The World Spins Madly On: Why geopolitics matter for investors

After some fits and starts to begin the second quarter, markets look to end April back at new highs. While global economic growth continues to tick upward and U.S. corporate earnings are coming in strong, attention remains focused on heightened geopolitical risks and their potential implications for investors. “Safe haven” assets, such as gold and U.S. Treasuries, have caught a strong bid so far this year.

As the new administration has recently learned, navigating the geopolitical landscape is much more complex than trying to implement a more business friendly agenda to boost economic growth. International relations are a tangled web of foreign policy, international integration, economics, politics, trade, geography, diplomacy, culture, religion, and military dealings. Predictions as to how things may play out over the near term are therefore fraught with uncertainty. However, we have identified seven key themes that are likely to generate risks and opportunities for investors in the coming months:

  1. Destabilizing effect of reactionary states. In a 2012 presidential debate, President Barack Obama responded to GOP presidential hopeful Mitt Romney’s statement that Russia was a political threat by quipping, “The 1980s are now calling to ask for their foreign policy back.” Just four years later, Russia and President Vladimir Putin dominated the presidential race headlines almost as much as the two candidates themselves. For many, it appears as though Russia is not trying to pick sides or manipulate outcomes so much as it is trying to deepen the already extreme partisanship in Washington and other Western countries with the ultimate intent of undermining faith in democracyThe U.S. military’s recent retaliatory American strike in Syria and the dropping of the largest ever non-nuclear bomb in Afghanistan have also been interpreted as the new administration sending a warning message to Iran and North Korea. While the previous administration implemented a policy of containment to prevent Iran from obtaining nuclear capability, it remains a wild card in the Middle East in its ambition to dominate the region. Perhaps today’s biggest concern is the existential threat from a nuclear-armed North Korea due to its proximity to Japan, China, and South Korea. If military force were required there, the results could be globally catastrophic.
  2. Terrorist threats from extremists. The world faces the twin threats of Al Qaeda and ISIS as they continue to compete for both territory and supporters, using increasingly random and barbaric tactics that have become more difficult to anticipate. This struggle is upending immigration policy across the Western world. While the U.S.—famously called a “Nation of Immigrants” by President John F. Kennedy—has become embroiled in controversy over whether “extreme vetting” of refugees is constitutional, Germany, under Chancellor Angela Merkel, has continued to assimilate immigrants. There have been significant challenges associated with accepting such a large influx of people in so short a period, but the German government is making an economic bet that if it can assimilate immigrants successfully, Germany’s competitiveness will increase over the long run.
  3. Threat of cyber terrorism. What at one time seemed like the plotline from a sci-fi movie is now one of the biggest global threats to governments, businesses, and individuals. The threat of cyber terrorism comes from three sources: nation states like Russia whose aim is to destabilize countries; criminals intent on stealing intellectual property; and terrorist groups. The third source may be the most difficult to protect against since the absence of any “home address” makes retaliation for cybercrime difficult or impossible to carry out. In 2016 alone, Yahoo reported the data breach of one billion account holders, and an attack on a Ukrainian power grid was the first confirmed instance of hackers leveraging malware to access computer and network systems to cause a power outage. The biggest story, of course, was the breach of the Democratic National Committee’s systems and how that may have influenced the outcome of the U.S. election through the information published by WikiLeaks. The rise of cyber terrorism has also led to a burgeoning industry of cybersecurity startups. According to CB Insights, cybersecurity funding deals reached a record high last year, and the third quarter was the most active quarter for deals with cybersecurity companies in the last five years. Tremendous growth in this industry is likely to continue as the world invests in securing its interconnectedness, creating opportunities for agile and deft venture capital investments.
  4. The rise of populism. Balentine discussed this trend at length in our 2017 Capital Markets Forecast. The main concern now is the threat of global contagion. As author Ian Fleming wrote in Goldfinger, “Once is an accident. Twice is a coincidence. Three times is an enemy action.” Brexit was the first expression of a rising tide of populism, and the election of President Trump was the second. All eyes turned to the French election, with many wondering if “Frexit” is imminent, which would signal the death knell of the European Union. However, the first round of the French election ended with Macron taking most of the votes. Additionally, the election loss of “Holland’s Donald Trump” and the recent strength of Chancellor Merkel’s party in Germany all suggest Europe is rebelling against the populist cause in favor of moderate candidates. But then how reliable can polls be after their dismal performance in 2016? One of the main fears about populism is that economic nationalism could degenerate into trade protectionism. Many economic historians view it as one of the main reasons why a severe recession in the 1930s turned into the Great Depression. Today’s brand of populism also views the question of “free v. fair” trade solely through the lens of economic benefits and costs; this is understandable given how reluctant politicians have been to acknowledge that there are winners and losers from free trade, even though, in aggregate, populations are better off. Yet that should not detract from one of the important ancillary reasons for free trade agreements across regions, which is their ability to bind the geopolitical interests of aligned countries. Despite early threats of altogether abandoning the Trans-Pacific Partnership (TPP) trade agreement, President Trump now says the US will “not pull out of NAFTA”, but rather “he’ll re-negotiate.”
  5. Bilateral relationship between U.S. and China. Consider this: China poured more cement between 2011 and 2013 than the U.S. used in the entire 20th century. Make no mistake about it, while the United States and China trade and cooperate in many spheres, such as climate change, China is by far the United States’ greatest strategic competitor given its growing economic clout. It has been the marginal consumer of almost every commodity for over a decade, highlighting its importance to commodity producing countries like Australia and Brazil and many other countries in the developing world. China is an ambitious power, yearning for a greater voice at multilateral institutions, such as the United Nations, World Bank, and International Monetary Fund. It is engaged in a delicate transition to a more sustainable, less investment and export driven, economic growth trajectory that is underpinned by greater domestic consumption. Many doubt that its economy today is as strong as reported due to the lack of transparent data. However, what is clear is that the Chinese have had to fuel large private sector credit growth to boost domestic demand and fill the excess capacity created by the enormous infrastructure spending that they have undertaken over the last decade. The longer-term effects of their “one child policy” also looms as a structural demographic headwind. For these reasons, currency markets have devalued the yuan every time the Chinese have hinted at moving away from manipulating its value. Later this year, the Chinese Communist Party holds its 19th National Congress to choose its leadership for the next five years. This event will be closely watched for the direction of policy and the likely balance between cooperation and competition underpinning the world’s most important bilateral relationship.
  6. Washington remains dysfunctional. As we have been reminded this year, waiting for change on Capitol Hill is like waiting for Godot. House Speaker Paul Ryan’s failed attempt to repeal and replace Obamacare was a heavy blow to the idea that a single party system would be able to shift the direction of fiscal policy and regulation quickly and efficiently. Today’s highly partisan and short-term political atmosphere means that change in any direction will only come slowly and incrementally. The current debate about whether the new administration’s planned infrastructure spending and corporate tax reforms can be deficit neutral is just one example of this. Though our debt-to-GDP ratio has moved in a more sustainable direction in recent years, the truly unsustainable element of our deficit is the current and projected growth in spending on our entitlement programs. Addressing the need for entitlement reform head-on would allow more scope for the broad simplification and long-overdue overhaul that our tax code requires. Yet no politician wants to raise those long-term, difficult choices in today’s climate. The last time we were able to legislate comprehensive tax reform was in the mid-1980s. Not only was it formed in an environment of much greater collaboration and bipartisanship, but it took two years to achieve.
  7. Opportunities lie in four industry revolutions. Four industries are driving innovation that may disrupt today’s geopolitical landscape. In the technology industry, advancements in 3D printing, the interconnectivity of the “internet of things,” and the need for cybersecurity are all revolutionizing how firms do business with one another. Our understanding of DNA sequencing and testing is pushing our understanding of life sciences in the health care industry to new frontiers. In the energy sector, hydraulic fracturing (“fracking”) technology has broken the old dynamics that gripped the oil market for decades and nudged the U.S. to the cusp of energy independence. In manufacturing, robotics are driving huge gains in productivity growth. In all four of these areas the U.S. is at the forefront of these revolutions, capitalizing on its innovative technology, entrepreneurial spirit, and deep capital markets.

While geopolitical events may be hard to predict over the short term, when viewed through the prism of these seven organizing themes, it is easier to identify how they may shape economic and market performance in the years ahead.

This blog post is a direct result of a client inquiry. If you have a specific question related to any financial, investment, wealth management, or economic topic, please email us.

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