At this point, I should probably point out that the above mentioned strategies are not the only investment strategies likely to be affected by slowing international trade. FX will certainly be impacted, potentially affecting global macro (discretionary as well as systematic), and commodities will also be affected, influencing a whole range of investment strategies. Even equity long/short could be affected as lower GDP growth affects equity returns. I have chosen not to comment on any of those strategies in this paper, but I am always available for a chat.  

Why is global trade slowing down?

To begin with, let me define what I mean by global trade. It equals exports plus imports, divided by two but, as exports equal imports when measured on a global basis, you might as well say that global trade equals global exports. From the days at school, you may recall that:

GDP = C + I + G + (X-M)

50 years ago, global trade accounted for only 6% of global GDP. In 2000, it had risen to 23%, and in 2011 it peaked at 29% before falling marginally more recently. Growing international trade was a major factor behind the strong GDP growth in those years.

Theoretically, exports (X) can never be more than 100% of GDP; i.e. global trade can never be higher than global GDP and, admittedly, it is far from those levels today. As you can see from chart 1 above, since the financial crisis, global trade has been hovering around 27-29% of global GDP.

As most trade between nations is in goods rather than services, from a practical point of view, global trade cannot exceed industrial production by much either. Researchers reckon that, from a theoretical point of view, global trade cannot be more than ca. 120% of global industrial production, given the current mix between goods and services in international trade (Source: Andrew Lees, Macro Strategy Partnership LLP). As of the end of 2015, the ratio was 104%, and it has moved broadly sideways since the crisis erupted (chart 2).

An increase in the ratio of global trade to industrial production from 34% in 1991 to 104% in 2015 explains the extraordinary growth in global GDP in the 1990s and 2000s but, at the same time, the absolute level now is rather worrying. Unless industrial production begins to grow much faster across the OECD (which would require a shift away from an increasingly service orientated GDP growth model back to manufacturing), or unless nations begin to trade services, we have almost certainly approached the end of the road in terms of global trade driving global GDP growth.

Global GDP growth ex. trade has compounded at 1.96% since 1990. With most of the juice having been squeezed out of the international trade lemon at this stage, one shouldn’t be surprised that the global economy is currently running at a growth rate very close to that number.

One could therefore argue that global GDP growth is certainly not running below its long term trend rate as many argue. It is running more or less at its long term trend rate - at least as far as the old economy is concerned. I have written extensively about the old vs. the new economy elsewhere, and shall not go further into that discussion in this research paper.

Adding to that, and as Paul Krugman has repeatedly argued, trade tariffs are largely a thing of the past. With free trade agreements in place between most countries, and hence with most trade tariffs gone, much of the low hanging fruit has already been picked and, going forward, international trade (and thus GDP growth) is likely to benefit only marginally from new free trade agreements.

Mitigating factors

Despite international trade accounting for 104% of industrial production worldwide and thus approaching levels where it cannot grow much further without some very fundamental and structural changes to how the economy grows, there are a number of mitigating factors that ought to be mentioned.

First and foremost, when I say that international trade cannot grow any further, it is when measured as % of GDP, i.e. when the ratio hits 120%, international trade cannot outgrow global GDP, but it can certainly grow.

Secondly, one ought to distinguish between volume and value (i.e. volume times price). Take oil. The price of oil has more than halved since the big selloff began in June 2014, but volumes exported continue to grow.

Thirdly, currencies also play a part in the downturn. Nigeria’s Naira and South Africa’s Rand both fell by 30% against US dollars when EM currencies ran into problems. Anything originating from an EM country is going to show a significant decline when measured in US dollars. In Nigeria alone, GDP in US dollar terms fell by 15% from 2014 and 2015, but the country’s oil trade halved in value, leading to a significant drop in international trade when measured as % of GDP.

Container leasing

Container leasing is an alternative investment strategy that has been on our radar screen for a while. Solid returns combined with seemingly robust investment management teams have caught our attention, and it is on our short list of strategies to do more in-depth research on.

I bring it up in the context of slowing international trade, because containers are the no. 1 way to ship goods from one country to another. In 1980, when the container model took off, at least as far as inland transportation was concerned, 0% of all goods shipped overland were shipped in containers. Today that number is 90%+.

With such high penetration already, you would certainly expect the growth rate in container shipping to slow down, and that could have an impact on pricing. With the world awash in containers, and with the growth of international trade likely to remain subdued, could container leasing as an investment strategy be negatively affected?

Prices on new containers are already extremely weak; rental rates likewise so (chart 3), and the price charged by shipping companies to ship goods has also collapsed. Sending a container from Shanghai to Europe today costs half what it did in 2014. No wonder the industry is struggling. We shall do more research in this area.

Shipping

The shipping industry is without doubt more negatively affected by the slowdown in international trade than any other industry. Almost $20 billion of revenues were lost last year as a result of sailing with empty containers (Source:  The Economist, September 2016), and the industry is full of companies flirting with bankruptcy (Note: One of the major ones – Hanjin Shipping from South Korea – has just folded). In 2016, results across the industry will likely show net losses of $5-10 billion on revenues of about $170 billion (Source:  The Economist, September 2016)

The industry has reacted to the lean times by building ever larger, and supposedly more efficient, container ships (chart 4), but the results have been absent – at least so far – and the reason is simple. Not enough of the older fleet has been retired, leading to significant overcapacity.

Some shipping companies originate from the alternative investment industry, and they have been particularly guilty of buying the older container ships, when they are replaced by newer and larger ships, so the overcapacity problem in the industry is to a degree self-inflicted. How the problem will be resolved remains to be seen, but I have no desire to participate in a bleeding industry.

Infrastructure

As container ships get bigger and bigger, more and more ports around the world will struggle to handle them without dramatic reconfigurations – something that isn’t cheap and probably cannot be justified based on the anticipated growth rate in global trade going forward.

The incremental terminal costs could actually be so significant that they more than outweigh the benefit of moving the cargo around in ever larger ships. The OECD have said in a commentary that mega container ships pose an “unsustainable cost on the rest of the container supply chain” and calls it a “taxpayer financed bubble” (Source: The Macro Strategy Partnership LLP, September 2016).

Whether it is or not, I would be very surprised if container ports around the world won’t be reconfigured to meet the standards of the new mega ships, which should leave an interesting investment opportunity on the table for infrastructure investors.

Trade finance

Trade finance is a broad term, which in reality is used to describe different strategies. Financing the physical movement of goods from one country to another can probably best be described as traditional trade finance. However, some trade finance funds specialise in receivables finance, whereas others specialise in value chain finance (where no commodity may physically move). My comments below relate (mostly) to traditional trade finance.

Trade finance can involve either the exporter or the importer, but rarely both. If the shipment in question is a container ship full of bananas from somewhere in Africa to Tesco’s supermarkets, the financing would be provided to the exporter, but the opposite could also be the case, in particular when the trade is between two EM countries.

As international trade growth is slowing you would expect trade finance to be negatively impacted but, in reality, it is a non-event, and expected to remain so for many years to come. The reason is as follows.

Prior to 2008, trade finance was provided by commercial banks in almost all countries, but commercial banks are back-paddling everywhere, as they are told by the regulator to cut back on lending. The only part of the world where commercial banks are still open for this sort of business is the US, which is why trade finance funds in the US are still virtually non-existent.

That has had a particularly significant effect on corporate SMEs, which account for a very substantial share of export/import markets – particularly in commodities. As a consequence, the trade finance market is undergoing drastic changes. Before the financial crisis, nearly 100% of trade finance was done by commercial banks; however, in the last 6-7 years, alternative providers of trade finance have taken an estimated 8-10% market share in Europe.

As the restructuring of the banking industry in Europe and Africa is still in the early stages, we expect alternative providers to continue to increase their market share for a long time to come. European loan books are more than twice the size of US loan books, and it will take regulators many years to bring that number down to a level they are comfortable with.

Importantly, for alternative providers, the growth in market share should more than outweigh any disadvantage from lower GDP growth rates and a subsequent slowdown in international trade.

Final comments

As stated earlier, more modest growth rates in international trade will almost certainly lead to slower GDP growth going forward. That, combined with exceedingly high debt levels, is a dangerous cocktail. A highly indebted world needs GDP growth of a certain magnitude to service its debt.

It is therefore not unrealistic to expect slowing international trade growth to result in rising defaults, leading to opportunities for distressed debt managers. That said, higher defaults are not a particular issue for any of the strategies discussed in this paper, but an issue for highly leveraged consumers and corporates in general.

One final note. Brexit was a stark reminder that the world is moving in the wrong direction at the moment, and Donald Trump could be another step in that direction. Growing nationalism could ultimately affect international trade negatively, although we are far from that point at present. Worst case, should it happen, the liquidity profile of the typical trade finance fund leaves us plenty of time to react.

Niels Jensen

23 September 2016