The return of geo-politics: Caveat Emptor

Glenn Silverman, Investment Strategist at RisCura

Since the end of the second World War, geo-politics have been largely incidental to the rise in globalisation and the ascent of global equity markets.

At times, significant global events such as the Cuban missile crisis (1962), the oil crisis (of the 1970s), China’s re-joining of the global economy (late 1980s on), and the fall of the Berlin Wall (1989), were once-in-a-decade events with a market impact, but overall, investors have been largely able to either ignore, or look through, these events.

Inflation, on the other hand, has had a far greater impact on markets over time. Since the 1950s, in periods when US CPI was on the rise, US equity markets provided a muted return of 3.7%, as opposed to a far more compelling 10.0% return when US CPI was falling. The oil crisis (1970s) was a geo-political event, which had a significant inflation impact, and hence, it also had a significant market impact.

Not unlike the 1970s, we now have the unusual combination of bad geo-politics, not only combined with high levels of inflation, but with geo-politics arguably creating, or indeed augmenting, the inflation woes. With this as a backdrop, it is clear that investors can no longer simply ignore geo-politics, as they have been safely able to do over the past few decades. Some would now argue that geo-politics is in fact ‘trumping’ economics i.e., it is, or will be, the dominant factor driving markets. And unlike in the 1970s, when climate change was unheard of, this further geo-political factor (with a global impact) is likewise set to have a material market impact.

One of the challenges with respect to assessing geo-political risks is that in the vast majority of cases, the potential risks don’t end up manifesting. Another feature is that, even if they do, they often play out over a long time i.e., providing sufficient opportunity to either adjust, or even exit, the position. Adding to the complexity, as geo-political risks are discounted (for example in a country or region), the valuations of that region tend to get cheaper, which makes it even harder to exit - both behaviorally (locking in a possible loss), or in terms of generally accepted investment philosophy (which preaches selling high, rather than when assets are cheap).

The key geo-political events playing out at present are in the form of Russia vs. Ukraine, and China vs. Taiwan. But looking at these too narrowly, masks the larger and far more ominous global re-alignment that is currently underway viz. that between the US / West and Russia (a former global superpower) and then China (a current global superpower). The uni-polar world, which has been in place since the fall of the Berlin wall, where the US dominated all aspects - cultural, philosophical, economic and military, is clearly long gone. The balance-of-power has now shifted, and quite significantly so, with the US / West now pitted against the combined forces of the likes of Russia and China, but also (potentially) some others who share an antipathy towards the US / West, and who possess significant armed forces, including substantial stockpiles of nuclear weapons. This might even be in the form of an enlarged BRICS grouping. The risk of war, including nuclear, has arguably not been higher since the Cuban missile crisis of the 1960s. The Doomsday clock sits perilously close to midnight.

What does all of this portend for capital markets? Many argue that globalisation has peaked, and with such, the associated negative impacts on the likes of - international trade, global supply chains, goods availability (from ‘just in time’ to ‘just in case’) etc. The impact of the above is arguably a double negative, in terms of the discount rate applied to cashflows, and hence to the valuation of all assets i.e., the discount rate needs to be higher to account for the higher geo-political risks, and to the extent that said geo-political risk leads to higher global inflation that would suggest a further, higher discount (interest) rate as well.

To provide some context, the period-of-time after the then Federal Reserve chair, Paul Volcker, raised rates to 20% in 1981, was a golden time for assets i.e., a period of disinflation, leading to lower interest rates, and to rising asset prices for many decades. The converse may now be in place, which would entail a far more challenging period for all asset classes. This would be especially so if it were to endure for a lengthy period of time, with some suggesting an ‘equal but opposite’ period lasting a decade (or even more). And very few believe that the Fed, or any central bank for that matter, would have the gumption, or political backing, to ‘do another Volcker’ nowadays anyway i.e., to raise short-term interest rates well above the current level of inflation, so as to comprehensively break the current inflation cycle.

Every bull market is inevitably followed by a bear market, even though the extent, and duration, of bear markets differ. Most bear markets happen quickly, aggressively and are then over, typically within less than two years. In 2022, capital markets fell sharply in the first half, before a strong recovery through July and early August. That rally does not mean that markets are out of the woods, however, especially if inflation does not fall meaningfully, and soon…. Caveat Emptor (buyer beware)!