the end of the Cold War and COVID. In 1989, interest rates in Australia were 17%. In the US they were a slightly less shocking 9.8%. What happened next requires no explanation. Lower interest rates allowed individuals to go on a debt binge. Governments followed suit to fund tax cuts and increased spending. The peace dividend of lower military spending added another avenue for fiscal stimulus into the economy. Along with this reduction in rates, we had massive injections of liquidity by central banks during the GFC and COVID.
Economic theory tells us that all this stimulus would lead to inflation. Yet, it was no where to be found. Why? Because of all the deflationary offsets of globalisation, technology, lower taxes and reductions in the collective bargaining power of workers. Low interest rates further reduced corporate costs while increasing valuation levels. Low inflation meant nominal returns were higher on a real or inflation adjusted basis. The investment world collectively shimmed out the risk curve.
There is a reason I started this story recounting my childhood trips to Russia and China. Even as a kid I had the sense that profound changes in the world created an opportunity for me to travel to these symbolic centres of communism. There seemed to be so much momentum behind this movement that was breaking down barriers and connecting the world. It was inconceivable that we would experience this breakthrough only to retreat back into opposing camps. Yet as I write this in 2022, it is hard to picture when or if I will be in Red Square again. A trip to Tiananmen Square seems to be on the precipice of falling into the same camp. The golden age of globalisation seems to be on the same precipice. Tensions are rising between Russia and China and the West. Supply chain shocks and the realisation that we had offshored the manufacturing of our most basic medical necessities during COVID has reintroduced the idea of nationalising supply changes.
I’m sure many readers think that less globalisation is a good thing. That is a legitimate view, as globalisation has been disruptive and outright negative for large groups of people. However, it is hard to argue that it didn’t benefit investors. Since this is an investing column, we need to explore the impact on investors as we retreat into a less globalised world.
The Wall Street Journal explored this issue last week in a series of graphs. These graphs illustrate the slow unwinding of the world order pre-Trump, pre-COVID and pre-invasion of Ukraine. World trade as a percentage of GDP went from 37% in 1990 to a high of 59%, as a flurry of free trade agreements came into existence. It has since fallen to 52%. International lending has fallen off the cliff as the percentage of bank loans to foreign markets increased from 27% in 1990 to over 56% before plunging to 36% by 2021. Military spending as a percent of GDP is increasing. Exports are dropping as the number of sanctions in place globally have expanded from 112 in 1990 to 411 in 2022. Decarbonisation efforts are leading to a flurry of spending and increased costs from companies and individuals. Are the deflationary offsets we’ve relied on for decades going away? Does that mean the age of low interest rates and low inflation is over? There are some troubling indications on the impact on investors. In five straight quarters, margins on S&P 500 companies have dropped. The latest figure is 12% which is a meaningful reduction from the high of 13.6%.
There is an allegorical story that describes the best way to boil a frog. Dropping the frog into boiling water will result in the frog immediately jumping out. Yet a frog that is placed in room temperature water that is slowly brought to a boil will hardly notice the change until it is too late. Most thematic investments are boiling water. They are too overheated to give you the result you are looking for. It is the theme that develops slowly over time that will produce the desired effect. The retreat from the golden age of globalisation might just be that slowly developing theme that will influence your portfolio in the decades ahead.
I would love to hear your thoughts. Please email me at firstname.lastname@example.org. Next week we tackle what to do about a world where margins are under pressure.