The world’s geopolitical equation has suddenly encountered a black swan event with the Russian invasion of Ukraine. The human tragedy is devastating. Global economic, political and social impact is yet to fully unfold, even as outlines are emerging of a different global order than perceived in just January of this year.
In macroeconomic context, global inflation is at multi-decade high. The near term causes, even before the Ukraine war, are said to be both supply and demand driven. Covid induced supply chain disruptions on the one hand and pent up demand on the other, as Covid-related restrictions got removed. Add to this the shortage of labour in specific sectors putting upward pressure on wages. Higher costs are being passed on by companies to the consumer. The war has added fuel to the inflation fire by disrupting the energy and commodity markets, which then feed into almost every other economic activity and price equation.
The longer term fundamental driver of inflation is liquidity or broadly speaking, money supply. As a student of monetary economics, I tend to subscribe to the famous Fisher Equation, which, in its simplest form is: MV=PT; Money Supply (M) multiplied by the Velocity of circulation of money (V) is equal to the number of transactions involving money (T) multiplied by the average price of each transaction (P). It is generally held that if V and T are constant, then M? = P? with lag of anywhere between 12-24 months. In my view, the inflation we began witnessing in the second half of 2021 had its genesis in the massive liquidity injection into financial markets by global central banks to counter the negative demand shock created by the Covid pandemic. The chicken was coming home to roost by the second half of 2021. Supply-side shock simply boosted the outcome. The commodity price shock due to the Ukraine war has further exacerbated the inflationary impact. Now that central banks have initiated the process of ending the ‘easy money policy’, financial asset returns are likely to follow a new, lower path than in the past decade.
Uncertainty regarding the eventual impact of the war on the one hand, and the degree as well as timing of response by central banks to curb inflationary expectations, has increased financial market volatility, from equities to fixed income to commodities and their derivatives. The result? The NASDAQ was near bear market territory with negative return reaching 20% at one point, S&P 500 was down around 10%. In Canada, the TSX Index’s year-to-date return is puny. The European market, as measured by EURO STOXX 50 index, is down 10% and China’s CSI 300 Index is lower by almost 15% this year, even after the recent rally driven by promises of state support. Many investment analysts have begun suggesting that ‘hard’ assets will outperform financial assets going forward. Some recommendations include infrastructure, digitization driven health facilities, logistics, rental properties and the like. The return to post-Covid ‘normal’ expected by most commentators in December 2021 is nowhere to be seen and uncertainty regarding global politics, economic policies and consumer sentiment remains elevated.
So where do we go from here? It would be foolish of me to postulate a definitive answer to the above question. I will however, with my limited knowledge and experience in global markets, attempt to put up a canvas on which to draw outlines of what may evolve over time, in terms of macro aspects and some sectoral implications over the next several years, as well as the opportunities and challenges over the longer term.
To start with, let us attempt to fathom the unfolding geopolitical scenario. Even in January of this year, geopolitics was not a significant factor in most analysts’ outlook for 2022. There were scattered concerns regarding US-China relations but nothing to suggest major resetting of the geo-political paradigm. Today, that paradigm has changed and changed drastically. Geo-politics has shot to the top spot amongst risk factors that investors are concerned about. The world has entered into new territory for sure. For history buffs, history may not repeat itself but can certainly rhyme.
Globalization, already under strain due to supply chain and trade-related tensions, is heading towards fragmentation. What does that mean for an investor? Certain trends are likely to accelerate in this context. Manufacturers are already moving to hold larger inventories of key raw materials, intermediate and finished goods. This means greater cash flow constraints and a higher cost-base due to storing and managing large-scale inventory, along with greater investment requirements related to on-shoring / near-shoring activities – in contrast to the great off-shoring and Just-in-Time (JIT) inventory management phenomenon that accompanied globalization. There will be winners and losers as this scenario unfolds. Producers of key raw materials (think Canada) and closer geographic proximity of relatively cheap labour to major markets (think Mexico) are likely to attract investor interest. Losers are likely to be locations highly depended on imported components and energy to manufacture finished goods where inflation in production and shipping costs is eating away at profit margins (think Vietnam), as well as sectors deemed to represent national security concerns (electronic chip and telecom component manufacturing).
One aspect of globalization was easier flow of people and ideas across the globe. Tougher immigration rules in many developed economies are likely to stem the ‘brain-gain’ from lesser developed economies. With possibility of Internet restrictions rising in the future, free flow of ideas is likely to be hampered, in turn negatively impacting innovation.
A key element in globalization was financial globalization. Broadly speaking, industry and businesses could raise money anywhere and investors could invest anywhere in the world. It allowed capital to move relatively freely into locations and sectors perceived by investors to offer best risk-adjusted returns and / or high growth potential. This meant that the cost of capital was reduced globally, enabling dynamic growth of new industries and companies, especially in the technology sector. However, post the 2008 global financial crises, the limits to unfettered global capital flow were seen while the ‘inequality’ factor came into sharp relief (remember the ‘occupy Wall Street’ protests?). With the US-China trade sanctions, risks to globalization rose further as major Chinese companies were sanctioned by the US and regulators moved to curb their listings. At the same time, Chinese regulators began discouraging their companies from raising capital from abroad. The Ukraine crisis may be the final nail in the coffin of financial globalization.
The weaponization of finance
With financial restrictions on public and private sector entities and individuals of Russian origin, the world has suddenly woken up to the reality of its dependence on US dollar-based global financial system. Over the coming decade implications for trade and finance in a single currency, i.e., USD, are likely to be profound. While no currency can take the place of US Dollar as the world’s reserve currency for the time being, there are likely to evolve currency blocks which would introduce frictions in international trade and financial transactions and reduce the efficiency of capital, while also impacting stability of the global financial system. In sum, the weight of the traditional financial sector in the GDP of developed countries will likely retreat from its peak at the height of globalization. There is also reasonable likelihood that the pendulum of capitalism may swing back to more government role in regulation, taxation and cross-border investment scrutiny versus lightly regulated market capitalism we witnessed in the last few decades.
Even Information technology, spearheaded by the Internet, is unlikely to escape the globalization retreat. As some countries impose restrictions on sites, content and people on the web and social media, while others enact regulations to protect their IT and communications infrastructure from cyber-attacks, what will this fragmented space look like in ten years’ time?
As globalization retreats, nationalism is on ascendency. Brexit in the UK, Trump’s ‘America First’ followed by Biden’s ‘Build back better’ slogan and the rise of autocratic politicians and leaders in parts of the world feeding on the discontent felt by those who did not benefit from globalization and fanning ethnic and religious tensions are the signposts of a post-globalisation world.
(To be continued)
(The writer is a board member of the Pakistan Stock Exchange and
vice-president of Canada Pakistan Business Council)
Copyright Business Recorder, 2022