Blog

Which probably is not that surprising after all. In the last months, several experts have pointed out that the underlying cause of the conflict is distinctly political-military in nature, and that the trade dispute is only a proxy-fight or one arena of a much more fundamental conflict. In that view, it is not about current account deficits or unfair benefits from trade, but about power, national security and wrestling for global political dominance. Technology plays a key role in this game, both as an economic enabler and as a military means.

Will the U.S. be able to retain the comfortable position as the global apex predator, or will China be able to successfully challenge that and reach super-power status as well? That seems to be the question, and the stoic hyper-rational logic of the homo oeconomicus simply appears to be insufficient, too narrow and a bit naive to fully grasp the consequences.

Political considerations can, and frequently do, override economic considerations. History books are full of examples. The last conflict between two global superpowers, commonly referred to as the (First) Cold War in the 20^th century, is one.

Most of us tend to only recall the agony and decay of the Soviet Union from 1980 onwards. It is often forgotten that the country managed to achieve spectacular GDP growth rates in the 1950s and 1960s, of 5.8% resp. 3.0% on average per year. The bold claim of overtaking the West economically did have a real foundation then.

Only the economic resources generated by that strong growth allowed the Soviet Union to establish as a global superpower and fund all its well-remembered military and space programs – just think of Sputnik or Yuri Gagarin. However, due to a complex set of factors, the Soviet economic model slowed down and essentially stopped working in the 1970s. Much of this was caused by internal problems, not a result of U.S. or NATO policy. And it was this, at the time largely unobserved, crash of the Soviet economy that initiated its downfall in the end. Soviet leaders made the great mistake of keeping military spending high and engaging in costly wars, significantly re-directing more and more increasingly scarce resources to military purposes – and so overstraining their economy without external influence.

When the West decided to intensify its own defense spending in the 1980s, this was only the straw that broke the camel’s back – it only pushed an already mortally weakened economy finally over the edge. The USSR did not lose the (First) Cold War because of military inferiority, but because of economic collapse.

This story is reflected by the numbers. Interestingly, with 8 to 13%, U.S. military expenditure (as share of GDP) was as high or maybe even higher than the Soviet Union’s in the 1950s and 1960s, with the burden decreasing significantly from 1970 onwards (Korea war, Vietnam). Conversely, Soviet military expenditure picked up from an est. 9% in the 1950s to 11 to 15% from 1970 on – with some estimating it as high as 20% in the early 1980s (Afghanistan war). For the U.S., even with SDI etc., defense spending never went above 6.6% in the 1980s – the economy could easily handle even these ambitious military projects and investments.

The pattern and strategy that can be derived from that is obvious: Thwart the adversaries’ growth model, ideally crash his economy – limit his resources. Keep up military pressure. Impose additional external burdens, such as excessive military spending. That way, either limit his military ability or send him into an economic downward spiral. All in all, an elegant way to get rid of an opponent.

China has begun to challenge the U.S. in the military sphere; its spending is minor in terms of GDP, but already perceived to be dangerous by some. Advanced technical capabilities and technology hikes might exacerbate this. In that situation, why not revert to a very successful strategy of non-conventional warfare that won the (First) Cold War without major bloodshed?

Even though China may appear invincible today, it might be not, with its rapidly ageing population, property market bubble and bloated shadow-banking system. Intensified confrontation could deliver a painful blow in a critical phase.

This leads back to the trade dispute: Considering the analysis above, we most likely haven’t even seen the beginning of a potential escalation of this conflict. There are many more torture instruments in the cabinet, such as:

• Prohibitive tariffs
• Strict export rules – cp. the (First) Cold War’s rules on high-tech exports
• Rules of origin (products, assemblies, parts)
• Import bans
• Sanctions for Chinese companies or Western companies doing business in China
• Outright embargos
• Mutual exclusion clauses

When carefully reading Vice President Pence’s Oct. 4 speech on the subject, in essence a comprehensive list of Chinese wrongdoings and American complaints, “Decoupling” the two economies seems to be the logical consequence. Such removing of China and Chinese companies from Western supply chains and products would fit perfectly well into the strategy described above. On from there, it’s only a small step to “Containment”, trying to limit the other’s influence in the world by forcing all others into an unwelcome choice: “you’re either with China or with America”.

Even President Trump’s seemingly accommodating statements that he sees “good chances for a deal” and that “it will be the best deal” should be read with care, in our opinion. Most probably negotiation tactics, they also fit all too well into what Satoru Mori of Hosei University (Japan) calls a “zig-zag upward trajectory” of short relief and intensifying tension. A pattern observed in U.S.-U.S.S.R. relationship in the (First) Cold War as well.

It does not take a lot of visionary thinking to see that such a development would be disastrous for global trade, a major driver of TIC growth in the recent past. And the much hoped-for opening of the Chinese domestic TIC market might not happen at all, in such a world of intensified hostility between the “West” and “China”.

We are not too optimistic that this trade dispute can be resolved and rather believe that things will get much worse. We would thus recommend TIC players and investors to accept the new political reality, finally factor this in and provide new guidance – instead of pretending that it’ll all be good.

Of course, you’re free to believe otherwise – at least for the time being in this part of the world.

Sources:

https://www.forbes.com/sites/yuwahedrickwong/2018/09/11/the-u-s-china-trade-war-and-global-economic-dominance/#132846df256a

Easterly, William and Stanley Fisher, "The Soviet Economic Decline: Historical and Republican Data" World Bank Policy Research Working Paper Number 1284, April 2001. Also published in the World Bank Economic Review 9(3): 341-371, 1995. https://datacatalog.worldbank.org/dataset/wps1284-soviet-economic-decline

https://nintil.com/2016/05/31/the-soviet-union-military-spending/

https://sipri.org/databases/milex

https://www.whitehouse.gov/briefings-statements/remarks-vice-president-pence-administrations-policy-toward-china/

https://thediplomat.com/2019/01/us-china-a-new-consensus-for-strategic-competition-in-washington/

https://www.ft.com/content/019b1856-03c0-11e9-99df-6183d3002ee1

https://www.washingtonexaminer.com/opinion/op-eds/pences-little-noticed-speech-marked-a-new-us-realism-toward-china

https://www.ft.com/content/2fec1b60-fefc-11e8-ac00-57a2a826423e

https://www.ft.com/content/d188cb1e-02b0-11e9-99df-6183d3002ee1

Photo © David Pacey (cc-by-sa/2.0)

When revisiting our ranking, mulling over expected 2018 results and analyzing the long-term evolution of the industry landscape, we arrived at a few interesting observations and conclusions:

• The “Big 3” officially have become the “Big 4”, as Eurofins can be expected to cling the 3^rd place in the ranking with an expected revenue of EUR 3.8bn, slightly more than Intertek (EUR 3.5bn 2018e). Eurofins continues its astonishing rise through the ranks, and could begin to take on Bureau Veritas soon - a clear statement how valuable a focused business model can be if paired with courageous execution (or how far big and risky bets can take you, depending on where one would like to position in the current debate around Eurofins' true viability)
• Listed players now occupy the industry’s front row – 12 years ago, the No. 3 and 4 in TIC and 7 of the 10 largest industry players still were foundations. Now, the four largest TIC players and 5 of the Top 10 are listed. In general, foundations slowly but steadily lose ground in TIC. The only reason why their importance in the ranking stays relatively stable is the absence of “commercial predators” large enough to replace them
• However, “foundation ≠ foundation”: DEKRA, TÜV SÜD and especially UL are expected to have done quite well also in 2018, whereas we believe that TÜV Rheinland’s and especially DNV-GL’s results will be mediocre again. In the case of DNV-GL, revenue might even have fallen below EUR 2bn

A 2018 TIC industry ranking like this would nicely confirm our main message of “focus” – those in TIC adhering to a clear-cut and concentrated strategy fare better than the rest. Satisfying maybe, but our considerations did not stop there:

• CCIC, the largest Chinese TIC provider, probably achieved a revenue of EUR 1.3bn in 2018. Our modeling is based on datapoints from other major TIC players, but still fraught with a bit of uncertainty. The company could very well be even more of a heavyweight, with potential revenue of EUR 1.5bn or even 1.8bn. This means that the TIC industry finally has to acknowledge that China is not just a source of revenue, but also of competition
• The “Tier-2 TIC players” continue to push forward. Element, Socotec, BSI, KIWA and RINA all achieve more than EUR 500m of revenue. They have become too big to swallow or to crush for most Tier-1 players, and they have built a few strong market positions (cp. Element in Aerospace testing). Not considering them would leave the picture incomplete

Thus, the case for extending our industry view to the “Top 20” is clear. And this heralds uneasy news for the “old Top 13”: Life is not getting easier.

In the case of Bureau Veritas’ Nicolas Tissot, who joined in May 2016 from French re-insurance company SCOR, it might seem plausible that the Board of Directors was looking for a candidate with more “TIC smell”/experience and a stronger BV-internal network. The choice of Francois Chabas would fit into this narrative, as he has spent more than 15 years with the company, slowly fought his way up the ranks and knows the business very well, having worked in several functions. In that case, the TIC industry would once again have demonstrated how much of a “peculiar animal” and “closed shop” it is. On the other hand, for example Matthias Rapp at TÜV SÜD, who joined from Automotive supplier Webasto, shows that outsiders can successfully find their way into the industry even if entering it on Board level.

Edward Leigh’s case appears to be a bit more complicated. If he were thrown under the bus in order to pacify investors’ mood and stabilize the stock price, as a scapegoat for Intertek’s mediocre half-year results, then this would have yielded exactly the opposite result, as the slide continued. Was there a desire to replace him with somebody more loyal? One argument for this might be the fact that his successor Ross McCluskey just joined two years ago from Inchcape. He was probably onboarded by his back-then and now-again CEO André Lacroix, who has displayed a clear preference for surrounding himself with Inchcape people. However, McCluskey might very well just have been hired because he had already demonstrated his competence. Did Leigh display an unpalatable level of disobedience, maybe in connection with the “ambitious” / “optimistic” financials around the Alchemy acquisition? Unknown.

Apart from such poignant yellow press-style narratives though, there are some hard facts which might explain this. The stock price developments of SGS and Bureau Veritas in particular have not been stellar since 2013, moving sideways in the long-run at best. For their strategic anchor investors, this lack of value creation (apart from dividend payouts) cannot be satisfying. Intertek’s stock price has skyrocketed in the Lacroix age, but has recently tumbled. Some investors could be worried that this is more a straw fire than really sustainable, especially as the “Resources” division is still ailing, not making progress and no strategy beyond “fix it somehow” in sight.

In other words: Pressure on TIC executive teams is mounting, as it gets harder and harder to credibly keep the dream alive. And before biting the bullet themselves, TIC CEOs, like their counterparts in other industries, tend to sacrifice somebody else first to placate the gods.

Taken from this angle: Carla, buckle up…?

https://www.thetimes.co.uk/article/intertek-executives-exit-is-pure-quality-gvmtg286n

https://www.thetimes.co.uk/article/intertek-s-finance-chief-heads-for-the-exit-zn5fbk600