Mid-Quarter Update: The Globalization Myth

This presents challenges and opportunities for the US and foreign economies. In the following pages, we quote generously from a Shannon K. O’Neil’s book The Globalization Myth.

2. The Globalization Myth

​​​“Globalization. You love it. You hate it. You embrace it. You blame it. But it isn’t the only, or even the real, story of the global economy over the past four decades. Yes, the world has internationalized. But it hasn’t really globalized. It has regionalized. This distinction helps explain who has gotten ahead and who has been left behind; those who engaged with their neighbors gained a competitive edge. It also provides a path forward for what the United States—and other countries, for that matter—should do to help their citizens and communities thrive economically. Isolation and autarky aren’t the answers. Nor is unfettered globalization. The Goldilocks middle of regionalization propelled a number of nations forward over the past forty years. And even in the wake of technological, geopolitical, and demographic shifts, geography still counts for a lot. Embracing and deepening regional ties is a way to succeed in an internationally connected and competitive world.”

Source: The Globalization Myth, Shannon K. O’Neil

3. Regionalization Not Globalization

“The regionalization of international ties is most pronounced in economics and markets. The story of economic globalization has been told and retold in books, speeches, articles, and news clips. Yet this conventional narrative largely misses the geographic limits of the majority of international commerce. When companies, workers, money, patents, goods, and services head abroad, they don’t go just anywhere. More often than not, they stick close to home. What’s happening to the global economy is better termed ‘regionalization’ than ‘globalization.’ The ‘global’ in ‘global supply chains’ in particular is a bit of a misnomer.”

“But usually, when manufacturing goes abroad, it doesn’t spread so far or so thin. Companies find the parts they need nearby. Suppliers sell to foreign customers close to home. The world has become more international but not nearly as global as the news would have you think. Since the great manufacturing dispersion began some forty years ago, commerce between neighbors and within regions has far exceeded that across continents.”

“Regionalization is the economic story of our time, but not all regions are created equal. Three big hubs, in Asia, North America, and Europe, dominate manufacturing. Asia’s is the largest, churning out nearly half the world’s goods. North America and Europe together supply another 40 percent of global products.”

“Not only do the three big hubs make the vast majority of the world’s goods, but they do it largely independently of other regions. Over two-thirds of Europe’s trade remains within the European Union (EU), as Europeans make things together and buy from each other. Asia’s trade ties, too, have deepened in recent decades. Over half of Asia’s international commerce remains within the continent. North America is the least intertwined; under half of its trade takes place between Canada, Mexico, and the United States.”

Source: The Globalization Myth, Shannon K. O’Neil

4. Regional Integration Histories

“Europe’s integration began in the ruins of the postwar world, as former enemies learned to trust each other through trade. From Rome to Brussels, Maastricht to Amsterdam, Nice to Lisbon, a stream of eponymous treaties bound Europe’s members, economies, companies, workers, and populations together. With each ratification, Europe’s ties thickened, its integration deepened, and the number of countries in the club grew. The expanding latticework of institutions, agreements, regulations, and court decisions came to govern not just commerce but also the daily lives of citizens in over two dozen countries. Despite frequent squabbles and several full-blown crises, the nations strove to uphold a single European vision, choosing to cede power to regional supranational institutions to propel and promote integration.”

“Asia’s binding together involved fewer diplomats; instead, CEOs backed by state bureaucrats led the charge. East Asia was the first to knit itself together. As Japan rebuilt after the war, its government-supported industries turned to factories in Taiwan, South Korea, Singapore, and Hong Kong to assemble cars, televisions, and footwear. A decade later, these ‘Asian tigers’ were rich enough to repeat Japan’s success for themselves, farming out their own production to neighboring Malaysia, Indonesia, Thailand, the Philippines, and the rest of Southeast Asia. In the late 1970s and early 1980s, China joined the assembly line as its neighbors began outsourcing labor-intensive work to the country’s new special economic zones.”

“It was the North American Free Trade Agreement (NAFTA) that spurred the rise of a production platform spanning North America. The United States, Canada, and Mexico had always traded with each other. But after the 1993 free-trade agreement, continental commerce quadrupled in size. A decade on, U.S. manufacturers were buying and selling more from Canadian and Mexican producers and consumers than from any others in the world… U.S. trade has more than doubled over the past two decades. Much of the growth in U.S. exports has been in intermediary parts sent off to be combined into computers, cars, planes, and thousands of other products. U.S.-made heavy machinery, tools, trucks, and tractors—known as capital goods, because they’re used to produce other products—are used by farms and factories all around the world. Add in raw materials—iron ore, cotton, petroleum, copper—and close to two-thirds of all the things the United States sends abroad go into making something else.”

Source: The Globalization Myth, Shannon K. O’Neil

5. How Regionalism Works

“According to a study by the Peterson Institute, a think tank for economics, the average U.S. household gains the equivalent of $10,000 in real disposable income from trade every year…”

“The truth is that while trade benefits the United States as a whole, some kinds are better than others. Regional ties help U.S. workers and businesses more than global ones do. Studies of communities hit by offshoring demonstrate this crucial difference. A well-regarded investigation by the economists David Autor, David Dorn, and Gordon Hanson estimates that during the first decade of the twenty-first century, up to two million U.S. jobs were lost to imports from China (though they did not try to measure jobs gained from increased exports). At the same time, studies of NAFTA have found limited effects on jobs and communities from trade with Mexico and Canada. How could one kind of trade undermine towns and entire industries and another cause barely a ripple? The answer lies in how regionalism works.”

“When U.S. companies buy and sell within North America, more work stays at home than if they set up shop farther away. And these jobs aren’t just researchers, marketers, or headquarter managers; they are also machinists and assembly-line workers in U.S.-based supplier factories. Because of the trade in intermediate goods, the average Mexican import is 40 percent U.S. made; the average Canadian one is 25 percent U.S. made. These ties with Mexico support an estimated five million U.S. jobs; the ties with Canada support another seven million. Combined, that’s as many Americans as can be found working in the entire U.S. manufacturing sector. As for a product coming in from China? Just 4 percent of it was made in the USA.”

“This same dynamic benefits other manufacturing hubs as well. When imports come from nearby, they tend to have more parts or inputs from home, providing more support for local factories and jobs compared to wares made farther away… More than two out of every three traded intermediate pieces in Europe come from within the region, meaning more work in European factories and offices.”

Source: The Globalization Myth, Shannon K. O’Neil

6. The US Lags in Regionalization

“The United States is questioning the open trading order it helped build. And China is pulling back, importing less as it strives to become more than a final assembly hub. Yet as politicians promise to bring factories and jobs back home, and companies look into shifting their production sites and sources, the benefits of regionalization continue. The multi-country advantages of diverse workforces, labor costs, technology, access to capital, free-trade agreements that harmonize rules and regulations, combined market size, and diversifying risks enable companies and their workers to make better products for less, even in a world of smaller batches and faster delivery. As more nations join together for a competitive edge, it leaves the laggards at a further disadvantage. For the United States, the best way to compete with the other regional manufacturing hubs is still to build its own.”

“Today, Asia and Europe make nearly two out of every three products sent abroad. Their success stems, in part, from their regional embrace. By integrating their markets, investments, and chains of production, European and Asian companies have become more globally competitive, creating jobs, wealth, and profits at home. The United States, meanwhile, hasn’t yet made the most of the opportunities that can come from commercial ties to its neighbors.”

“A new kind of globalization is on the horizon, one of new technological tools, demographic shifts, climate changes, and a billion new online consumers. Many of these trends play to the United States’ strengths: clear legal rules, world-class universities, a growing working-age population, open markets, wealthy consumers, advanced technology, and globally recognized services and brands. The United States can handle competition. But it will be easier and done better with partners. If it continues to leave the benefits of regionalization to the rest of the world, more Americans will get left behind.”

Source: The Globalization Myth, Shannon K. O’Neil

7. Regional Supply Chains

“This isn’t the first time that ‘globalization’ has reshaped the world. International trade has ebbed and flowed throughout history, creating towns and cities, building governments and nation-states, starting and ending wars. What is different today is the nature of trade. A century ago, most of what crossed borders was ready to be consumed—olives from Italy, wine from Spain, furs from Canada; later on, cars from Germany, sewing machines, printing presses, and cash registers from the United States. Sure, resource-rich countries shipped iron, copper, and coal to power far-away factories. But trade generally involved things made or grown in one place and sold in another.”

“That began to change after World War II. Rather than making the final sale, more companies became suppliers, sending parts to meet up with those made by others for assembly. As companies sliced up manufacturing into discrete parts and processes, they looked abroad. Through offshoring, outsourcing, and subcontracting, international commerce and connections grew. Trade in intermediate goods rose. Commercial ties between countries increasingly no longer meant just buying and selling goods to and from each other but also creating things together. Supply chains, or what scholars often refer to as ‘global value chains,’ began to link up countries, economies, and societies. Today, 80 percent of trade involves raw materials or intermediate goods.”

“Still, the narrative and the reality of globalization have diverged fairly dramatically. Trade tripled over the past four decades; nearly a third of what the world makes now leaves its country of origin. But those products don’t go just anywhere. If distance were truly no object, the average international sale would involve a 5,300-mile journey (the average distance between two randomly selected countries). Instead, half of what is sold internationally travels less than 3,000 miles, not much farther than a flight from New York to California, certainly not enough to cross oceans. As companies have gone abroad in search of better and cheaper components, as they have built out their own operations or contracted others to do it for them, they have mostly stayed close to home. They haven’t typically gone global; they’ve gone regional. This is particularly true for the more complex production chains in electronics, machinery, and transportation equipment. The internationalization of the making of things required fundamental changes in transportation, information, and financial flows. It depended on treaties, free-trade agreements (FTAs), and favorable international norms. Usually seen as the drivers of globalization, these factors pushed the more prevalent and intense regionalization that has occurred.”

Source: The Globalization Myth, Shannon K. O’Neil

8. Few Winners from Globalization

“Yet with all the talk of globalization, international trade truly transformed the economies of only about two dozen countries. Bangladesh, Hungary, Mexico, Poland, Romania, and Vietnam are among the handful that have seen trade more than double as a proportion of their economies since 1990. For eighty other countries, including Chile, Egypt, Kenya, and Norway, trade barely budged or actually shrank as a percentage of GDP. The remainder are somewhere in between. Clearly, cheap shipping, virtually free communication, sophisticated software, and flowing capital don’t tell the whole story. That’s because the world regionalized more than it globalized. As the international flows of goods, services, money, information, and people grew over the past forty years, more than half moved between neighbors and other nearby nations.”

“Most of the winners of this latest round of globalization tied themselves to countries next door. China’s era of double-digit growth began with regional inputs; similar ties helped neighboring Vietnam leave behind years of economic stagnation. Many eastern European countries surged as they integrated with ‘old Europe.’ NAFTA helped Mexico’s economy more than double in size.”

“Companies’ forays abroad, especially initially, have been more regional than global. Sweden’s Ikea expanded first to Norway and Denmark. Ford Motors’ inaugural international plant was just across the Detroit-Windsor Ambassador Bridge in Canada. Foxconn started on its path to becoming the biggest electronics maker in the world with a factory in Shenzhen, less than five hundred miles from its home in Taiwan.”

“Big globalizers aggregate the twenty-four nations in which trade as a percentage of GDP more than doubled since 1990; limited globalizers, eighty-four countries in which trade stagnated or declined as a percent of GDP over that time; and slow globalizers, the other seventy-six nations that have seen trade’s weight in their economies rise at a slower pace.”

Source: The Globalization Myth, Shannon K. O’Neil

9. Foreign Direct Investment

“Tens of thousands of smaller corporations followed their higher-profile colleagues in going abroad but also, when doing so, sticking close to home. European companies have invested over a trillion dollars in their brethren nations in the past two decades, far more foreign direct investment (FDI) than came from outside the Union.”

“In Asia, roughly half of all greenfield investments (in which a company creates a new foreign subsidiary and builds and outfits its own factories or offices) comes from other Asian nations, a percentage that has been rising over time.”

“And while foreign direct investment in North America is less regional than elsewhere, Canadian companies outpace all but the British in setting up shop in the United States. Scotia and TD bankers have opened offices from New Orleans to New York; the auto-parts maker Magna now has more plants in the United States than in Canada. And for Mexico and Canada, U.S. corporations are by far their biggest outside investors; Walmart, GE, Ford, GM, and thousands of others have laid out hundreds of billions of dollars in the two countries. The world over, fifty cents out of every dollar of foreign direct investment stay within their home region. If distance truly were no object, and investors followed GDP growth patterns and global opportunities, less than twenty cents would stay so close.”

Source: The Globalization Myth, Shannon K. O’Neil

10. Making and Selling Things

“Research backs up the idea that businesses have gone more international but not necessarily more global. One study of the Fortune Global 500—a set of companies explicitly chosen for their international reach—shows that more than two out of every three dollars of their revenue come from sales within each company’s home region. That number hasn’t changed much for over two decades. Other studies of multinationals show an even greater concentration, with four out of every five dollars brought in close to home. In fact, only a handful of companies live up to the “global” hype. For every Coca-Cola, Nokia, Sony, or Canon that has conquered the world, there are many more Carrefours, Siemens, Sumitomos, Whirlpools, Walmarts, Alibabas, Cisco Systems, General Electrics, and Mitsubishis that have expanded mostly next door. And these regionally focused corporations mostly outpace the globe-trotters.”

“Making things is, if anything, an even more regional business than selling them. Ikea stores may span the globe, but two out of every three of its products are made in Europe. The fashion house Zara similarly sews a good portion of its trendy clothes in Spain and Portugal, then sells a third of them in Asia and the Americas. Canon’s cameras are put together between Japan, Taiwan, China, and Malaysia for consumers in the United States and Europe.”

Source: The Globalization Myth, Shannon K. O​​​​’Neil

11. Regionalized Finance

“Finance, too, is more regional than most people recognize. Over half the money moving across borders circulates exclusively within the European Union. Another big chunk moves within Asia, led originally by Japanese financing for the Philippines, Vietnam, South Korea, Taiwan, and China. The 2008 global financial crisis only deepened this regional focus, as chastened U.S. and European banks curtailed their global aspirations, leaving even more to local and regional players. Of the well-known big banks, none is truly global. Deutsche Bank may have offices in over fifty countries, but two-thirds of its clients and profits come from Europe. Bank of America, Barclays, and JPMorgan are as, if not more, regional in nature. The financial sector as a whole is even more concentrated—three out of every four dollars made by banks come from within their home region.”

“Even portfolio holdings, the hottest of international money, don’t live in a borderless world. When buying stocks and bonds, the average investor goes no farther than the distance between Singapore and Tokyo. And cash, the most versatile asset of all, travels mostly next door when it ventures abroad.”

Source: The Globalization Myth, Shannon K. O​​​​’Neil

12. Regionalization Beats Globalization

“In total, over half of the flows in international trade, investment, money, information, and people occur within regions. Globalization is, as much as anything, a regional affair. This shouldn’t be all that surprising. The whole point of offshoring and outsourcing is to become more competitive. Sticking close by allows companies to benefit from different costs, skills, and access without losing the trust and understanding that make operations hum.”

“And just because it is cheap to talk to someone on the other side of the planet doesn’t make it easy to coordinate long, complex manufacturing processes. Lower wages or the promise of new consumers often can’t offset the intangible costs of doing business outside your comfort zone. This starts with language. Even talented linguists can get tone and meaning wrong when using their second (or third or fourth) tongue. Profits can literally be lost in translation. As a result, almost a fourth of all trade takes place between countries that speak the same language.”

“Organizational gurus at McKinsey have found that the experience of Walmart and Vodafone holds more broadly. Looking at over five hundred companies, they concluded that even the best-run multinationals pay a “globalization penalty.” The more spread out they become, the harder it is to set standards, connect to customers, innovate, and maintain company esprit de corps.”

“McKinsey’s study complements work by academic scholars. One study of over a hundred U.S. manufacturing multinationals found that those that expanded regionally brought in higher profits than both those that went farther afield and those that stayed home and that their earnings diminished with distance.”

“Operating abroad can bring big profits. Otherwise, corporations wouldn’t do it… But stray too far, and you may run into trouble. International supply chains haven’t dispersed as far as either globalization’s cheerleaders or its skeptics assume. Businesses have found that sophisticated supply-chain software and systems can only take you so far—a few countries away but often not much more than that.”

Source: The Globalization Myth, Shannon K. O​​​​’Neil

13. The Reality of Regionalization and Hype of Globalization

“As supply chains came to dominate the manufacturing world, three distinct regional hubs formed: Asia, Europe, and North America. By combining regional understanding and cross-country advantages, companies found that they could more effectively compete in the global economic race. Countries that have become part of a regional bloc now have a distinct advantage over those that remain outside. Recognizing regions isn’t all that new. Throughout the 1960s and 1970s, scholars debated the good and bad of regional economic and geopolitical blocs for global trade, security, the spread of authoritarianism, and, later, a wave of democratization. With Japan’s rise in the 1980s, the former McKinsey Tokyo head turned business writer Kenichi Ohmae popularized the idea of global economic ‘triads.’ In his telling, multinationals from the United States, Japan, and Europe were dividing up the world.”

“In the 1990s, economic regionalism picked up speed on the ground. The United States, Mexico, and Canada signed NAFTA. Europe built on its single market, laying out a decade-long integration roadmap for one passport, one monetary policy, and one currency. The newly founded Asia-Pacific Economic Cooperation (APEC) finally added trade to the diplomatic docket in Asia.”

“Yet by the start of the twenty-first century, the popular and scholarly focus on regions dissipated. Emerging markets captured the collective imagination. Goldman Sachs’s research head Jim O’Neill christened the geographically dispersed BRICs—Brazil, Russia, India, and China—the next global economic power bloc. Fareed Zakaria announced the ‘rise of the rest.’ Pundits opined on the ‘multipolar world.’ And ‘globalization’ spattered the titles of hundreds of books, thousands of reports, and millions of articles. But even as the idea of globalization caught on, the reality of regionalization kept going.”

Source: The Globalization Myth, Shannon K. O​​​​’Neil

14. Emerging Markets ex-China

In this section we review the Emerging Markets ex-China. As we did for the developed equity markets in our last quarterly report, this time we seek to measure the innovation, profitability and valuations of emerging market companies by sector through the lens of our intangible-adjusted financials, making comparisons with other regions.

15. Capitalizing Intangibles Methodology

-After converting foreign currencies to the USD at the current rate, we take the top 85% of the market cap of each developed market country.

-We remove the 50% least liquid companies (by trailing 30-day average daily trading volume*price).

-We capitalize 1) research and development, and 2) other intangible investments, by removing “costs” from the income statement and recategorizing them as investments on the cash flow statement and then assets on the balance sheet.

-We record a non-cash charge on the income statement that reflects amortization of intangible capital.

-All intangible assets are carried at amortized historic cost, rather than market value.

-All data is from Factset’s fundamental database and our own proprietary database of intangible-adjusted financial statements that we maintain.

-Our intangible-adjusted data drives our investment process and informs our security analysis.

-In this analysis we will focus on the emerging world equity markets (ex-China).

16. Opportunity Set
There is a large opportunity set in the emerging markets outside China. There are 1,050 non-financial companies encompassing the top 85% of the market cap of each country (liquidity adjusted). Interestingly, the technology sector has the largest number of constituents. Hong Kong represents roughly half of R&D and other IP spending.

The average market cap of EM ex-China is the smallest of any region at $8B. The universe is overwhelmingly allocated to Asia, with Hong Kong, South Korea and Taiwan representing 724/1,050 non-financial companies, or 69% of total issues. And yet, technology is less than 20% of issues.

​​​​​17. Tangible vs. Intangible Investment

These companies are more focused on tangible investment rather than intangible. It is the only region where capital expenditures ($656B) outweigh intellectual property investment ($402B).

18. Lowest Total Capital Investment

R&D/Sales and other IP/Sales are the lowest of all regions in the world. Capital spending/Sales is about on par with Developed Asia, but intangible investment is roughly half of Developed Europe or Asia. Total capital investment is the lowest of all regions by several percent.

19. EM ex-China has $716 billion in intellectual property.

On a reported basis, EM ex-China have roughly $13.2 trillion in capital employed. They also have the lowest net debt levels of any region.

On an adjusted basis, total assets are only about $700B higher than reported given the lack of intangible investment. On an adjusted basis, EM ex-China’s debt level is just above Developed Asia.

20. On a reported basis, EM ex-China companies have almost 31% of their assets represented by property, plant and equipment. This is highest of any region. Intellectual Property/Sales trails other regions by 2-5%.

21. While EM ex-China non-financial companies post the lowest gross profit margins of any region, they do generate operating cash flow margins higher than Developed Asia on both a reported and adjusted basis.

22. Operating cash flow-based profitability is higher than Developed Asia but below Developed Europe and North America.

23. Valuations are the cheapest of any regions on an adjusted price-to-cash-flow basis.

On a reported basis, EM ex-China companies sell for 7.17x cash flow and 1.36x book value. Two sectors sell for a discount to reported book value.

On an adjusted basis, emerging markets ex-China sell for the cheapest cash flow multiple of any region, yet the multiple of book value is about 20% above Developed Asia.

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Disclosures

Charts and data: Factset, Knowledge Leaders Capital, as of 12/16/22

The information contained herein is provided for informational purposes only and should not be regarded as an offer to sell or a solicitation of an offer to buy the securities or products mentioned, nor should it be regarded as investment, tax or legal advice. Please consult an appropriate professional advisor for advice specific to your situation. Knowledge Leaders Capital may deviate from the opinions, investments, or strategy implementation as discussed in this presentation. The strategies discussed in the presentation may not be suitable for all investors. Knowledge Leaders Capital makes no representations that the contents are appropriate for use in all locations, or that the transactions, securities, products, instruments, or services discussed are available or appropriate for sale or use in all jurisdictions or countries, or by all investors or counterparties.

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