How Deglobalization, Trade Could Slash Equity Multiples

It's more than a coincidence that globalization has been accompanied by almost 30 years of elevated stock prices.

Three decades ago, the Berlin Wall crumbled, China opened its economy to the outside world, and a new economic environment emerged. The internet bubble may be the signature financial event of the 1990s, but the advent of globalization created a spate of new markets for American multinational corporations as blue-chip companies like General Electric and Coca-Cola were able to sell goods and services in places they couldn’t have imagined a decade before.

When the U.S. entered a new millennium with 4% unemployment in 2000, many companies decided to locate production facilities in nations where labor was plentiful and cheap, most notably China and India. The upshot was a just-in-time, transnational supply chain optimized with numerous interconnected moving parts that lifted corporate profit margins to record levels.

In the wake of the financial crisis, the backlash to globalization started to catch fire. Even before the 2016 election, many American politicians were expressing displeasure with the World Trade Organization, and both parties voiced doubts about the Trans-Pacific Partnership. “Trump is just an accelerant throwing gasoline on the fire,” Erik Weisman, chief economist at MFS, says.

“People in Topeka” and non-globalized regions around the developed world “feel they’ve been lied to,” he continues. Even if Presidents Trump and Xi Jinping manage to work out a U.S.-China trade deal, financial markets might rally, but it’s unlikely to quell protests in Paris or Hong Kong.

Fallout from populist nationalism has sweeping implications for the investment world that are just beginning to dawn on the markets. It’s no coincidence that, starting in the 1990s, PE multiples for equities began to elevate. As value investing legend Jeremy Grantham, co-founder of GMO, noted in these pages two years ago, equity prices between 1997 and 2017 sported higher multiples “for the entire block of 20 years” than they did in 1929. Much of that multiple expansion can be traced to the low interest rates and deflationary pressures that accompanied globalization.

Today, many of globalization’s basic principles are fraying. The International Monetary Fund is calling capital controls, in certain circumstances, a positive development. In the U.S., much of Europe and the United Kingdom, free movement of labor is under fire.

Information flows, transmitted over the internet, were once universally viewed as a public good, a way to liberate and uplift national populations. Great universities like MIT placed class curricula online, offering access to teenagers in the emerging world. Now numerous countries from China to the European Union are trying to regulate search engines and social media. Some are even trying to transform the internet into their own intranets. Moreover, globalization took place over a 30-year period marked by falling taxes, tariffs and interest rates, Weisman observes.

Resurgent populism is going to require a reset. But deconstructing the supply chain isn’t going to be that easy, and altering it could make the system increasingly fragile.