If there is a simple lesson to be drawn from last week’s market rout, it is that there is fragility in complexity. The coronavirus outbreak has, like the 2011 Japanese tsunami and Thai floods that disrupted auto and electronics businesses, or the 1999 earthquake in Taiwan that brought the semiconductor industry to a halt, shown us the vulnerabilities of our highly interconnected economy and global supply chains.
This time around, the trigger is an outbreak spreading outwards from China, still the factory of the world as well as its second-largest economy. It comes at a time when US politics are in flux, and we are in the midst of what Ray Dalio, founder of the Bridgewater hedge fund, recently called a “paradigm shift” for both markets and economies. This is a new era in which few of the old rules will apply.
Goldman Sachs last week warned investors to expect zero profit growth from US companies this year, mainly because of the growing impact of the virus. But I wonder how much profit growth big corporations will be able to expect even after the infections play out and the results of the November US presidential elections come in.
In this new and unsettled era, the main forces that have propelled profit margins over the past 40 years or so — globalisation, increasing corporate concentration, a lower tax burden for corporations versus workers, and a larger share of wealth going to companies versus workers — are all facing headwinds.
The healthy margins of today’s highly optimised, extremely complex multinational corporations have largely depended on their ability to manufacture in China, sell in the US and Europe, and stash wealth wherever it makes most sense — particularly in favourable tax destinations like Hong Kong, Dublin or the Cayman Islands.
As Gavekal founding partner Charles Gave put in a client note last week, these companies have become as optimised, fast paced and high performing as English rugby player Manu Tuilagi. “Yet, as England fans know, the problem with Tuilagi is that injuries mean he is seldom available to put on the white shirt. The more optimised a system is, the more fragile it potentially becomes.”
I’ve wondered for years when the fragility inherent in complex global multinationals would force them to shift their business models, and I think we’ve reached that moment. I believe coronavirus will speed the decoupling of the US and Chinese economic ecosystems, increasing regionalisation and localisation of production. That may result in “supply chains that are less efficient but more resilient”, says Mike Pyle, BlackRock’s chief global investment strategist. He also believes the trend towards decoupling and deglobalisation will speed up in the wake of the virus.
A pullback from no holds barred globalisation may come with some upsides (see Raghuram Rajan’s book The Third Pillar for more on that). However, it will cost companies more in the short to midterm. There is only so much production slack that countries like Vietnam can quickly pick up from China.
If decoupling continues, multinationals will have to make costly choices around labour, productivity and transport in order to manage a shift away from China. That’s something that many investors are counting on, given that the two most likely winners of the 2020 US presidential elections, Donald Trump or Bernie Sanders (now seen as the Democratic favourite by many) both believe that greater economic nationalism is a good thing.
Mr Sanders and many other Democrats would also like to curb corporate concentration, which has helped boost margins but reduced government tax revenues, labour’s share of revenue and competition. Many on both sides of the US aisle (not to mention in Europe) would be happy to curb the power of Big Tech, which is responsible for the single largest chunk of the S&P 500 for varying political reasons, from national security and competition concerns to privacy and tax justice.
Beggar thy neighbour tax politics (to which the US capitulated in 2017 with Mr Trump’s tax cuts and rule changes) have bolstered corporate margins for decades. But that looks to be shifting, too, with some European countries taxing tech giants, the OECD putting pressure on member states to work together on new digital tax rules, and states including California considering things like a digital dividend tax. In a world where populists are gaining influence, I find it hard to imagine corporate taxes or the labour share of income going in any direction but up.
Meanwhile, the spectre of slower growth or even recession by November, makes a Sanders presidency more likely. Even if Mr Trump were reelected or the US Federal Reserve approved more quantitative easing, I doubt that US corporate profit margins will return to levels anywhere near where they have been in the past several years.
Mr Trump is, predictably, urging investors to buy equities. But the right response to that advice depends on whether you think we’re going back to business as normal for the longer haul. I don’t. We may well see the market begin to come back. It would respond positively to additional monetary stimulus from the world’s central bankers or a slowing of the spread of coronavirus, or both. But I doubt that shape of the share price graph will be a perfect V. The other big V — the virus — has exposed too much vulnerability.
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