How can investors navigate a fracturing economic order? - with Neil Shearing

Paul Diggle

Hello and welcome to Macro Bytes, the economics and politics podcast from Aberdeen with me, Paul Diggle. Today's guest is Neil Shearing, Group Chief Economist at Capital Economics and author of The Fractured Age, How the Return of Geopolitics Will Splinter the Global Economy. And I've known Neil going back at least 15 years now. We were former colleagues at Capital Economics and here at Aberdeen Investments we really value the economic and investment research and insight coming from Neil and his team. And Neil is also a fellow at Chatham House. He previously worked at the UK Treasury. And I'm really looking forward to this conversation about the fractured age, the future of globalisation, the return of superpower rivalry, and how investors can navigate this new economic and geopolitical environment. So Neil, welcome to Macro Bytes.

Neil Shearing

Thanks very much for having me, Paul. Good to talk.

Paul Diggle

So Neil, a core argument, or the core argument you're making in the book, The Fractured Age, is that the world economy is not deglobalising, it's fracturing. So obvious scene-setting question, what is fracturing? Why is it distinct from, more complicated than, more interesting than a straightforward story about deglobalisation?

Neil Shearing

Yes, so the genesis of the book really goes all the way back not to this Trump administration, but to the first Trump administration. And if you cast your mind back to that period, there was lots of talk about deglobalisation. So the administration was putting on tariffs, other countries were retaliating to those tariffs. You couldn't open the FT or the Wall Street Journal without being faced with headlines about the world turning inwards, back to the 1930s, deglobalisation and so on and so forth. And when we looked at the data, this rhetoric of deglobalisation was everywhere, but not in the figures, not in the data. Actually, global goods trade as a share of world GDP continued to increase through the first Trump administration and even today is at or close to record highs. So there was a narrative of deglobalisation everywhere, but it wasn't in the data. So we asked ourselves, well, what has changed? And the more we looked at it, the more we kind of stepped back and surveyed what was actually happening, it became clear to us that the defining feature of the global economy over the past decade had been a deepening rivalry between the US and China. That was causing the global economy to split into these competing blocks, fracture in other words, into these competing blocks. The US and China were pulling apart, other countries were being forced to pick a side. And that was the, as I say, the defining feature of the global economy over the past decade. So that's the idea of fracturing. It's not that the world's deglobalising, it's not that there's less trade. It's just that in certain parts of trade, the world is coalescing into these two blocks. And really, when we think about the economic consequences of this fracturing, and as I talk about in the book, the two things to keep in mind are, what are the contours of fracturing? Where are the fault lines? Is it all trade, or is it all goods and services, or is it just some strategically important areas? And how do different countries coalesce in these blocks? Are some countries able to straddle both sides? Do they tend to side mainly with the US or do they tend to side mainly with China? The composition of these blocs is going to be incredibly important when thinking about the economic consequences. So in a nutshell, that's the idea of fracturing it and that's how we should be thinking about the economic consequences.

Paul Diggle

Okay, brilliant. So lots to get into there. US-China, as you say, Neil, is this key axis along which fracturing is occurring? We're going to get deeper into that. But why don't you tell us more, first of all, about the sectors or product categories or areas of economic activity along which that fracturing is occurring? Is it every area of economic activity or is it limited to specific parts of the economy?

Neil Shearing

Yes, really good question. And actually one of the questions I always get and kind of pushback to this idea is, well, what evidence is there? So one of my factoids is if you look at the sources of US mobile phone imports over the past three or four years, go back to 2020, China was supplying about 60% of phone imports to the US, came from China. Now that is on course to fall to about 20% this year. Equally, if you go back to 2020, India supplied almost no mobile phones to the US markets, and it's on course to become the biggest supplier of mobile phones this year. And of course, this is in response to reconfiguration of supply chains caused by, or driven by, strategic concerns amongst Apple and the major cell phone providers. So it's actually happening. We can see this in the data, but as you say, it's not happening across all product categories, it's being confined to a number of different areas, which are principally, what I call in the book, kind of geo-strategically important sectors. And if you want to kind of get into what that means, my central scenario is that this fracturing is contained to areas that affect either supply chain security, national security, or technological leadership. They're the three kind of core areas along which this fracturing is taking place. So think things like cell phones, mobile phones. We don't want what are essentially computers and loads of data in our pockets necessarily being produced by what the US is increasingly viewing as a strategic adversary. Green technology, electric vehicles, batteries, semiconductors most obviously, rare earths, critical minerals, we've seen that in the news over the past few weeks. Biotech, pharmaceuticals, dual use goods, things like drones that have applications in both civilian and military sectors. I think these are the sectors that are going to be the focus of fracturing. If we cast our mind forwards, pass the clock forward kind of 10 years, I'm sure we'll still be importing vast amounts of kind of furniture, clothes, toys, white goods from China. So my sense is that a reasonable central scenario is that this fracture is contained, as I say, these geo-strategically important sectors.

Paul Diggle

Does fracturing happen at the level of the financial system too? Does it affect capital flows or FDI or payment systems?

Neil Shearing

And that is a critical question because, of course, the latest phase of globalisation, this period of hyper-globalisation that we had in the 1990s and 2000s, was different from previous waves of globalisation in its both the extent of the integration, but also the sectors that it covered, previous waves of globalisation, principally about goods and people, a much larger financial component to the wave of globalisation that reshaped the global economy in the 1990s and 2000s. So it follows, will this fractured age give rise to a more fractured global financial system? And I think, again, in some areas, yes, it will. If we're thinking about investment in private markets, where perhaps some of the listing, the rules around investments are a bit more opaque, then I think there will be a sense in which capital flows between these two blocks start to diminish. If it's the case, though, that we're thinking that in this fractured world, China's going to suddenly dump all of its dollar denominated assets because it's concerned about sanctions or even just it doesn't want to be investing vast amounts in what it increasingly perceives to be a strategic competitor, I'm less clear on that, actually. I don't think that's going to happen, principally because there's nowhere else for China to go. About $9 trillion of external assets China now has. If you have and have accumulated that amount, the sheer size of those external assets means that it really only has the dollar to, those assets can only really be held in dollar markets because the dollar is so dominant and those markets are so big. So I think in some areas, as I say, kind of private markets, investment between sectors, between blocs in strategically important sectors, I think we will see a diminution of financial flows, but at an aggregate level between blocs and in particular this idea that China will suddenly start to divest all of its dollar denominated assets, I have a harder time believing that's going to happen.

Paul Diggle

Yeah, you've got to think that China would also be aware of the losses it would inflict on itself where it to also wholesale dump treasury holdings.

Neil Shearing

Exactly, yes. Is this kind of almost Faustian pact that the two sides have entered into when it comes to accumulation of assets and liabilities. China, as you say, can't divest its dollar assets, given the sheer size, very quickly, without it becoming evident in financial markets what's going on. And of course, that would precipitate a fall in the value of the remaining assets in dollars that it did hold and so undermine the strength of its own balance sheet. So yeah, in some senses, that acts as a bit of a counterbalance, I think, and means that we're not going to see a major fracturing on the financial front.

Paul Diggle

So you talked about the period there, Neil, of the 90s and 2000s, a period of hyper-globalisation. And one of the underlying sort of assumptions that I think many people are making, policymakers ,politicians, was that economic interdependence, that was the globalisation linkages that were building up during that time were stabilising. Globalisation was flattening the world geopolitically. And there was, I think, a related assumption that China's integration into the global economy, into the financial system, its economic liberalisation would inevitably then therefore also lead to a degree of political liberalisation. So what was wrong with that sort of what we can now see as a bit of a naive assumption that economic interdependence is stabilising, that China would follow economic liberalisation with political liberalisation.

Neil Shearing

Yes, it's remarkable when you look back at that era, and I did a lot of reading, obviously, for the book, and there's some quotes in the book about the types of things that global leaders were saying in the 1990s and 2000s about globalisation - both how it's this kind of indomitable force, you can't really stop it. So don't try to resist it, you have to kind of embrace it. It's kind of inevitable, a bit like gravity some people have likened it to back in the 1990s and 2000s, but also that it would help to reshape the world in a way that not only made it more prosperous, but more peaceful too. So it would help to spread values as well as economic prosperity. And clearly that has not been the case. Now, and I think some of that is just a simple misreading of what exactly was happening in not just China, but also other large emerging economies like Russia. They were never likely to become kind of Western liberal economies and I think also hopes that the political system would liberalise too were, as you say, naive. So I think it was slightly just a misreading of the forces that were driving change in those economies. And then, of course, the culmination of the period of hyper-globalisation in 2008, the global financial crisis. Now, I don't think globalisation was responsible either for the global financial crisis itself or the weak recovery that we've had since then and the loss of manufacturing jobs in the Western world. This is a much more complicated picture. It's not all globalisation's fault. But it's certainly easy to blame globalisation. And we've seen this new brand of populist leaders from Trump to Farage down, blaming, if you like, or putting some of the fault, some of the blame for the loss of manufacturing jobs in the US and in Europe at the door of globalisation. It's become a convenient scapegoat. So a combination of factors, misplaced optimism, perhaps a bit of naivety about the benefits of globalisation, allied with globalisation becoming a convenient scapegoat for the difficult times that advanced economies have had over the past 10, 15 years. And then the cherry on the top, if you like, is in 2012 when Xi becomes leader of China, really signalling to the world that China was not going to use the open global trading system to liberalise, but rather to challenge US hegemony overseas and reassert the primacy of the party and centralised policy at home. And obviously that became most visible in the ‘Made in China 2025’ industrial strategy that came, that was published in 2015. So a series of events that happened between the global financial crisis and then 2015 I think signal to the world that this period of globalisation, hyper-globalisation, had ended. And as you say, a bit of naivety on the part of the Western leaders, the Western world in the 1990s and 2000s, about the benefits of that globalised world itself.

Paul Diggle

And then China has demonstrated a very different political and economic development path than this one that we thought or policymakers thought in the 90s and 2000s would inevitably unfold as a form of state-controlled liberalisation with co-option of the middle class to be very dependent or part of that development model, nationalism and the idea of a Chinese national revival as a substitute for, say, the Western liberal democracy path, the integration of technology and surveillance is part of that social model as well. So I think just the emergence of this model of economic development that naive policymakers in the 90s and 2000s were just not thinking about or aware of.

Neil Shearing

Indeed. And there's a, as you suggest, there's a kind of political element to this in terms of just a different set of values and a different approach, including to democracy. But there's also a pure economic increasingly an economic aspect to this too, which is that China's high savings, high investment growth model, low rates of consumption, depends necessarily on it running large trade surpluses. The external sector is still an extremely important source of demand in China's economy, in fact, perhaps the most important source of demand in China's economy at the moment. There's a widespread perception that China's exporters have had a pretty tough time with things over the past few years. Actually, nothing could be further from the truth. Share of global export volumes up from about 12% in 2018 to almost 18% today in the case of China. So it was partly kind of, as you say, kind of difference in the politics, but also increasingly becoming clear that the consequences of this growth model that China was pursuing was these large trade surpluses and current account surpluses that depended necessarily on the world's supplying and demand to China. And it's one thing doing that when China's the world's 10th largest economy, or even it's the 5th largest economy. If it's the world's second largest economy and the second largest economy by some distance, it becomes increasingly hard to do.

Paul Diggle

So as you were talking about earlier, Neil, and one of the key arguments running in the book is that it's not just the US and China along which this fracturing is occurring. It is their blocks as well. So tell us who is in each side's economic and political block and what are their strengths? What are their weaknesses? What characterises the two blocks?

Neil Shearing

Yeah, this is a really critical question, I think. And it's one to which there's no clear answer. The contours of these blocs are by definition fuzzy. So if you think about, say, Argentina, five, six years ago, clearly leaning towards China, both politically and increasingly economically. China's biggest export market, big investment from China into Argentina. And the Fernandez government, sympathetic towards China and China sympathetic towards the Fernandez governments. Now under Milei, there's been a political shift in Argentina to be much closer towards to the US. And we've seen over the past few months the benefits of that to Argentina in terms of credit lines and various support packages provided to Argentina by the Trump administration and the US Treasury. So clear demonstration that these blocks are fluid, the boundaries are fuzzy. Nonetheless, I think we can have a good go at putting different countries into these blocks. At Capital Economics, we've done a lot of work trying to sort countries according to blocks in an empirical sense. So we've tried to use data, a data-driven approach. We've looked at things like trade flows, capital flows, memberships of different defence and security alliances, how countries vote at the UN General Assembly, for example, as a proxy for geopolitical alignment. And then that enables us to sort countries into whether they're a strong US ally, whether they lean towards the US, whether they're unaligned, and there's a small number of countries that will be, whether they lean towards China or whether they're a really strong China ally. And what emerges is a really interesting map of the world. And if you look at the split of the world's population, the world by population, about half of the world's population is in the US block and about half's in the China block. If you look at the world by GDP, though, much more is in the US block, about 3/4, about 2/3 of the world's GDP in the US block and about 25% in the China block. So who's in there? Well, in the US block, I think we've got most of, we can assume that most of Europe is still, despite the strains in the relationship between the US and Europe over the past six months or so, Europe is still a US ally. Canada, Mexico, Australia, large parts of East Asia, Japan, Korea, Taiwan. India at the start of this year we had leaning towards the US. I think that's now more in question to be fair. But that gives you a good sense of the types of countries that are in the US bloc. In the China bloc, by contrast, it's mainly commodity producers or autocracies or frequently both. So Russia, Iran, Venezuela, most obviously, but also large parts of sub-Saharan Africa too. So the US bloc, larger in terms of GDP. The US bloc more economically diverse, if you think about that group of countries I've just outlined. Korea, Taiwan, Japan, high-tech economies, traditional manufacturers like Germany, knowledge economies like the UK, natural resource producers like Canada, Australia, low-cost manufacturers like Mexico, Vietnam - much more economically diverse. And that's helpful for the US because it means that when we're thinking about things like relocating supply chains around mobile phones, they can retain some of the benefits of the globally integrated economy while also moving production out of China for geostrategic reasons. So that economic diversity as well as the economic size of the bloc really matters. Now, the question is, I think, under this administration, can that bloc hold? I think one of the critical questions and uncertainties, frankly, when we think about the economic consequences of this fracturing is can the US keep its block together and retain that strong starting point, or does it push its allies away and in a sense shoot itself in the foot? In the book I say that an America first agenda would really amount to an American last agenda, given that it would impose far more costs on the US economy in this fractured world.

Paul Diggle

Well, let me ask you about that, Neil. How far can President Trump push the likes of Europe or India and they remain in the bloc? Is it plausible that India joins the Chinese bloc? Would Europe find an unreliable US necessitating it trying to pursue strategic autonomy outside of the US or China bloc? I know that you've written at Capital Economics, you've written this idea that about this idea that maybe Trump is the mortar in the bricks, that he is pushing other countries closer together. So what, how do you see him as changing the nature of this fractured setup?

Neil Shearing

Well, I think the evidence of the past six months or so is that the US can push quite a lot, actually, at least in the short term. If you look at the rapidity of which we've had trade deals between the UK and the US, between Vietnam and the US, between Europe and the US, and now between Japan and Korea and the US. Leaders everywhere trying to do deals with the Trump administration and doing so on terms that are still far more favourable than those on which a deal has been done with China. So I think the evidence of the past few months is the US probably does have a bit of leverage over its strategic, over its allies, and it's willing to use that. And those allies are willing to suck up a bit of cost as part of that process. Now, I think the key point though is that, well, it's twofold. One is the more that both sides, both the US and China, pull on their levers that they have to exert control over their allies, the more that they pull on them, the weaker that those levers get. There's only so much that allies will put up with before they start to, before they start to push back. So I think the US administration has leaned on its allies and squeezed its allies a fair bit over the past six months or so. And by and large, they've tolerated that, but they won't do indefinitely. The second point is, I think the big emerging economies are probably slightly different to, say, the major advanced economies. There's cultural, historical, social, as well as economic and financial links that bind Europe and the US together. The same's not really true of, say, India. India has been slapped with a 50% tariff by the Trump administration over its purchases of Russian oil. India historically has tried to remain unaligned famously through, for example, the Cold War. So perhaps a bit more of a tradition of non-alignment there. Well, certainly a tradition or more of a tradition of non-alignment there. And so I think if the US pushes anyone away, it won't be necessarily Europe. I think over the long term, Europe remains an ally of the US. But it could push large emerging economies, the most important of which is India, closer to China. Now, I don't think India necessarily therefore becomes a really strong ally of China. There's lots of reasons why that would be difficult to envisage happening, long-running border dispute between the two countries being the most important, but also concerns in Delhi about strategic competition, economic competition in China, squeezing Indian producers, the wisdom of getting Chinese technology to embed it in the Indian ecosystem too - lots of concerns there in Delhi. So maybe not India becoming a really strong ally of China, but I think maybe less of an ally of the US, if you like, moving to that more neutral, unaligned block, and that would come at a cost to the US if that were to happen.

Paul Diggle

Are there, there obviously are losers from fracturing, but who are they? Are they particular countries, sectors, types of firm who are ill-suited to this new world?

Neil Shearing

Well, it really depends, as we've discussed, on the contours of the fracturing, where the fault lines sit in terms of sectors, but also where the kind of geographic contours of the fracturing, the different compositions of blocks start to emerge. So they're the critical questions to keep in mind. Now, in the book, I set out a world in which this fracturing is contained in a central scenario to these geo-strategically sensitive sectors that we've talked about, things like chips and smartphones and biotech and dual use goods. And by definition, it's firms in those sectors with large customers in Western markets and production in Chinese markets that are going to be more exposed and more vulnerable. In contrast, I think countries, firms that are operating in sectors that are less strategically important, toys, furniture and the like, are potentially less vulnerable. So anything that's kind of high tech, if you like, if you want to delineate, I think that's where this fracturing is going to come to bear in the first instance. And then the question becomes, what about the geographic breakdown of fracturing? Now, in a world in which India and Vietnam and Mexico align with the US and supply chains are reorientated in order to serve the US market from those countries, then India, Mexico, Vietnam, for example, become a big beneficiary. In a world, though, that the US pushes those allies, those countries away, and it becomes much more difficult for firms to reallocate production out of China in strategically important sectors, into another low-cost producer that is an ally of the US, well then I think the US becomes the loser, because what that means is more cost and more cost for US consumers. So it really depends upon where the fault lines of this fracturing sit and lie in terms of sectors, but also countries and the geographical split. If it's contained to strategically important sectors, and if the US block holds, then I think most of the costs fall on China. If it's a much broader split, and if the US bloc doesn't hold, then more of the costs will fall on the US. I've set out a relatively, I would say, benign central scenario. If you're feeling particularly sunny and you're in Edinburgh, so it's not very sunny, don't read chapter 8 because chapter 8 is called where could it all go wrong? And it outlines different ways in which we get a more extreme form of fracturing, even conflict between these blocks. That's pretty gloomy stuff. Save that for the Scottish summer if I was you.

Paul Diggle

Are you a buyer, Neil, of this ‘Thucydides trap’ notion that hot conflict between the US and China is inevitable, that if you push sufficiently far along the spectrum of fracturing into some of those more dangerous scenarios, they don't just involve profound economic decoupling, but they involve kinetic conflict?

Neil Shearing

I don't know whether I'm a buyer or not. I find the thesis convincing, put it that way, but I'm just a lowly macroeconomist. I'm not a geopolitical strategy wonk. So I'm not sure necessarily how much expertise I bring to bear, but it's pretty clear that the risks of conflict between the two blocs have increased in this fractured world. And there's lots of potential flashpoints, you know, Taiwan being the most obvious, but also lots in the South China Sea too. So I don't think it's necessarily as simple as saying, oh, it's all about Taiwan, it's all about the South China Sea, and there must inevitably be conflict between these two blocs. Part of the motivation, actually, for writing the book was not to, was to chart a course, if you like, that said, here are the political and economic drivers of this decoupling and fracturing between the two blocks. And here's why resisting it is going to be quite difficult. Here's why the idea that you can just kind of put the globalisation genie kind of back in the bottle and go back to the 1990s, 2000s, that's kind of hopelessly naive. We have to kind of accept the world as we find it and try to prevent some of the more extreme forms of fracturing from taking place because that's when the economic costs and frankly the political and human costs become much greater.

Paul Diggle

So if you were advising the government of the US or China or the UK, Neil, how would you be telling them to navigate, prepare for, contain fracturing?

Neil Shearing

Really good question. I think the first point is, as I've just said, they need to accept it's happening and try not to resist it, but to try and shape the contour such that you get the least politically, economically and human, that you diminish the political, economic and human costs of this fracturing. That is to say, we try and confine it to the sectors that we think are most strategically important and prevent big schisms between blocs emerging. If I was advising the US bloc, so the US government, I would be telling them that this America First agenda really means America last. America is starting from a position of enormous strength in this fractured world by virtue of the size and the economic diversity of its allies. Do not push them away, because the more you push them away and the more that you cause the US block to fracture itself, the greater the costs that will be imposed on America. And if I'm advising corporate leaders and leaders in boardrooms, I'm thinking about what are the sectors that you're involved in? What are the sectors where you have kind of key demand from and you're sourcing key inputs from? Are they likely to be a key fault line in this fractured world? Where are your markets too? Because you might be producing in China, in the China block, but selling to the US block. If you're in a sector that is particularly vulnerable and exposed to this fracturing, and you need to think about supply chain resilience. And one of the key messages in the book actually is that when you think about supply chain resilience, the slower that takes place, the slower that adapts, the slower you reconfigure supply chains, the fewer economic costs it imposes on those firms and on those economies. The more rapid the adjustment, the greater the economic costs. So start making adjustments now.

Paul Diggle

And then Neil, final question, you obviously do advise investors in financial markets who are navigating the fractured age. What do you think investors should be doing to succeed, to find sources of return, to pick winners even as these tectonic plates of the economic and geopolitical system are shifting?

Neil Shearing

Well, the first point I think is to say don't buy into the argument that the world is deglobalising. So the whole idea that anything that is reliant upon a big reassuring of jobs thesis to support an investment, I'd be deeply skeptical of. I don't think it's going to happen in the US. I don't think it's going to happen to a large degree in Europe either. So by and large, the contours of a globalised world, I think, will, the key kind of pillars of a globalised world will stay in place. So we shouldn't throw the baby, we're not throwing the baby out with the bath water and parts of the globalised world will stay intact. Instead, a bit like the advice to firms really, it's to think about sectors that you're investing in and the degree to which they are exposed to this fracturing. If it's technology, how might firms in those sectors be exposed to either US export controls or, frankly, greater reluctance on China, on the part of China, of using US and Western tech, because they want to develop their own domestic sources of technology. If it's firms that are very dependent upon critical minerals that are not just mined in the China block, but also refined in the China block. What might that do to that firm's supply chains? What might it do to cost if they have to source from alternative locations? And what might it do to profits in the meantime? Those would be the questions that I would be asking when I'm thinking about how to allocate money in this fractured world.

Paul Diggle

Brilliant. Well, that's about all we have time for this week. My guest has been Neil Shearing, Group Chief Economist at Capital Economics and author of The Fractured Age, How the Return of Geopolitics Will Splinter the Global Economy. It's an excellent book. I really recommend it. Neil, thank you so much for joining us. And thank you, as ever, for listening. Please let me ask you to like and subscribe to Macro Bytes wherever you get your podcasts. But until next time, goodbye and good luck out there.

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