The waning global enthusiasm for trade has raised concerns that globalization is reversing. This situation could threaten your wealth, but need not, provided an appropriate diversification and hedging strategy is in place.
Protectionism looks to be on the rise. After almost three decades of hyper-globalization, we have learned that while its benefits, and those of free trade, tend to be spread across society as a whole, the costs of it can be concentrated, and are often deeply felt by those affected. Amid stagnant median incomes and rising wealth inequality, resistance to trade is increasing, and protectionist sentiment is on the rise. The political consensus that had promoted trade liberalization is now shifting, with an increasing proportion of votes now attainable by offering protectionist rhetoric.
In 2016, Brexit, Donald Trump’s victorious run for the US presidency and tortured negotiations over global trade deals such as the Trans-Pacific Partnership, Transatlantic Trade and Investment Partnership, and CETA pact all demonstrate growing skepticism about the merits of globalization.
What are the consequences for investors?
In our interactive quiz, The End Game?, we demonstrate how changes in policy can have meaningful consequences for markets, economies, and portfolios. As protectionism rises, we see two main effects:
First, the markets of smaller, more open economies that depend on trade with a single larger country or trading bloc are particularly vulnerable. The poor performance in 2016 of the British pound, Mexican equities, and the Mexican peso that resulted from fears of a reverse in trade clearly illustrates this situation.
Second, even if countries do not repeal trade agreements or erect trade barriers, competitive devaluation still remains a risk as countries attempt to boost weak growth through beggar-thy-neighbor currency policies (or policy moves to that effect). Since 2012 the euro, Japanese yen, and British pound – three of the world’s four most heavily traded currencies – have, at some stage, declined by around 20% in the course of a year.
Globalization is a fact of life. But we have underestimated its fragility.
What to do about it?
If the world economy becomes less global, investor portfolios will need to become more global. Despite the direct fallout from Brexit, UK-based investors exposed to multinationals (whose profits rose in local currency terms) fared well in 2016. As political risks proliferate, investors may feel more inclined to keep money closer to home, where they better understand the political climate. But they will need to fight this instinct and invest in a globally diversified way.
Investors will also need to reduce their vulnerability to global currency risks by hedging overseas investments back into local currency. Anti-globalization tendencies raise the risk of sudden declines in individual currencies – hedging can help investors shield local purchasing power from the dangers of excessive currency volatility. Investors who bought UK or Mexican assets in 2016 without hedging currency likely saw deeply negative returns. Slower global growth that results from rising protectionism is clearly not a boon for investors. Global trade as a percentage of GDP climbed from 26.9% in 1970 to a peak of 61.1% in 2008, almost perfectly matching the rise in global prosperity. It’s not surprising that the International Monetary Fund’s World Economic Outlook (October 2016) cited the return of protectionist measures as a key risk to the continued health of the world’s economy.
But this trend need not unduly impair portfolio performance, provided investors avoid concentration in small markets, diversify globally, and avoid taking undue currency risks.
A trend of rising protectionism increases the risk for investors in small, open economies that rely on a large trading partner. Slower trade is bad for growth, but diversification and currency hedging can shield investors from some of the risks associated with anti-globalization.
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