These changes have important knock-on implications for corporate behaviour and are a key aspect of a new regime in policy and market behaviour.
A decades-long process of globalisation is coming to an end as the world becomes more protectionist.
Donald Trump rode to victory in 2016 on a populist ticket that blamed the decline of US industry on China. Supply chain disruption stemming from the Covid-19 pandemic and Russia’s invasion of Ukraine have caused even more countries to question their reliance on a small handful of suppliers of key goods and commodities.
And the rapid and severe sanctions imposed on Russia have exposed a new fault line in the world order. Countries that previously might have sided with the US rather than China on certain issues are now taking a more neutral stance.
The emergence of a new world order is likely to drive a new global investment cycle. This is set to occur as global value chains (GVCs) are reorganised, the energy transition is accelerated and governments respond to the greater perceived threat of war with higher defence spending.
Some economies will benefit from the shake-up of GVCs, particularly those that are able to increase market share, or export the natural resources required for the energy transition.
However, with security concerns rather than economic efficiency set to drive future decision making, there is a risk that the new order will move the world economy in a more stagflationary direction. These changes are a key aspect of a new regime of supply-side shortages and more frequent price increases (see Regime shift: investing into the new era).
Looking back it now seems that the gains from globalisation peaked around the start of the new millennium, and widening cracks in the world order are actively unpicking them as China increasingly challenges US dominance. Driven by a decoupling of the US and China, the shifting balance of geopolitical power has important knock-on implications for corporate behaviour.
A new world order is emerging from military and trade wars as old alliances are tested
Geopolitical tensions between the US and China have been growing for some time.
Washington has become increasingly concerned about China’s detrimental impact on the domestic economy as deindustrialisation left a vacuum for populist economic policy. It helped Donald Trump win the presidential election in 2016 that fired the starting gun on the trade war with China.
The contrast with the early noughties couldn’t be starker. Then we saw a Bill Clinton-led administration cheerleading China’s accession to the World Trade Organization (WTO) whereas today bashing China is the one policy with bipartisan support. In a highly polarised US Congress, hawkish policies are no longer the preserve of the extremities of the political spectrum.
Concerns about an over-reliance on China were magnified during the Covid-19 pandemic, when lockdowns disrupted Asian supply chains and led to shortages of goods. In the first instance, shortages were confined to areas such as medical equipment and PPE as the world scrambled to cope with the pandemic.
However, they became more widespread as lockdowns in most of the world concentrated demand into the goods sector, where manufacturers continued to face disruption and did not have the capacity the meet unusually strong demand. That caused delivery times in the global manufacturing sector to lengthen (chart 1), sowing the seeds for a sharp increase in goods inflation.
Shortages caused many countries to begin to reassess the prudence of relying on a small number of countries, and China in particular, for the supply of key goods. But it was Russia’s decision to invade Ukraine that is likely to prove a watershed moment in the creation of a new world order and break-up of GVCs.
After all, the invasion was met with the unprecedented and rapid reaction by the US and its allies to impose severe financial and economic sanctions.
Russia has only ever accounted for a small part (c.2%) of global trade and played a relatively minor role in international investment and GVCs. So, at face value, the impact of the war and sanctions might not have seemed to be a threat to overall globalisation. However, the country is a major global energy producer, accounting for 12% of global oil exports and 3.6% of gas exports in 2020, prior to the invasion of Ukraine (source: trademap.org).
The war has exposed Europe’s heavy reliance on energy imports from Russia, the price of which skyrocketed, at one stage threatening to plunge the eurozone into a deep recession.
The immediate economic impact of those sanctions is starting to ease as energy inflation subsides. However, the sanctions have left an indelible mark on the world. For a start, companies are now more aware than they were prior to the war of political risks and costs associated with trade and foreign direct investment (FDI).
Shortly after Russia’s invasion, estimates from the United Nations Conference on Trade and Development suggested that two-thirds of the Russian FDI stock was held by companies domiciled in developed market countries opposed to the conflict. A large part of this has since been written off.
In addition, the rapid imposition of severe sanctions appears to have widened the divide between the US and China which risks a more permanent de-coupling of the world’s two largest economies. Last year’s vote to expel Russia from the United Nations Human Rights Council (UNHRC) achieved its two-thirds majority, but China was among the 24 countries which voted against the decision.
United by a mistrust of Western institutions, Russia and China have formed an alliance that has “no limits”, indicating scope for broad-based cooperation. The pair are economically complementary as Russia seeks more sophisticated technology while China is very commodity-dependent. Both are particularly wary of the North Atlantic Treaty Organization, or NATO.
Those voting patterns may also be a sign that the US and its allies are losing influence further afield. Countries/regions that have historically been aligned with the US, such as members of the Gulf Cooperation Council (GCC), parts of Latin America and other emerging markets (EM) joined India in abstaining from the vote to remove Russia from the UNHRC.
Alliances that might in the past have been rewarded with an influx of long-term US investment now seem less certain. The rejection of a US-supported UNHCR motion for a debate on the situation of human rights in the Xinjiang Uyghur Autonomous Region gave another important insight. It gave an idea as to which side of the divide countries might fall in the event of a more serious US-China decoupling
Beijing has so far been careful not to accelerate trade with Russia in order to avoid an escalation of tensions.
As the no-limits alliance develops, however, there is a risk that support for, or even a lack of opposition to Russia will be interpreted in a hostile way, and ultimately attract sanctions from the West. Multi-lateral efforts to take a lead in decarbonising the global economy, such as an EU Carbon Border Adjustment Mechanism (CBAM), will likely be tested in a new world order, which can also be broadly defined by an accelerating response to climate change.
We explore the changes underway here in part five of the regime shift series (see Regime shift: the accelerating response to climate change). As mentioned above, India was one of the notable countries to abstain from the aforementioned UNHRC vote and together with China now accounts for about half of Russia’s marine-bound oil exports. Along with China they have opposed CBAM, depicting the policy as veiled protectionism.
Higher political risk points to a reorganisation of global value chains and move away from “just in time”
Meanwhile, we saw a flurry of fresh protectionist policies in the run-up to the US mid-term elections in November 2022. These events seriously threaten trade in high-value industries such as semiconductors between China and Taiwan and the US and China.
The new policies were another reminder of the threat to GVCs already tested by Brexit, tariffs left over from the Trump era tit-for-tat trade wars and the Covid-19 pandemic. All of these events, as well as the costs of the Ukraine war, will likely influence how multinational companies (MNCs) behave, and shape FDI going forward.
As global corporations have discovered, ignoring political risks can be expensive. Identifying risks in advance, however, is never straightforward and companies may be looking more closely now at how countries vote in international forums as they assess their options for the future.
Evidence from the transcripts of earnings calls with major listed US companies show that many firms are already discussing the need to diversify their supply chains. Hits for words such as “reshoring” have risen significantly in recent years (chart 2). As such, it seems that the threat of a new world order is already starting to drive a reorganisation of GVCs.
Certainly, the global energy market has already been turned upside down since the invasion of Ukraine as Europe moved to stop buying Russian energy.
Russia has been forced to redirect its energy exports to friendlier nations such as China and India, sold at a discount to global prices. In Europe, the short-term solution has been to cut back energy consumption and scramble to install infrastructure to replace Russian pipelines with LNG terminals.
However, the disruption to global energy supplies has accelerated the energy transition as countries aim to become more self-sufficient with investment in renewables.
The Inflation Reduction Act in the US contains large subsidies worth $369 billion for companies operating in the clean energy sector. This example of fiscal activism also includes protectionist policies. Among these are requirements to purchase locally-produced equipment rather than importing goods from China, which currently dominates the manufacture of clean energy products.
The threat posed by large subsidies in the US is also set to be met with new industrial policies for the energy transition in Europe. A green subsidy race is taking shape in the West.
Governments are also offering inducements for companies to reshore production in key industries. For example, the US CHIPS and Science Act which was signed into law in 2022 offers around $280 billion in new funding for the research and manufacturing of semiconductors in the US, including large tax credits for capital expenditure in the sector. That has already seen major players such as Taiwan Semiconductor Manufacturing Company(TSMC) unveil plans for new foundries in the US.
MNCs are also likely to consider moving operations in countries such as China to destinations that offer greater protection from geopolitical risks or trade tariffs. And disruption to GVCs that have caused shortages of key goods in recent years means that “just in case” is replacing “just in time” as the guiding principle for inventory management.
Some emerging markets could gain market share as companies leave China
Estimates from the McKinsey Global Institute suggest that 15-25% of global goods trade could shift to different countries over the next five years. Several Asian EM rank well as replacement low-cost manufacturing destinations for industries currently producing relatively low-value goods in China. They have a combination of either relatively attractive business environments, high governance standards, and/or productive workforces with low labour costs.
These countries include India, Malaysia, the Philippines, Thailand, Vietnam and Indonesia, although with contrasting strengths and weaknesses, which would play a role in determining the kind of industry they might attract.
For example, many companies would surely find India’s relatively large and low-cost working-age population appealing. And while India does score relatively poorly when it comes to its business environment, positive change may be afoot. Covid-19 has forced the government of Narendra Modi to start pushing through reforms in areas such as the labour market and agriculture, which could eventually improve operating conditions for companies.
Like India, the Covid crisis has also forced Indonesia to revive long overdue structural reforms with the recently approved Omnibus Law. The country ranks well on the basis of its relatively large and young population which will act to suppress labour costs.
If these countries are successful in attracting a significant influx of manufacturers, there could be substantially positive economic impacts. In the short-term, economic growth would be boosted by capital inflows to fund investment and the construction of factories and infrastructure.
In the longer term, an increase in manufactured exports would lift productivity and thus potential GDP growth. This would likely lead to an improvement in the balance of payments, a decline in structural interest rates and better exchange rate dynamics. All of this would be supportive for the performance of their domestic financial markets.
Accelerated energy transition may benefit high-value industries in EM and producers of raw materials needed in the transition
As we’ve seen, China has facilitated the energy transition to date in the advanced economies of the West. So it is already a major producer of equipment used to generate clean, renewable energy and now controls the lion’s share of solar panel production, for instance.
However, green subsidies in Europe and the US are designed to increase self-sufficiency in green technologies and “buy local” requirements will dampen the spillover of increased investment from here. The really big EM winners going forwards seem destined to be the countries and companies that manufacture key energy transition products where they have a clear competitive advantage. So, the global semiconductor duopoly that is Samsung in South Korea and TSMC of Taiwan seems likely to serve these two countries very well.
However, the manufactured end products are only part of the story as the energy transition will require huge amounts of natural resources. And this presents new vulnerabilities for markets such as Europe and the US. This is because many of the countries that are major exporters of the industrial metals needed for most new energy technologies have so far leaned towards the China side of the fault line.
Supply chains for the raw materials needed in the transition are more geographically concentrated than that of oil or natural gas. For example, the global production of lithium, cobalt and rare earth elements is controlled by a few countries (see chart 3). China itself accounts for around 60% of global production of “rare earths” and dominates the production of graphite, a critical battery component.
It has also invested heavily in regions such as Africa in recent years, where many supplies are located. The Democratic Republic of Congo (DRC), for instance, is responsible for around 70% of global cobalt supply.
Whereas oil exporters in the GCC could conceivably lose influence on the global stage in the long term, countries that dominate the production of in-demand metals may gain influence and become another source of long-term tensions between China and the US.
Metals such as aluminium, copper, nickel, cobalt and lithium, which are used in a broad spectrum of products, are likely to see a big mismatch between supply and demand. Their prices have the potential to rise significantly over time and provide a windfall for those EM that export them.
Exports of aluminium ore (bauxite) were equivalent to almost 25% of Guinea’s gross domestic product (GDP) in 2020 and so it seems that its economy should benefit significantly from strong demand in the future. Similarly, exports of copper and related products represent big shares of GDP in Zambia, Chile and the DRC.
Beyond this handful of countries, though, lop-sided control of tight supplies of key metals points to future input price pressures for the rest of the world as the energy transition picks up.
Deglobalisation and new world order a stagflationary threat to the global economy
The key point, though, is that while there may be some winners from a shift in global manufacturing and accelerated energy transitions, the drive to secure supply chains could have a negative overall impact on the global economy. Indeed, if globalisation in recent decades was a force for faster growth, lower inflation and interest rates then a reversal of those trends threatens to take the world in a stagflationary direction.
Much will depend on how far down the road of decoupling the world goes. Some industries have already been diversifying away from China without any noticeable impact on global growth and inflation. For example, China’s share of the global footwear and clothing sector peaked around a decade ago as rising wages in labour-intensive industries caused firms to switch to lower-cost destinations such as Bangladesh and Vietnam, without creating any inflationary impact (chart 4).
In addition, there are some industries that lend themselves to operating regionalised supply hubs without any obvious detrimental impact on activity. This could prove important given that many MNCs are likely to be reluctant to exit altogether key long term growth markets such as China.
The car industry is a good example of this, where firms manufacture vehicles in three major regions of North America, Europe and Asia. Firms have been able to manage these complicated operations without driving up prices. If anything, cars have become cheaper in real terms (chart 5).
However, there is a clear threat that supply chains will be less efficient in the future. Increasing inventory is an obvious course of action for MNCs worried about supply chain disruption. But building in buffer stocks in this way would be a reversal of the more efficient just in time model which helped drive significant declines in the inventory-sales ratio in the first decade of the century.
These declines occurred between China’s ascension to the WTO and the Global Financial Crisis (GFC). However, judging from recent trends in the US there was already some increase in inventory-sales ratios in recent years and prior to Covid. This may not reflect the broader international picture but could be attributed to low interest rates after the GFC which reduced the cost of funding inventory.
Going forwards, inventory is likely to rise given its low cyclical position and as firms choose to hold greater stocks, in the long run, to guard against disruption, but higher interest rates may temper this trend.
Meanwhile, the more that the relocation of supply chains is driven by security concerns than economic fundamentals, the less optimal the outcome is likely to be. For example, whereas we identified a handful of Asian countries that could be suitable replacements for China, firms that want to exit the region altogether may be forced to choose countries that are less competitive.
Reshoring through bringing supply chains home would boost domestic activity, but clearly represents a retreat from the globalised model of extended supply chains. Should reshoring become established, supply chains may become more robust and resilient to global shocks, but security comes at a price.
For example, moving production from low-cost regions such as Asia back to developed markets will be expensive and require a period of strong capital expenditure. And while MNCs would benefit from a decrease in transport costs (shipping and fuel), they would face higher unit labour costs given that workers’ wages are far higher than in countries such as China.
As we will discuss in part four of the regime shift series, this means that reshoring will come alongside greater investment in robotics and artificial intelligence (AI).
Military spending is also likely to increase with implications for investment elsewhere
In practice, we will probably see a mix of reshoring, higher inventories, “friend-shoring” as firms opt for some diversification of supply chains to “safer“ countries, and a partial withdrawal from international trade. However, all of these measures to secure supplies will require huge investment. And they come at a time when fiscal activism means that government spending is likely to increase in the future.
The perceived increased threat of conflict as a result of the emergence of a new world order means that another strand of the search for greater security is also likely to be increased military spending.
Military spending is generally equivalent to 1-2% of GDP (chart 6) in most countries but is likely to rise significantly – world spending averaged about 6% of GDP during the 1960s and around 4% of GDP in the 1970s and 1980s. Indeed, despite the perilous state of the UK public finances, the British government has still found space to add £6 billion of military spending over the next five years. And the recent agreement between the US and UK to supply submarines to Australia illustrates that the trend is already gathering pace.
Greater military spending is good news for the defence sector, but it will put further upward pressure on government borrowing at a time when we expect a general return of fiscal activism to strain the public coffers. All of that could push up interest rates and ultimately crowd out other investments such as those required in the private sector to drive the energy transition and reorganisation of supply chains. That raises the threat of less efficient outcomes.
The upshot of all of this is that the emergence of a new world order is likely to be detrimental to the global economy. As countries seek to secure their future energy supplies and firms scramble to protect their supply chains the world may go through a boom in capital expenditure in the years ahead. This is at a time when public spending is also likely to increase.
But higher costs, along with shortages of key inputs and less efficient supply chains, threaten to lead to structurally higher long-term inflation. And with central banks likely to prioritise dealing with inflation over supporting growth, the emergence of a new world order seems set to deal a stagflationary blow to the global economy.
Summary and conclusions
- A new world order appears to be emerging. Hawkish US policy towards China over trade and security shows no signs of softening, suggesting that the two superpowers will continue to decouple in the years ahead as they compete to be the world’s number one economy.
- Russia’s invasion of Ukraine has exposed another fault line in America’s global influence, as traditional allies of the US failed to support sanctions imposed by Washington.
- The emergence of a new world order is likely to lead to a reorganisation of GVCs. Disruption during the initial phase of Covid-19 highlighted concerns about their highly-concentrated nature. Firms are likely to hold more inventories to avoid near-term shortages, while diversifying production to other parts of the world.
- The new world order is also likely to cause an acceleration in the energy transition. Europe’s over-reliance on Russian energy exports has been exposed since Moscow’s decision to invade Ukraine. The EU is likely to follow in the footsteps of the US by introducing large fiscal support for the transition.
- Military spending will probably increase as the new world order raises the threat of conflict. Russia has already invaded Ukraine, while ongoing tensions between China and the US over Taiwan are unlikely to dissipate.
- There will be some winners from the disruption caused by the emergence of a new world order. Economies, mainly in the emerging world, that are able to attract manufacturing firms leaving China could boost their potential rate of growth by raising market share. Meanwhile, those economies that export minerals critical to the energy transition will see demand rise in the years ahead.
- However, the new world order will be negative for the global economy. The reorganisation of the GVCs, energy transition and higher military spending will be expensive. Meanwhile, less efficient supply chains will also raise costs. As a result, inflation and interest rates are likely to be structurally higher, leading to slower growth.