Geopolitics and doing business in Hong Kong and China.
The International Monetary Fund’s (IMF) World Economic Outlook was published in October 2019 and, as usual, provides a valuable back drop to international business investment decisions. One of the key observations discussed in that report is not that the emerging markets are making the most significant contribution to global growth with 4.6% expected in 2020 (advanced economies 1.75%), but that 70% of this emanates from those countries that have recently experienced significant challenges in their economies (including: Argentina, Iran, Turkey, Venezuela, Yemen, Libya, Brazil, Russia and Saudi Arabia). This suggests to me that risk in the global economy is skewed to the downside.
Overview of Global Economic Growth Prospects
The factors that are affecting the global economy should be well known, and include: US-China (and to some extent, European) trade and tariff differences; a global slowdown in manufacturing – particularly in the automotive sector; disruptions to supply chains as a result of disputes over technology; uncertainties around BREXIT; the increasing awareness of the impact of climate change; and the resulting caution that this drives in corporate investment decision making.
The service sector is one relative bright spot, but with protracted weakness in global manufacturing, business-facing services, such as logistics, finance, legal, and wholesale trading, are vulnerable to a softening in demand. Depending on the severity, firms in these service categories could cut back on hiring and weaken the feedback cycle between employment growth, consumer confidence, and consumer spending.
The ability of economies to ‘self-right’ over time is a factor that should provide some hope to concerned managers, but the challenges to industry and employment that is impacting inflation rates cannot be ignored as these are feeding the ‘lower for longer’ view on interest rate costs and growth. Concerns over deflation are rising again as these could impact propensity to spend and increase the real cost of borrowing. Understanding these and other global risks is critical to any investment decision making and particularly impact the cost benefit calculus of investment value and return.
One of the likely drivers of economic improvement should be the expansion of fiscal policy in those countries with the head room to do so. Germany, for example, but also several advanced economies that have surplus or low deficit budget positions which could provide significant potential to take advantage of low debt cost to invest in both infrastructure and climate change mitigation strategies.
The IMF also postulates that the assessment of whether economies have reached optimised output potential capacity should be reconsidered and that available economic slack should be assessed more as a better explanation of why there is higher unemployment with ostensible full capacity output. In short, the IMF argues through scenario analysis that there could be more productive capacity than conventional economic theory assumes; furthermore, it postulates that because the capacity for output growth may be underestimated output capacity is not optimised in advanced economies and that there is also space for fiscal loosening. In other words, governments could be looking at the wrong numbers when setting fiscal policy and could be in danger of inadvertently throttling down on potential growth. This means that infrastructure and climate mitigation investment could be made without creating excessively inflationary outcomes.
Therefore, it looks as though the advanced economies will grow relatively slowly – which given their maturity and size is perhaps to be expected – while the emerging markets will grow more robustly.
Looking at the global market the balance between slow and fast-growing markets shows that one is compensating the other so that the expected overall global growth rate for 2020 of 3.4% is down from the 3.6% estimated in the April 2019 IMF report. “Projected growth for 2019, at 3.0 percent, is the weakest since 2009.” Says the IMF, “Except in sub-Saharan Africa, more than half of countries are expected to register per capita growth lower than their median rate during the past 25 years” (my emphasis). With developed countries expecting 1.75% in 2020 (1.7% in 2019) and emerging and developing economies at 4.6% (3.9% in 2019), the global economy is increasingly reliant on emerging markets as the engine of growth and, therefore, expansionary business opportunity.
But there are risks to these forecasts any one of which could upend these estimates which need to be carefully considered and accounted for as part of the investment decision process and particularly where business valuations are being prepared as part of that assessment.
These key risks include:
- Marked slowdown in global manufacturing output due in part to the significant slowdown in global car production and sales – down 3% in 2018
- Weak business confidence on rising trade and technology tensions between US and China as well as between Japan and South Korea
- A slowdown in demand in China, driven by needed regulatory efforts to rein in debt and exacerbated by the macroeconomic consequences of increased trade tensions
- The impact on economic development of unmitigated climate change
According to the IMF’s October 2019 Global Financial Stability Report … “Market sentiment has been volatile since April, reflecting multiple influences that include additional US tariffs on Chinese imports and retaliation by China, fears of disruptions to technology supply chains; prolonged uncertainty on Brexit; geopolitical strains; policy rate cuts and dovish communication by several central banks. The net effect of these forces is that financial conditions across advanced economies are now generally easier than at the time of the April 2019 Report, but they are broadly unchanged across most emerging market and developing economies…”
“Among advanced economies, major central banks have turned more accommodative, with a dovish shift in communications earlier in the year followed by easing actions during the summer. Among emerging market and developing economies, central banks in several countries (for example, Brazil, Chile, India, Indonesia, Mexico, Peru, Philippines, Russia, South Africa, Thailand, and Turkey) have cut policy rates since April…”
“Capital flows to emerging market economies have reflected the broader shifts in risk sentiment since April, with investors lowering their exposure to equities and rotating toward hard currency bonds. Portfolio flows into the emerging market asset class remain stronger overall than during the retrenchment of late 2018; investors continue to differentiate across individual economies based on economic and political fundamentals.” (IMF World Economic Outlook, Oct 2019)
Of further interest is the significant drop in recorded foreign direct investment (FDI) in 2018, but on closer analysis this is impacted by repatriation of surplus offshore reserves to the United States by American corporates due to changes in the tax rules making repatriation tax effective. The sharp decline (90%) in global FDI flows in 2018 seems to be explained almost entirely by multinational corporations’ financial operations, with no meaningful aggregate impact on emerging market economies. These developments further underscore how FDI transactions and positions recorded in the balance of payments are often unrelated to greenfield investment or mergers and acquisitions, but rather reflect tax and regulatory optimisation strategies by large multinational corporations. It does make you wonder, therefore, how much real investment is taking place as opposed to financial engineering strategies!
Also, attempts by advanced economies to ‘reshore’ operations to the home country is likely to undermine global growth. Given the relative costs of production, reshoring leads to higher-priced consumption and investment goods in advanced economies. Domestic demand declines, as does output, despite the decline in imports. In emerging market economies, lower production and exports reduce incomes, households and firms cut expenditure, and output declines more modestly than in advanced economies. However, households in both advanced and emerging market economies suffer equally, owing to the deterioration in emerging market economies’ terms of trade. Nationalist policies regarding trade may, therefore, increase downside risks to global economic growth.
The trade-off between lower growth in developed economies and growth in emerging markets is facilitated by accommodative central bank monetary policy. However, should a ‘risk off’ episode occur in financial markets that tighten financial conditions this could undermine emerging markets growth with adverse effects on the global growth and business confidence. This risk and the reliance on previously stressed emerging markets driving significant growth provides a challenging environment for business decision makers to be working in.
In the medium-term risk areas to watch include:
- Worsening trade and geopolitical environment – recent activity in the Arabian Gulf is but one such factor
- Disruption of global supply chains – particularly in technology supply
- Unmitigated climate change with policies required in terms of carbon pricing and investment in new technologies
- Failure to implement micro-economic reforms at the national level in emerging and some advanced economies
- Risk-off strategies in financial markets
Accommodative monetary policy has achieved a great deal but there is still a need to avoid a downturn in inflation expectations and easing financial conditions that may increase risk to be managed with stronger macro-prudential policies with proactive supervision to limit systemic risks.
The need to use fiscal policy where this can be accommodated by the economy, together with a robust understanding of the real slack in the economy, and taking advantage of low debt can be used to finance infrastructure and climate remediation investment which should underpin growth without distortionary inflation arising as a consequence.
Impact on business decision making
So, what does this really mean for managers looking to expand globally? A key element in these decisions is evaluating an opportunity and given that developing a valuation is more of a craft than either a science or an art form, there is a real need to properly asses risk elements in the projected cash flows and discount rates to be used in an investment cash flow evaluation model. There is no intention here to launch into a discussion on valuation theory, but one part of the discount rate formulation used needs to accommodate a realistic assessment of the risks that can impact the calculation, and I think this might be achieved by increasing the discount rate with a consequent lowering of project / investment valuation estimates in line with your view on systemic risk.
The assessment of revenue and cash flows should be based on a robust understanding of the impact of macro and micro economic factors with a focus on the expected growth rate of the target economy and the level of growth that the business can reasonably realise. Rarely will a business grow sustainably faster than the overall economics of a market will allow, but there are many modelled estimates that make this assumption. A realistic assessment of what the investing company can achieve needs to be made and this requires looking at global and local factors impacting potential market and business growth. Successful ‘disruptor’ strategies might win a greater share initially, but the self righting factors of global capitalism tends to discount these away over time as markets adjust.
Where systemic risks arise which cannot be identified directly within projected cashflow, an assessment of how these should and could be reflected in the discount rate estimate needs to be done. This is a matter of judgement based on the facts. The risk of beneficial flights of fancy need to be avoided. Realism (should) rule!
This might be best achieved by assessing the identified risks (for example, those discussed above) and estimating how they could affect the calculation and the resulting value assessment. This requires analysis and judgement to arrive at a realistic assessment of the risk that should be included in the investment decision process. In many cases, or at least as a preliminary calculation, the use of country risk and currency risk adjustments may address these matters but would still be necessary to understand something about the basis to those estimates and that they remain current. A deeper market analysis will be required.
This has got me thinking about how the current ‘lower for longer’ interest environment may well be distorting business valuation to the upside. This may have been justified initially when ‘normalising’ of typical business returns (assuming there are any!) was to be expected several years after the global financial crisis, but it does seem that this prolonged low rate environment is building in too much upside to value estimates. My reason for thinking this is that in advanced economies, if growth continues to be lack lustre and there is a rebalancing between advanced and emerging economic growth, then it may be that some form of adjustment to the downside in values could be coming – you can’t have sluggish economic growth that isn’t accounted for in revenue and cost estimates or the discount rate estimation.
Property values seem to experience this ‘exuberance’ and the matter is open as to whether it applies to company valuations also. It’s really a matter of whether you believe that continuing low economic growth can still support strong valuation, and, if so, for how long and what are the factors that will underpin such an assessment of value – at the end of the day, the valuation is a current estimate of future dividend and cash flow expectation, if these are not tenable then nor is the valuation.
This further supports the need for robust research and market assessment when looking at setting up in a new market where the complexities of differential growth rates, country and currency risk is also a factor to be considered.
The aim of this article has been to raise awareness of the global and regional economic factors driving market risks and differentiated growth expectations and how these might affect the determination of market entry investment strategy and potential target market business valuation. As always, there are risks, but there are opportunities too and the accelerating growth in the Asia region provides continuing opportunity, and as average income levels rise these should continue to grow (all things remaining equal, of course!).