Since the end of World War 2, geopolitics has been largely incidental to the rise in globalisation and the ascent of global equity markets. Significant global events such as the Cuban missile crisis (1962), the oil crisis (1970s), China’s rejoining of the global economy (from the late 1980s), 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 past these events.
On the other hand, inflation has had a far greater effect on markets over time. Since the 1950s, in periods when US consumer price inflation was on the rise, US equity markets provided a muted return of 3.7%, as opposed to the far more compelling 10% return when the US consumer price index was slowing. The oil crisis was a geopolitical event which had a significant inflation effect and hence also a significant market impact.
Not unlike the 1970s, we now have the unusual combination of bad geopolitics, not only combined with high levels of inflation but with geopolitics arguably creating, or indeed augmenting, the inflation woes.
With this as a backdrop, it is clear that investors can no longer simply ignore geopolitics as they have safely been able to do over the past few decades. Some would now argue that geopolitics is in fact trumping economics. That is, it is — or will be — the dominant factor driving markets. And unlike in the 1970s, when climate change was unheard of, this further geopolitical factor (with global implications) is likewise set to have a material market impact.
One of the challenges with respect to assessing geopolitical 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 and provide sufficient opportunity to either adjust, or even exit, the position.
Adding to the complexity, as geopolitical 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 behaviourally (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 geopolitical events playing out at present are Russia versus Ukraine, and China versus Taiwan. But looking at these too narrowly masks the larger and far more ominous global realignment that is under way — that between the US/West and Russia (a former global superpower) and then China (a current global superpower). The unipolar world that has been in place since the fall of the Berlin Wall, where the US dominated all spheres, including cultural, philosophical, economic and military, is clearly long gone.
The balance of power has now shifted, and significantly so, with the US/West now pitted against the combined forces of the likes of Russia and China but also potentially some others that share an antipathy towards the US/West and possess significant armed forces, including substantial stockpiles of nuclear weapons. This might even be in the form of an enlarged grouping of Brics (Brazil, Russia, India, China and SA). The risk of war, including nuclear war, has arguably not been higher since the Cuban missile crisis of the 1960s. The doomsday clock sits perilously close to midnight.
What does all this portend for capital markets? Many argue that globalisation has peaked, and with such the associated negative effects on international trade, global supply chains and goods availability (from “just in time” to “just in case”). The effect of the above is arguably a double negative in terms of the discount rate applied to cash flows, and hence to the valuation of all assets. That is, the discount rate needs to be higher to account for the higher geopolitical risks, and to the extent that geopolitical risk leads to higher global inflation that would suggest a further, higher discount (interest) rate as well.
To provide some context, the period after then Federal Reserve chair Paul Volcker raised rates to 20% in 1981 was a golden time for assets, a period of disinflation leading to lower interest rates and 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, with some suggesting an “equal but opposite” period lasting a decade or even more. And few believe the Fed, or any central bank for that matter, would have the gumption or political backing to “do another Volcker” nowadays. That is, to raise short-term interest rates well above the current level of inflation so as to comprehensively break the 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 and 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 markets are out of the woods though, especially if inflation does not fall meaningfully, and soon... As always, caveat emptor (buyer beware) applies.
• Silverman is an investment strategist at RisCura.
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