Riding the Global Business Cycle
By Christopher Farrell
Andrew Grove, the legendary co-founder of Intel, calls an event that changes the way we think and act an "inflection point." Well, the world economy stands at an inflection point now -- the unexpectedly rapid transformation of a synchronous global downturn into a simultaneous global recovery. Going forward, swings in the business cycle will be increasingly global in nature, says W. James McNerney Jr., chairman and chief executive of 3M, the $17 billion multinational technology company.
Of course, economic linkages among nations have been strengthening for a long time. In the 19th century, plunging shipping costs spurred a dramatic increase in worldwide trade, and improved communications systems facilitated a massive flow of international capital. But global commerce was disrupted by war, depression, and beggar-thy-neighbor policies. The ratio of merchandise exports to world output fell from a peak of 8.7% in 1913 to 7% by 1950.
Global commerce picked up again in the post-World War II period with the ratio of world trade to world output breaching the 1913 level by 1970. This time around, growth in international trade was also driven by declining transportation and communications costs, as well as by the rise of the multinational corporation. All the major industrial nations suffered through synchronous recessions in 1974-75 and 1980, although the recoveries differed somewhat. Nevertheless, the Cold War and the pursuit of economic autarchy by many developing nation dictators limited the degree of global integration.
Today, international ties have never been stronger. The global economy opened up with the collapse of the Berlin Wall and the fall of communism in the late 1980s. Governments everywhere focused on a set of policies designed to spur economic growth: Keep inflation low and fiscal policies sound. Improve the education level of the population. Trade with the outside world, and encourage foreign direct investment. Technological advances forged sturdy economic bridges between nations, as real computing and communication costs plummeted by 99% over the past three decades.
Meanwhile, money moves around the world at quicksilver speed, with global gross capital flows in 2000 at $7.5 trillion, a four-fold increase over 1990, according to the International Monetary Fund. Foreign portfolio assets more than doubled as a percent of household assets since 1980. And we're all watching CNN -- whether it be from Minneapolis or the Middle East -- while more and more of us plug into the Internet from home and at work.
Little wonder the international business cycle is emerging as a major economic force. "It reflects the freer flow of goods, capital, ideas, and people," says Carl Steidtmann, chief economist at Deloitte Research in New York.
This time, large parts of globe sank into recession along with the U.S., including Japan, Malaysia, and Singapore in Asia; Argentina, Canada, Brazil, and Mexico in the Americas; and Germany in Europe. True, the U.S. exerts unusual pressure on the rest of the world: It accounts for nearly a third of world nominal gross domestic product at market exchange rates and over one-fifth of world GDP on a purchasing-power parity basis. Nevertheless, trade and financial links among nations ensure that American consumers and business also feel the impact of slackening economic activity in Europe, Latin America, or other regions of the world economy.
The revival has been equally striking. U.S. consumer confidence is surging, and German business confidence is at an 11-month high. Canada's economy is expanding at a blistering pace. South Korea is improving, and Taiwan is emerging from its worst downturn in half a century. The Japanese economy remains a deflationary mess, but merchandise exports are picking up smartly, the first optimistic sign in years.
The dark side of a more synchronized global economy is that a currency crisis in Southeast Asia or a market meltdown South of the Border can now derail the U.S. economy. But a global economic cycle also holds the promise of moderating U.S. downturns.
For instance, many commentators feared that the combination of a global telecom bust and a worldwide slowdown would send the U.S. spiraling downward into its worst recession since the 1930s. Yet the recession was the mildest of the past half-century. The global economy provided critical economic support, as the slide in U.S. exports was matched by declining imports.
America's consumers and businesses benefited from falling import prices, especially energy prices. Foreign investors kept up their buying of U.S. securities. And the Federal Reserve Board didn't worry about inflation as it fought to stave off collapse. "To the extent the world moves permanently in the direction of greater global competition, the pressure is toward declining inflation around the globe," says James W. Paulson, chief investment officer at Wells Capital Management.
The rise of the international business cycle has valuable implications for investors. It's standard financial advice that American investors should diversify by putting some 10% to 20% of their portfolio into overseas markets. But in a global economy, picking stocks by country or region isn't enough. Instead, investors must diversify across industries, especially in those sectors like technology and pharmaceuticals, where globalization dominates.
Investors would be wise to look for companies that are worldwide industry leaders -- like the ones that make up the BusinessWeek 50 -- no matter where they're headquartered. For instance, from 1986 to 2001, a global equity value portfolio designed by country would have outperformed the world index by some 4% a year, according to research by UBS Asset Management. But choosing stocks around the world by industry sector would have generated a 7.8% better performance than the world index.
"The country-specific factors have been fading in significance over the past three to five years, and industry factors are more dominating," says Stefano Cavaglia, head of quantitative strategy at UBS Asset Management. "As the global business cycle becomes more important, the next layer of investment complexity is investing by industry."
The capitalist business cycle is alive and well. But in coming years, the swings in economic activity will be increasingly global in scope rather than domestic. And that's a point with quite of bit of inflection.
Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over National Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online
Edited by Douglas Harbrecht