Global affairs

Our assessment of President Joe Biden’s first 100 days in office focused almost entirely on domestic matters: the acceleration of the vaccine rollout, the enactment of the American Rescue Plan, and his proposals on infrastructure spending and tax increases. His, and thus our and the market’s, focus was understandable, given that the US is only now clearly emerging from the pandemic, with economic activity normalizing.

But it was only a matter of time before geopolitical matters came to the forefront, whether unexpectedly or as a result of the administration pivoting to deal with a host of simmering issues. They’ve certainly had to over the past month, with the pandemic getting worse in India and elsewhere in Asia; renewed fighting in Israel; the cyber attack on the Colonial pipelines; rising tensions with China over Taiwan; Russian conflict in the Ukraine and increased military buildup on the Arctic coast; and ongoing North Korea nuclear concerns.

With most investors preoccupied with rising inflation, pandemic recovery, and the Federal Reserve’s response to evolving macro conditions, everything else is treated as a secondary matter for the market outlook. Usually, that’s the right response to geopolitical shocks. Such events can dominate front-page headlines and the news flow, but their actual economic and market relevance is far less. A simple rule-of-thumb for judging whether that’s appropriate is to evaluate the potential impact on growth, earnings, and inflation from a geopolitical event. Except in extreme situations, the impact is not meaningful, at least not enough to change the market outlook for investors.

Applying this framework to a few of the recent geopolitical events helps to put them into perspective.

First is the combination of Middle East developments—the escalation of fighting between Israelis and Palestinians, and US and Iran talks to revive the nuclear deal—and the cyberattack on Colonial Pipeline. Their direct economic impact is almost entirely on the supply and price of oil, which was up about 2% two weeks ago before declining nearly 3% last week. These geopolitical events may have had some influence on the price, but far more important is global oil demand as the economy recovers from the pandemic. Oil supply has been well behaved, held in check by OPEC+ and US producers, leaving fluctuations in actual and expected demand as the factor driving energy prices. At this time, geopolitical shocks pale in comparison to pandemic shocks impacting demand, and thus oil prices.

Turning next to US-China relations, tensions are rising over Taiwan, adding to an already tense relationship. Recently, the Biden administration signaled its intent to move toward establishing official relations with Taiwan, widely viewed as a red line for China. All-out conflict is still very remote, but even verbal sparring exacerbates the strained relationship. Even if further escalation doesn’t occur, this just adds to the momentum for both countries to decouple on strategic economic matters. This is most applicable in technology, which is why there is a bill currently making its way through the Senate with bipartisan support that would dedicate USD 120 billion to investments in technology and innovation to bolster the US’s ability to compete with China.

Finally, the Colonial attack was a reminder of the vulnerability of the nation’s infrastructure, but more generally the threat posed by cyberattacks on financial markets and other critical businesses that could severely disrupt the US and global economy. The challenge is heightened because it’s often not nation-states engaged in these actions—it wasn’t in the Colonial case—making them less predictable and harder risks to mitigate through conventional state diplomacy. While that may sound ominous, it’s also true that such attacks, at least thus far, have negligible consequences for the entire economy. Very disruptive events are possible, but also very low probability, in our view. This matters for investors because they shouldn’t be positioning their portfolios to protect against such risks in the base case, but they can buy protection, at a cost, against extreme downside scenarios.

So while geopolitical matters are always important to monitor, we do not foresee any of the current developments posing a significant risk to the bull market. We continue to see the economic reopening, and fiscal and monetary support, as the key drivers of equity markets in the near term.

Contribution from Jason Draho, Head of Asset Allocation Americas

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