02 February 2023
The UK and US economies are in the midst of a long-lasting structural change following the severe shocks unleashed by the pandemic.
The hyper-globalisation that has dominated the global economy over the past 30+ years is giving way to an era of regionalisation. This new era will radically alter the flow of trade, investment and technology. But it won’t stop there: through consumer action and impact the wave of change will ripple through and be felt at societal level.
Rapidly fading is an era defined by insufficient aggregate demand, when consumers enjoyed low-cost goods produced in low-wage regions and delivered in tight-knit supply networks. In its place will be a period defined by insufficient aggregate supply, supply shocks and persistent geopolitical tensions.
Identifying such a shift is always difficult, made even harder during periods of crisis. But the changes that are taking place in geopolitical alignments, globalisation, growth and liquidity are too significant to ignore.
Globalisation, as we have known it, is ending.
At the center of this transformation is the decoupling of the British, American, European and Japanese economies from China. This shift is altering the flow of trade and investment around the global economy.
We are in the early phases of this decoupling. The re-directed flow of goods will initially lead to a period of economic stagnation and diminished liquidity. Policymakers will have narrower fiscal and monetary space to respond to these shocks.
Whatever policies are adopted will require a bias toward price stability and higher interest rates as each economy emerges from pandemic-era disruptions.
Understandably, for consumers, businesses and investors, this time will be filled with uncertainty. While the trends, such as digital transformation, that characterised the global economy over the past three decades will endure, many other dynamics that shape growth, for example trade and investment, will be different.
The changes in those conditions will require different managerial and technological skills to navigate.
How regionalisation plays out
The decoupling of the British, American, European and Japanese economies from China is resulting in a division of trade relations into two separate tracks: the goods economy and the services economy, with technology at the center of it all.
The trade track:
On the first track, trade, capital and technology flows are being heavily influenced by security concerns among the G7 nations as they embrace the return of industrial policy.
Consider the recent restrictions on technology transfers placed by the United States on China. Most notably, restrictions on sophisticated and highly sought-after microchips. The primary goal of these restrictions is to nurture nationally important industries and to protect a manufacturing labour base. It will be interesting to see how the UK and other European G7 economies react, and if they follow suit. Having left the EU, the UK is particularly vulnerable to subsidies encouraging strategic investment in the US and EU.
Some businesses will come out as winners in this new landscape. But for consumers, these policies will result in higher prices as businesses shift from the low-cost manufacturing centers in China.
This, in plain English, is what US Treasury Secretary Janet Yellen means when she says American firms and their major trading partners should consider ‘friendshoring’, relocating production to countries that fall within the US economic sphere of influence.
Such a shift will almost certainly result in more North American investment by UK and European firms that want access to wealthy US consumers. It will also result in more investment in places like India and Vietnam from UK and US businesses that want access into the dynamic Asian economic region.
A live example of this shift in policy is Apple. Its recent announcement that it would begin sourcing microchips from North America is the signal that many global firms have been waiting for to begin reducing their exposure to China.
The services track:
On the second track, services, policymakers are taking a different approach. For the most part, the services sector will continue with fewer trade restrictions, just as it has over the past three decades. If anything, that approach will accelerate.
Scott Lincicome at the Cato Institute has argued that, even as the global trade of goods peaked before the 2008 financial crisis, the digitalisation of services has enabled increased global trade of those new services.
Digital globalisation offers tremendous potential for rural communities, health care, small businesses, manufacturing and, most especially, entertainment. These entities are all able to benefit from greater access to international markets as ‘superfast’ broadband proliferates.
Helping push this along is a natural progression for economies, as they move from providing basic goods, to meeting an increased demand for services as incomes rise and consumer choice expands.
It is natural that firms and households will want to move up the value chain as the global digital transformation of commerce advances.
This trend is happening in advanced economies all over the world where internet access is commonplace. Expect it to become the norm in developing economies as well. In the meantime, we are nowhere near the end of identifying all the implications of digital trade or managing its governance.
The geopolitical security competition will, for the most part, not alter the digital transformation of the service sector. The ideas behind that evolution are fungible, easily transferable and not amenable to trade restrictions.
It is far easier to put constraints on the transfer of existing or older technology, as well as physical goods, than it is to stop the movement of ideas. History remembers how quickly the American nuclear monopoly melted after 1945.
But there will be constraints put on financing those developments outside of the economies that remain on good terms with Washington, Brussels, London and Tokyo. For this reason, the flow of capital is also going to be constrained.
When an economy experiences a series of shocks, it often ends up with less capacity to produce. Businesses exit existing patterns of production, and investment shifts to more profitable and less risky areas of the economy.
The post-pandemic era will be no different, and we can expect stagnant growth over the next 24 to 36 months.
Growth in the UK economy is a function of productivity and labour force growth. During the past decade, the growth path was driven by roughly a 0.6% productivity growth trend and 1.0% growth in employment, resulting in a general 1.6% growth trend.
However, UK growth has been flattered in the last decade by a surge in employment as immigration rose and the after-effects of the global financial crisis abated. Looking at the whole of the post war period, UK employment grew by an average of just 0.5% per year. Today that is not the case, the UK workforce hasn’t grown at all since 2019.
With productivity slowing noticeably during the initial post-pandemic era, and labour force growth slowing to a trickle, the combination of rising costs entailed by the shift of production away from cheap labour in China will dampen the overall pace of growth.
Today, the growth of the labour supply is not sufficient to meet demand. Baby boomers are retiring, immigration has slowed, and the pandemic is still taking a toll on labour force participation. For this reason, trend growth is likely to decline to between 1% to 1.5% in the near term following a recession that will likely last until late 2023 and result in a peak-to-trough drop in GDP of 2.5%.
As inflation continues to act as a deadweight on real income growth, there will be calls for government assistance during the coming economic downturn.
That is just one factor that will lead to greater competition for scarce capital, which will in turn drive interest rates higher and restrain growth.
The end of easy money
Contributing to this stagnating growth is the end of historically low interest rates.
The era of ultra-accommodative policy, on the part of the major central banks – with the exception of those in Japan - will result in an overall reduction of liquidity within the UK, US and other global economies.
Rising policy rates and the reduced size of balance sheets will cause interest rates to rise along the longer end of the investment curve.
This will result in an increase in the cost of issuing debt for public and private actors. The cost of financing economic expansion—be it for a large public company, a private middle market firm or government issued debt—will all become much more expensive.
As interest rates rise and tighter financial conditions ensue, firms that have lived off nominal zero interest rates and negative real rates will face substantial rollover risk.
Risks around the commercial real estate sector will become more precarious, and firms that inhabit slower-growing portions of the economy, or have exposure to higher material costs, will face greater challenges in the coming years.
This will provide opportunities for the private equity and mergers-and-acquisition communities, but they will nevertheless entail substantial transition costs in terms of servicing debt, loss of employment and a slower overall pace of growth.
It is useful to remember what drives rates higher over the medium term. Interest rates are determined by:
- expectations of inflation;
- the response to that inflation by monetary authorities; and
- the risk of holding a security until maturity.
Interest rates tend to move lower during periods of a reduction in the rate of inflation, and move higher during periods of increasing inflation, as the central bank pushes the overnight policy rate higher.
A second component, known as the term ‘premium’, includes the risk of inflation moving higher or lower than expectations. For instance, if inflation were to exceed expectations, then the Bank of England would be required to push short-term rates higher, causing a bond market selloff that would reduce the value of holding that security.
As the nature and composition of globalisation changes and as growth slows, a shift in structure is occurring within the real economy and the financial markets.
It’s likely that global economic growth will slip into a recession this year because of monetary tightening, ongoing geopolitical tensions in Europe, or Asia, and households reducing their spending.
Once the UK economy emerges from recession, it is likely to be characterised by stagnation, with annual growth ranging between 1% and 1.5%, a notch below the pre-pandemic rate of 2.0%.
But why are we focused on the long-term growth trend in the context of an increasing liquidity constraint?
Recall that short-term bond yields are directly affected by monetary policy, with two-year bonds yields representing the present value of expectations for short-term money market rates over the course of two years.
But yields on long-term bonds, while still affected by changes in the policy rate as we’ve seen lately, are more likely to include perceptions of economic growth and the real return on investment.
As those growth expectations reset lower, firms will be tempted to hold back on critical productivity-enhancing investments, which feeds back into the post-globalisation transition and its rising cost structure.
The current economic uncertainty means that the risk premium for issuing government and corporate debt is rising. At present, lenders are requiring increased compensation from borrowers to cover the risk of recession and diminished demand, with the yield spread between investment-grade corporate debt and government debt rising above 2 percentage points. Riskier high-yield debt is now requiring 4 to 5 additional percentage points of compensation.
As both the British and American, and indeed global, economies adjust to higher input costs and risk around purchasing debt as inflation remains elevated, both the policy rate set by central banks and longer-term interest rates determined by the private sector will reset higher.
Ultimately, the result is a higher cost of doing business for all firms.
Since the end of the Cold War and leading into the collapse of Long-Term Capital Management, through the global financial crisis, into the pandemic and then of course heading into Brexit, the primary policy response to these shocks has been increasingly lower interest rates. At the time, that monetary policy was seen as unorthodox and sought to stimulate growth amid the context of insufficient aggregate demand.
That era has likely ended. We have entered a period of insufficient aggregate supply, persistent supply shocks, higher inflation, higher interest rates and slow growth. The onset of the pandemic and the economic forces that were unleased have resulted in a structural shift that is transforming globalisation, growth and liquidity.
The regime changes in those three areas of economic and commercial life will result in a higher cost of issuing debt to finance economic expansion and to meet social obligations.
Perhaps the geopolitical tensions between China and the developed economies, led by the United States, will abate, and the conditions that characterised the hyper-globalisation of 1990 to 2020 will return.
Just don’t hold your breath. The next phase of the century will be uncharted waters.