The world has come to feel increasingly fragile in recent years. Relationships between nations have decayed, while the pandemic exposed significant vulnerabilities in global trade. There is a sense now that companies must become used to operating in an increasingly deglobalised world – one where cross-border trade is no longer fluid and geopolitical risks pose a meaningful threat to the way they do business. Is this a realistic assessment? And if so, how might professional investors adapt?
Certainly, global events have weighed disproportionately heavily in recent years. Anna Rosenberg, head of geopolitics at the Amundi Institute, suggests asset management groups have been forced to pay closer attention to geopolitical risks as they have exerted greater weight on markets.
“The markets did not used to care about politics – they just cared about numbers,” she argues. “But then with Brexit and Trump, political decisions suddenly became very important in order to predict how the market would move.
“And then there was Covid, where politicians were deciding whether to close borders, to shut down, which had huge ramifications for stocks – for the hospitality sector and so on. As such, it became increasingly important to try and predict what politicians would do next.” This way of thinking continued to be important as the pandemic forced a reappraisal of global supply chains and created structural changes in the world economy.
Then, last year, Russia’s invasion of Ukraine brought still more challenges for fund managers. Many were forced to write down their holdings in Russian companies to zero as Moscow’s stock exchange closed to investors from countries imposing sanctions. Russia-dedicated active funds suspended dealing, while ETFs closed. In both cases, investors have not realised any of their capital.
The invasion and its aftermath also affected companies outside the region that had significant dealings in Russia. BP, for example, held a 20% stake in Rosneft, while Shell had joint ventures with Gazprom. Financials and consumer goods businesses also had a presence in the country and were forced to weigh up the potential reputational hit of continuing to do business there against the financial damage of withdrawing.
“Companies have taken steps to address the situation,” says Christopher Rossbach, chief investment officer at J Stern & Co. “In some cases, this has been by suspending or closing their businesses in Russia – such as luxury goods company LVMH. In others, it has been by refocusing on delivering essential and basic foods to local people but suspending most of the brands they sold before the war and halting non-essential imports – like food giant Nestlé.”
China v the US
And there is a fear of worse to come. Chinese and US relations have grown increasingly mistrustful, with tit-for-tat protectionism over key industries, such as technology, vital natural resources and renewable energy. Semiconductors – seen as crucial for the development of technologies such as artificial intelligence and electric vehicles – have been in the eye of the storm.
According to The Economist, Taiwan – whose sovereignty China has never recognised and, one way or another, has ambitions to reunify – produces more than 60% of the world’s semiconductors and 90% of the most advanced ones. The US passed the Chips and Science Act in August 2022, which assigned $280bn (£226bn) to boost its own domestic semiconductor industry – but also sought to cut China out of the supply chain.
In response, China has been shaking up its technology strategy, launching a new Communist Party science commission and an updated Ministry of Science and Technology. It is seeking to promote greater collaboration between its semiconductor companies and provide increased access to subsidies. There is also a new arms race over data storage and ‘supercomputers’, designed to power machine learning. It is the tip of an iceberg of tensions between the two superpowers.
Financial market impact
This all creates a febrile and difficult environment for investment managers. The big question is whether the associated moves can be predicted with any certainty, and their impact on financial markets or individual companies quantified. “Markets and geopolitics are not that correlated,” notes Jake Moeller, senior investment consultant at Square Mile Investment Consulting & Research. “There may be a short-term impact but, in the long-term, it is more difficult to judge the impact.”
Rosenberg acknowledges there will always be the events that cannot be predicted – but fund managers can still glean an advantage by being flexible enough to react quickly when these so-called ‘black swans’ do happen. She goes on to argue, however, that assessing geopolitical risk is increasingly important and it is possible to predict many key events. “The Russian invasion, for example, was not a black swan event,” she argues. “There was a lot of evidence of troops amassing at the border – the challenge is people do not want to imagine the worst.”
The Amundi Institute looks at individual factors that may combine to create one outcome or another, which in turn allows it to make a prediction and assign a probability. “The unpredictable then becomes a little bit more predictable,” says Rosenberg. “The key is to stay on top of the nuanced change – the incremental change to a scenario. How does the US sending battle tanks to Ukraine change the war, for example? That way, a surprise only happens when there is a true black swan event, like the pandemic.”
BlackRock takes a similar approach with its Geopolitical Risk Indicator, highlighting its 10 risks, their likelihood, the market attention and giving a view. At the moment, the first five risks are the Russia/Ukraine conflict, US/China strategic competition, a major cyberattack, global technology decoupling and gulf tensions.
Implementing political risk analysis
Then comes the question of what to do with the information provided by these risk assessments. For fund managers, it can influence their thinking on individual companies in a variety of ways.
Seb Petit, investment specialist on the Scottish American Investment Trust at Baillie Gifford, says: “We own Taiwan’s semiconductor giant TSMC, and clearly the tensions around China and Taiwan are part of the ongoing debate among the team. TSMC is a leader – almost a monopoly, in fact – in next-generation chip manufacturing. Last summer it was trading on only 12x earnings, but we didn’t increase our position because of these political tensions.”
Adrian Hilton, head of emerging market debt at Columbia Threadneedle Investments, suggests the issue is less whether risks exist than whether investors are properly compensated for taking them. “Dedicated country analysts are constantly monitoring events and engaging with local experts and policymakers to spot potential risks,” he says. “The key question is not ‘can bad things happen?’ but rather ‘do prices compensate us adequately for the risk they might?’.
“We can’t spot everything, of course, which is why portfolio diversification is so important in mitigating our overall exposure to unexpected events.”
Hilton points out there can also be opportunities in the market’s interpretation of political events, offering the example of the scandal that erupted over South African president Cyril Ramaphosa’s personal finances in December 2022. In the ensuing panic, yields on South African local currency bonds spiked on fears the president would be forced to step down, but the concerns proved overblown, and yields fell significantly over the next two months.
Moeller, meanwhile, adds the example of the recent banking crisis, where “the baby was thrown out with the bathwater” and buying opportunities again emerged.
Robert Alster, chief investment officer at Close Brothers Asset Management, says: “Another important point about a crisis is that major events sometimes affect a whole industry, such as the Fukushima disaster and nuclear power. Such events can alter investor perceptions for many decades, and that may provide opportunities such as the higher premium placed on renewable investments as a result.”
Equally, it is important that fund managers have a crisis management strategy for any black swan events as they arise. When a crisis hits, Alster says, his teams immediately carry out an analysis of every portfolio and holding in order to assess exposure to the affected area across all assets types – shares, bonds, alternatives and managers.
“In the case of Russia and Ukraine we also had to decide a policy in relation to the future purchase and sale of Russian securities by clients,” he continues. “We also asked our research analysts to consider second-order effects – companies’ possible withdrawal from Russia, for example – as well as supply-chain effects. This might be the restriction of electrical wiring looms from Ukraine affecting European car production. Finally, we would look at the longer-term effects of reshoring and de-globalisation.”
Companies may be beneficiaries or victims of these new trends and fund managers will need to decide which side they fall on. “Many companies have benefitted from the globalisation trend, seeing a lowering of the cost of production,” says Baillie Gifford’s Petit. “We do not expect that to completely reverse but there are companies that might suffer from retrenchment. It was an important driver for some companies – German automakers, for example, have grown used to sourcing manufacturing in China.”
Shifting economic sands
It is also important to consider the impact on the overall economic landscape. If, for example, companies are forced to recreate more flexible supply chains or to reshore production closer to home, it will raise their input costs, potentially contributing to inflation. That said, it may also make companies more resilient and better able to withstand crises. It may also create new opportunities as the supply chain reshapes – Mexico, for example, has been a beneficiary of US companies reshoring away from China. In a similar vein, Apple supplier Foxconn has moved some manufacturing to Vietnam, as has Samsung, which creates local growth.
Meanwhile, there is the potential broader impact on the world order. If China and the US are to be enemies rather than mistrustful collaborators, China may do more to impose its vision of the world. The foundations of the current world order were laid out at Bretton Woods in 1944 and have prevailed ever since. It is easy to forget that countries such as China did not sign up to these rules and are keen for the world’s economy and political system to work differently.
In the longer term, this may create a significant realignment, with implications, for example, for the hegemony of the US dollar (see boxout) or the trading of commodity markets. Rather than a world centred on the economic dominance of the US, it may become a multi-polar world, with the US, European Union and China-led Asia exerting equal power. Such a change could then need to be reflected in investment portfolios, many of which remain dominated by the US.
While there seems to have been an abrupt end to the long era of economic collaboration between nations during the past few years, it is worth noting that globalisation has not substantially gone into reverse.
This has led some economists to characterise it as ‘slowbalisation’ rather than deglobalisation. The KOF Globalisation Index shows only a small reversal in globalisation since 2018, taking the world back to levels seen in 2015. This needs to be set in the context of a vast expansion of globalisation since 1990.
The world is changing, but investors have time to adapt. Nevertheless, there can be little doubt that geopolitical risk factors are exerting a greater force on companies, particularly in key areas such as technology and raw materials. Fund managers who are not on top of this analysis may find risks are not properly assessed and opportunities are missed.
DOLLAR ON THE SLIDE?
The US dollar has been the dominant global currency since the end of the Second World War. It is the leading reserve currency and also the accepted medium of exchange for global commodities such as gold and oil. This gives the US enormous flexibility on its monetary policy, allowing it to maintain a vast deficit, with relatively low borrowing costs. Other countries have to hold its sovereign bonds in a way that simply does not happen for any other nation.
There has, however, been a question as to whether this might all change as the global world order shifts. Will China continue to accept a world where it is forced to hold large reserves of US dollars in order to buy the natural resources it needs to grow? Could the renminbi challenge the greenback as a global reserve currency?
That eventuality is still a way off. “Although China’s share of global foreign exchange reserves (2.9%) has increased sharply in the past four years, it remains a fraction of the US dollar’s (58.9%) and less than the combined holdings of Australian and Canadian dollars in foreign exchange reserves (4.4%),” noted JP Morgan Asset Management in its recent Long Term Capital Market Assumptions Report.
“For the renminbi to become a reserve currency, significant changes would be needed in China’s financial infrastructure. At minimum, they would require the liberalisation of the current account and the removal of restrictions on cross-border capital flows, enabling market forces to determine the currency’s value.” As things stand, with its 20%-plus global share, the euro is far closer to challenger status.
The group warns, however, that in the coming decades, the position of the dollar may be eroded as market participants seek to reduce their reliance on a single currency in an increasingly multi-polar world.
This article first appeared in the April edition of Portfolio Adviser Magazine