Deglobalization: A Potential Boon for Small Enterprises
After two generations of (increasing and very profitable) globalization, the world economy has suddenly turned toward deglobalization. This change, which looks like it will endure for some time, has profound implications for country selection, style selection, and security selection.
Macroeconomically, this turn of events may not be negative. Globalization simply means buying goods and services from the lowest bidder anywhere in the world and selling them to the highest rather than introducing local biases into the decision. Because transportation and transaction costs have fallen drastically, the lowest bidder is often someone who previously had no hope of working their way out of extreme poverty. The sellers of goods and services are not the only people who have benefited; buyers have paid lower - often much lower - prices.
Over the last 40 years, globalization has brought billions of people into the world economy for the first time. The percentage of the world’s people in extreme poverty (consuming less than $2.15 per day per person) has fallen from 40% to 8% over that time frame. As a result, the World Bank now classifies half the world’s population as middle class. This is one of the greatest human achievements in the history of the world.[1]
Deglobalization is the opposite. Many people in the world could become poorer, which is clearly the wrong direction for humanity. From an investment perspective, deglobalization will have both positive and negative effects, creating winners and losers. As a portfolio manager, I try to find opportunities and act for the benefit of our investors.
My analysis suggests that small cap stocks, considered globally and in aggregate, are likely to be the winners, while large cap stocks may lose out in relative terms. In absolute terms, no one can predict which direction the market will be going, but I suggest overweighting small caps in order to benefit from potential relative outperformance. The reason for the expected difference in relative performance is that small cap companies tend to sell into domestic markets while large caps sell internationally or globally. In addition, small companies across the globe have lower correlations with one another than large companies do, making it easier to generate excess returns through small cap stocks.
A Brief History of Globalization and Deglobalization
The desire to expand the reach of a business internationally or globally is as old as history itself. The Roman Empire, for example, was a commercial globalization movement as well as a political and military movement.
The Golden Age of Globalization occurred from 1870-1913, when Europe and North America began reaching out to the rest of the world commercially, taking advantage of peace and rapidly falling shipping costs.
The outbreak of World War I in 1914 put an end to all that, and the resulting deglobalization was sudden and severe. It was no longer possible to transport goods safely across the seas. After World War I, the U.S. became isolationist, and the Smoot-Hawley tariff act put the final nail in the deglobalization coffin. The Great Depression occurred partially because of trade destruction. World War II was even worse for trade, despite bringing an end to the Depression and boosting the U.S. economy.
After World War II was over, the U.S. economy flourished, positioning the country as the world’s dominant, most prosperous power. International peace agreements and the growing influence of multinational corporations ushered in a tentative new era of globalization, though it was partially hampered by the spread of communism.
Eventually, the Second Golden Age of globalization blossomed in the 1980s and drove an unprecedented boom in non-U.S. financial assets. Europe and Japan led the way in the 1980s. Japan peaked early and has never fully recovered. More recently, Western Europe has struggled. Eastern Europe, however, has moved closer to parity with Western Europe, a huge advance for that region.The most remarkable change took place in China, which grew from exactly 0% of the cap-weighted world market portfolio in 1978 to 14% today, second only to the United States. Now that’s globalization![2]
The prospect of the whole world becoming integrated into one economy is not dead, but it ran into a severe stumbling block in 2020 that continues to worsen instead of improve.
Why Deglobalization Now?
The recent move away from global trade and investment toward local sourcing of labor and resources was first sparked by COVID. Although the pandemic is more or less over, it continues to impact the world economy. Supply chain interruptions caused by COVID and the ensuing response – across medication, semiconductors, auto and airplane parts, oil, even food – demands that companies and governments rethink their reliance on overseas manufacturing and safe, inexpensive shipping. The result has been a spiraling effect where each move toward localization catalyzes even more localization.
An increasingly unstable geopolitical situation has also emerged. Not only did Russia invade Ukraine, but mainland China threatens Taiwan and asserts dominance over Hong Kong. For most of the 21st century, a rough balance of power existed between the U.S., China, Russia, and the EU (with or without the U.K.), but that sense of balance has decidedly passed. Consequently, each major power is actively reducing its dependence on the others. We’ve seen this classic pattern of deglobalization before, the most serious example being in 1914. While I do not think this is 1914 redux, many trends are similar.
Current United States Trade and Manufacturing Vulnerabilities
Our paradigm of global trade is now vulnerable. Over 90% of semiconductor manufacturing – a staple as important as steel or cement – occurs on a small island a few miles from a hostile China. Essentially all of Europe’s fossil-fuel energy comes from Russia. The South China Sea, claimed by China as part of its territorial waters, is a corridor for much of the manufacturing output that the whole world buys.
It may also come as a surprise to readers that, through the supply chain, China controls most of the electric vehicle battery industry. While most of the technology is American, and the dominant battery manufacturer (Panasonic) is Japanese, China supplies about three-quarters of the lithium, cobalt, and nickel needed to make the batteries.[3]
Completely free trade is hampered by the U.S. military’s and health care system’s reliance on foreign suppliers – rocket fuel in the case of the military (one of the necessary ingredients is made only in China!), and pharmaceuticals and medical devices in the case of health care.[4,5] In my opinion, it is an urgent matter of national security that we have at least the capability, if not the actuality, of manufacturing these on short notice. U.S. companies will obviously benefit from this shift, which will likely boost the returns of small caps relative to the stocks in the S&P 500, an index comprised of companies that, in aggregate, earn about half of their profits internationally.
All that said, the modern era of global business is anything but over. It is just facing some retrenchment and moderating forces. Relying on potentially hostile countries for our basic needs was never a great idea, and now it has become an outright danger. The ability to meet our country’s needs cannot remain at the mercy of governments and corporations in other countries, particularly those with which we have poor or uncertain relations.
As a result, comparative advantage and cheapness are no longer the only variables on which supply-chain decisions are made. Safety, logistics, and resilience are important, too. Small innovators in the U.S. and in nearby, friendly countries will benefit from these trends.
Why nearby, friendly countries? Can’t we do all of this in the United States?
The U.S. has increasingly specialized in technology, finance, health care, and intellectual property rather than manufacturing. Consequentially, U.S. labor costs and other factors of production have become more and more expensive. The U.S. has the highest PPP GDP per capita of any large country,[6] and labor costs are soaring as it has become difficult or impossible to fill job vacancies. American workers deserve a raise, having waited endlessly for one in real terms. As a result, manufacturing in Mexico and the Caribbean has suddenly become more attractive.[7] Smaller companies in these regions can benefit from deglobalization, as can larger enterprises.
Industrial Technology Innovation: What is it and Who are the Leaders?
As manufacturing moves back to the United States and surrounding areas, one growth sector will be industrial technology. Although everyone has heard of the technologies themselves, few people know what they’re for or connect them specifically with manufacturing, so I’ll provide a revealing list from World Industrial Reporter:[8]
Industrial IoT (internet of things)
3D printing
Artificial Intelligence and robotics
Big data analytics
VR (virtual reality) and AR (augmented reality)
Blockchain
Cleantech
Smart manufacturing, a catch-all term for “a fully-integrated and collaborative manufacturing system that uses real-time data and…technology to meet the changing demands of a manufacturing unit.”
These fancy-sounding techniques are already widely in use and will become even more commonplace. While many of the users are big corporations, the techniques themselves are often developed and implemented by startups and venture-backed private companies as well as publicly traded small cap firms. The takeoff of the sector, already underway, could accelerate as the techniques are used for everything from sorting the contents of recycling bins to controlling coal mining robots safely from above ground (really!).
As has been demonstrated repeatedly throughout history, the introduction of labor-saving devices and processes (for that is what this is) increases the overall number of jobs, rather than reducing them.[9] However, the job mix will change and require more skill and sophistication in the workforce. This is a good thing, because higher-skilled jobs are also more highly paid, and growth in this sector provides a path forward for improving education and training, both public and private.
Market Results from Early Stages of Deglobalization
This retreat from the “borderless world,” a once-popular theme that now seems unimaginable, should be a tremendous boon to manufacturers and other companies that sell primarily in their own domestic markets. These tend to be small- and mid-sized companies.
However, this effect has not yet shown up convincingly in the data. For the two years ended November 30, 2022, the small cap Russell 2000 index underperformed the large cap S&P 500: 3.03% versus 7.78% annualized. If you include the big COVID crash in the spring of 2020 and look at three-year numbers, large cap still edged out small cap (because large companies are usually more resilient in a crash), so there is no clear confirmation of a boom in small caps. The small cap results so far in 2022 are encouraging, but not by the kind of margin that I’d call a boom.
I’d note that relative valuations favor small caps going forward. A recent Yardeni report shows U.S. small caps selling at 13x forward earnings compared to about 18x for large caps. According to an equation popularized by Jeremy Siegel, these multiples indicate an expected real return of 7.6% for small caps versus 5.7% for large caps.[10] This is a respectable but not overwhelming premium.
It’s more difficult to get long-term historical data for small caps versus large caps internationally, but we can observe the correlations in real time. As in the United States, correlations are lower for small caps, making portfolio construction in the pursuit of excess returns both more straightforward and fruitful.
Relative Returns on Small and Large Cap U.S. Stocks in Globalization and Deglobalization Periods
To assess whether small cap outperformance has been associated with deglobalization historically, I used Ken French data, which compares the returns on small cap U.S. stocks with large cap U.S. stocks starting in 1926. I started my analysis at the bottom of the Great Depression mega-bear market on July 1, 1932 and broke up the subsequent time period into four phases or “regimes”:
Isolation/depression/war (7/1/1932-1945) - Deglobalization
American Exceptionalism (1946-1963) - Globalization
Turmoil and stagflation (1964-1982) - Mixed
Globalization on steroids (1983-2020) - Globalization
The winner in each period is highlighted in bold text:
Clearly, my prior assertation – that globalization helps large caps and deglobalization helps small caps – can be supported by this data.
Conclusion
Both historical return patterns and valuation levels support the case for small caps beating large caps in this next regime of deglobalization. Of course, such forecasts have very wide “error bars”, and anything can happen. But the way to bet is an overweight in small caps, both in the U.S. and internationally.
To wrap up, I believe deglobalization, which is at this point unavoidable and likely to continue for some time, will be highly disruptive to all kinds of existing arrangements. Any disruption provides opportunity, and it is up to the equity analyst to figure out where these opportunities might translate to excess returns for the investor. Logistical and national security concerns, as well as purely economic forces, appear to push us in the direction of deglobalization at this time.
[1] https://blogs.worldbank.org/opendata/september-2022-global-poverty-update-world-bank-2017-ppps-and-new-data-india
[2]https://en.wikipedia.org/wiki/List_of_countries_by_stock_market_capitalization
[3] https://www.npr.org/2022/02/21/1082172649/how-china-dominates-the-electric-vehicle-supply-chain
[4] https://www.americanmanufacturing.org/press-release/report-says-u-s-military-dangerously-dependent-on-foreign-suppliers-2/
[5] https://www.mckinsey.com/capabilities/operations/our-insights/the-resilience-imperative-for-medtech-supply-chains
[6]https://en.wikipedia.org/wiki/List_of_countries_by_GDP_(PPP)_per_capita
[7]https://www.forbes.com/sites/forbestechcouncil/2021/05/27/beyond-outsourcing-how-to-get-started-with-nearshoring/?sh=78d48e617990
[8] https://worldindustrialreporter.com/8-technological-innovations-shaping-future-industrial-world/
[9] https://www.amazon.com/Fewer-Richer-Greener-Prospects-Abundance-ebook/dp/B07Z9PRDT7
[10] https://www.yardeni.com/pub/stockmktperatio.pdf. - The equation says that the earnings yield (reciprocal of the P/E ratio) of a stock or index is its expected real return.