Geopolitics: managing portfolio implications

For the 2018 Milken Institute Global Conference, we asked speakers to identify one event that has changed their industry and the world in recent memory. See their insights and share your thoughts using #MIGlobal. See more coverage on the Milken Institute LinkedIn page.

In an interconnected global economy, portfolio returns are increasingly impacted by geopolitical events, which have consequences that extend far beyond the place where they occur.

Geopolitical risks are poorly understood in financial markets and often mispriced. This is because it doesn’t matter until it matters. The key is to understand the transmission mechanism into the global economy, trade and markets.

Placing such events into context helps price both risk and timing of investment decisions. The challenge is to structure the market ‘noise’ – the plethora of prices, news and events – into useful data sets, information and knowledge. Yet true alpha lies in turning knowledge into insight. This requires ‘imagination’. For imagination to be effective, one needs to understand the context which, when combined with deep analysis, enables the construction of investment strategies.

There are many crosscurrents facing investors today. The major themes we at CQS are monitoring are populism, challenges to the world order, growth, possible disruptors and other emerging issues. Some events may matter a great deal to the world, humanity and our moral compass, yet not impact trade and the economy. We seek to identify events and their transmission mechanisms into markets as we construct portfolios. Many events have incited volatility, exacerbated by changes to market structure. Geopolitical changes are presenting investors both risks and opportunities.

Two such geopolitical developments are China’s Belt & Road Initiative (BRI) and European Union reform.

China to shape the world’s future

China will remain an engine for global growth, with China’s BRI expected to be one of the most significant contributors to global growth over the coming years. One of the largest infrastructure projects in history, it aims to strengthen China’s economic leadership by linking Europe to China through countries across Eurasia and the Indian Ocean.

The BRI is ambitious, taking in 65 countries, which comprise 60% of the global population and 30% of global GDP. To put this in perspective, $8 trillion was invested in quantitative easing following the Global Financial Crisis, while BRI is estimated by some to invest $10 trillion into the real economy, albeit over a longer period of time.

BRI will continue to impact global growth, corporate earnings and security selection, as well as investment decisions. There will be winners and losers. Sectors such as commodities should do well; the effect on certain economies will be positive; and currencies will be impacted as China seeks to establish the Renminbi as a reserve currency. Investors should ‘follow the money’. Furthermore, the scale and character of Chinese activity is extraordinary and, if successful, China may not just be set to dominate the region but remould the world order which is already impacting foreign and trade policies globally.

Populism and calls for European Union reform

The European Union and Eurozone continue to face a number of political challenges, with growing calls for reform. It is directly impacting some of Europe’s largest countries – and it is not just about Brexit, which has become a catalyst for reform.

Migration has played a significant role in the European political landscape. Populism is alive and well and has directly affected the course of recent elections in France, the Netherlands, Austria, Germany and Italy. The September 2017 elections in Germany created unprecedented difficulties in forming a stable coalition government, which was only sworn in last month. Italy is facing another weak coalition with little appetite for structural reform. Should the Northern League be part of a coalition, it would likely place Italy on a collision course with the European Central Bank. In France, Macron faces confrontation with unions over reforms.

The EU and Eurozone are faced with centrifugal forces causing stress within EU about economics (North vs. South), national and cultural identity (East vs. West), and debates about the type of model it will adopt; from Federation to an economic community only?

In the short-term this uncertainty may not matter, but the longer-term effects could materially change the value of the Euro, the EU’s ability to trade across borders and could even lead to social disorder. The growing stresses in the EU and Eurozone, with the potential for more politically-inspired volatility on the horizon, will test the asset management industry’s ability to navigate the complex challenges presented to investors in this region.

Conclusion

The growing importance of geopolitical events in today’s world has highlighted the importance of asset managers’ fundamental understanding and timing their investment decisions with care. We must remain aware of potential potholes, be prepared to be nimble in trading, and embrace volatility as a catalyst for investment opportunity. It is a complex world and it has never been more intriguing.