Living with an unknowable future, and how this will impact the rule book of the global economy, is one of the key jobs of an investor. But while this has always been true, the tone of many market commentators suggests it is truer today than it has been in a long time.
Inevitably, that is a threat to a model-based view of the world, assets and risk. Sometimes this is surmountable; since 2016, most banks have assigned probability weightings to the many possible outcomes for Brexit, tweaking them at each stage of the political drama in real-time while rarely making a definitive call.
In other cases, a probabilistic view of various scenarios can bring highly paid analysts to doom-laden conclusions. In February, Deutsche Bank published a report that calculated there was a 5 to 10 per cent near-term probability of each of the bank’s three most worrying geopolitical scenarios – a significant escalation in trade tensions, a no-deal Brexit and a sharp slowdown in China’s growth – any of which could spark a recession.
Of course, shocks happen, and each event is still possible. But assigning round numbers to tail-risk events also feels a lot like guesswork.
A climax ahead?
At the same time, markets’ appreciation of geopolitical currents often manages to be not only short-sighted, but reactive and amnesiac.
At the start of 2019, few investors in the Hang Sang Index predicted that Hong Kong’s apparently passive, smartphone-addicted populace would stand in mass defiance of China, and bring the city state to a standstill. The idea that a few drones could knock out 5 per cent of global oil output in a single weekend was clearly inconceivable to energy traders, judging by the record one-day spike in Brent crude futures. This year also brought the worst escalation in hostilities between nuclear-armed India and Pakistan in decades, a flashpoint that went barely noticed in major asset prices.
At the same time, market prognostications on our forever-uncertain future often fall back on a strain of vague hyperbole. Barclays Private Bank, which recently told its clients that with “Brexit unfinished and a US presidential election in November, 2020 is set to see geopolitical uncertainty climax”. If next year marks a climax, does that mean investors should look forward to 2021?
To be fair to the bank, its 2020 outlook also contains a more nuanced take, which outlines “a string of events or developments that could tilt globalisation towards an increasingly contentious relationship between countries or towards a more conciliatory framework”.
This gets us closer to the historical current for which “uncertainty” serves as shorthand: the unpredictable new ways in which domestic discontent and international power struggles are redesigning the globalised world.
To Barclays, the US presidential election, the outcome of Brexit and the levels of political cooperation within the European Union “each has the potential to support or derail” financial markets. “A more fragmented global order, with countries embattled in trade tensions, is one that does not foster confidence and increases uncertainty,” the bank adds, noting that investment levels in 2019 mirrored those “seen during periods of global recession”.
Slow-burn/event-driven
This mood music matters, partly because geopolitical cycles rarely move suddenly.
But markets are also obsessed by flashpoints, and taming every possible black swan out there. Two-thirds of global investors surveyed by Swiss bank UBS agreed with the statement that markets are “driven more by geopolitical events than business fundamentals, such as profitability, revenue and growth potential”.
Understandably, this means demand to price the likelihood of those geopolitical events as accurately as possible. And, happy to oblige, some analysts do make valiant attempts to turn chaos into data points. One example is BlackRock’s ‘geopolitical risk dashboard’, which the asset management giant updates each month via an econometric framework that translates plausible events into risk factors. Broadly speaking, its assumptions look sensible. Risks notable by their absence: climate change, pandemics and rising inequality between and within nations.
Then again, few risks play out as expected. As BlackRock’s schema hints, the collapse of the eurozone consistently ranks as one of the greatest fears for global asset prices. But the European project also confounds analysts (and some investors) because, for all its fragility, it has little choice but to carry on as a patchwork of seemingly contradictory forces.
The historian Adam Tooze put it well in a speech to the CFA Institute earlier this year: “The trilemma for Europe is that the EU is fundamentally politically indispensable, clearly in need of structural reforms, yet completely absent of political leadership in pushing toward the changes necessary.”
This is another important lesson for investors’ appreciation of geopolitical risk: that network effects often mean institutions are stronger than they first seem, and rarely unravel in a flash. One massive exception to this rule was the toxic and overextended transatlantic banking system of 2008, which collapsed like a house of cards. But even then US financial hegemony has remained a highly investable theme.
Indeed, in the wake of the Great Financial Crisis, many expected the US dollar to tumble as owners of dollar-denominated sovereign debt liquidated their holdings and stuck a pin in the world’s largest credit line. In fact, the opposite has happened, as the greenback has continued to rally along with its share of outstanding global debt (see chart).
The US may be fiscally weaker, and therefore more sensitive to the above scenario, but the dollar-based global financial system is not retreating, in turn maintaining the US’s huge leverage as the reserve currency.
US-China: risk number one
There are currently few reasons to believe this will change in 2020, regardless of the outcome of November’s election. But what will remain a constant is the intensification of the US-China rivalry.
Arguably, the entire market narrative around the trade war is near-sighted. Listen too long to some talking heads, and you might think we are dealing with two corporate giants locked in an extended and complex merger negotiation, and that markets are simply waiting for relations between the two countries to reset before risk premia can be repriced.
“It's in everyone's interest to see this spat get resolved and go back to normal trade relations between the US and China," said Alex Feldman, chief executive of the US-ASEAN Business Council earlier this year.
In geopolitical terms, what is unfolding is a far more profound reconfiguration of the global order. Given its centrifugal-like role in global trade growth, China is arguably already the world’s most important economic power. What we currently call a trade war, with its bipartisan support and increasing involvement of America’s security apparatus, is probably just one chapter in a multi-decade stand-off.
For investors, the greatest impact is unlikely to be the daily swings in sentiment as markets digest Donald Trump’s latest tweet, or the “reduced exports, imports and investment spending” JP Morgan Asset Management forecasts next year. Instead, it will be on individual companies, and how they fit into this new world. If the US-China trade war is perhaps the most important sign that globalisation is wavering, then transnational corporations can no longer be seen as geopolitically neutral.
Then there is the potential blowback for China’s hyper-leveraged economy, which is probably the largest single transmission mechanism for a global recession. Should the inevitable financial restructuring fail and lead to a hard landing, UK investors in mining stocks, HSBC (HSBA) or Standard Chartered (STAN) may need to brace themselves.
