Given the shifting geopolitical picture, there is a concern that we could be entering a world divided into blocs which are even starker than during the Cold War. The US, Europe, Japan and other developed countries will be on one side; Russia, China, India and the main oil producers would be on the other.
This could dramatically reshape how things are done within the global system, not least the impact on how institutional investors invest.
The war in Ukraine has already led to most institutional investors pulling their investments in Russia. The question is, could this be the beginning of a wider trend, where investors may have to stay within their own political bloc?
“Possibly,” says, Richard Tomlinson, chief investment officer of Local Pensions Partnership Investments (LPPI). “It’s hard to say how the next decade will evolve and whether formal restrictions will be expanded to limit where capital can be deployed.”
Having said that, Tomlinson identifies an investment trend that has emerged. “Risk appetites have certainly moved, generally coming down and pushing into more familiar, ‘safer’ assets. This is likely to play out in reducing allocations to areas that are seen as less ‘friendly’ and where assets are not always governed by a clear and stable legal framework.”
But he does have questions over the seriousness of the scenario. “It’s definitely a non-zero probability that we enter into a perilous Cold War period in the next few years and investors are essentially forced out of large regions of the world. I don’t see this as a base case though,” he says.
Geopolitical risk
“Not necessarily staying within our ‘own bloc’,” says George Graham, director of South Yorkshire Pensions Authority (SYPA), addressing the same point of investors being restricted to their designated bloc of influence. “But I do think we are likely to see geopolitical risk in its various forms being weighted more heavily in investment decision-making processes, which also might lead to asset owners looking for products defined in different and more granular ways.”
For example, Graham says: “People might look for products which focus on some countries and not on others, particularly within emerging markets to reduce the amount of geopolitical risk exposure.”
But David Vickers, chief investment officer of Brunel Pension Partnership, says it’s better to arrive than to travel. “If it came down to a bloc situation, yes it would be a problem. But the bigger problem will be the journey to that. It would be bad for the world over.”
What could this mean for investors, particularly pension funds – in terms of asset allocation? The changing situation for SYPA is propelling thinking already under deliberation. “We are already considering the level of our emerging market exposure as part of our strategy review, although this is driven by a consideration around whether we still buy into the emerging market growth story to the same extent as previously,” Graham says.
“If the bloc premise is correct, then you might expect to see some shift away from emerging markets as they will become more difficult to invest in as the geopolitical competition creates more trade barriers,” Graham adds.
We are clearly moving from a globalised world where most major players ‘play nice’ to one of reduced trust and lower co-operation.
Richard Tomlinson, Local Pensions Partnership Investments
Long horizons
Looking at the situation, Tomlinson says LPPI will broadly hold tight. “In the short term, we are unlikely to change much. Our clients have long investment horizons and our senior team have all managed money through multiple market cycles so we tend not to chase the latest ‘hot’ area.”
In most asset classes, LPPI tend to skew towards the quality end of things, Tomlinson says, and seek to minimise unrewarded risks. “We do have some exposure to emerging markets but it is small. In my opinion, governance, legal and misappropriation risks are frequently underestimated when looking outside developed markets.
“That’s not to say you cannot invest successfully, but you need a different playbook and specific local expertise,” he adds. “Due to this, our portfolio is pretty well positioned at present if we do move into a splintered world but we are always challenging our thinking and assumptions.”
Tomlinson does though come back with a more cautious scenario envisaging a disruption when taking a more medium-term view. “There is a real risk that the next decade or two could look very different to the period where most investors today have been managing money. Not many of us were investing pre-Volcker. I was about to start primary school when he took the helm at the Fed.”
Expanding on this further, Tomlinson says the disruption is a real and potentially serious proposition. “The implications could be significant over the next decade,” he says. “We are clearly moving from a globalised world where most major players ‘play nice’ to one of reduced trust and lower co-operation.”
This will naturally have its own negative ramifications. “De-globalisation and building additional redundancy into supply chains will likely be inflationary. It’s now about security of supply and not just driving costs to the lowest level,” Tomlinson says. “Increased geopolitical tensions are likely to lead to higher average risk premia, so all else equal, this will mean lower asset values.”
A new regime
For Emily Haisley, managing director of risk and quantitative analysis at Blackrock, geopolitical disruption is also real, problematic and one in which investors need to be aware. “A new regime is taking hold,” is how she describes it, “but we do not see this yet reflected in the pricing of stocks and bonds.”
Interestingly, Haisley puts the focus on developed markets and the Western bloc. “We have cut developed market equities to underweight. We see an increasing risk of the Fed overtightening, expect growth to stall and see earnings estimates as overly optimistic.” This presents quite a list for investors.
In addition, heightened volatility often creates greater market mispricing, therefore investors need to be on their guard, Haisley says. “The new regime requires being nimble and using frequent tactical changes.”
Derrick Irwin, portfolio manager at Allspring Global Investments, says there is a balance between different bloc markets that need to be identified. “It is likely that correlations between emerging and developed markets will continue to fall, adding to the diversification benefit of emerging market assets for global investors,” he says. “Diversification will be critical as the downside from asymmetrical risks – such as a conflict over Taiwan – will be significant for emerging and developed markets.”
The rapid and nearly complete severing of Russia from the global financial system offered a glimpse of the worst-case scenario for how this new world order could evolve.
Derrick Irwin, Allspring Global Investments
Security spending
An interesting development in the shifting geopolitical picture means national and regional security concerns could well drive significant outward investment – the decision by the United States to build a new military base in Poland is a noteworthy example.
“Geopolitical competition is often a driver of government spending on innovation, as numerous examples from the Cold War attest. Re-orientation of supply chains – ‘friendshoring’ as former Fed chair Janet Yellen described it – will create new economic hubs,” Irwin says. “For example, trade between the US and Mexico has been growing faster than trade between the US and China since 2018, and we expect this to accelerate.”
The emerging market picture is bound to change, as they will be central to the competing bloc scenario. “The investment landscape in emerging markets is changing, and it will be critical for institutional investors to understand which companies will be winners and losers as the playing field shifts,” Irwin says.
But there are also positive effects. “Opportunities will also emerge, particularly in emerging markets,” Irwin says. “The battle for secure supplies of commodities will likely lead to greater investment by China and the West in key commodity producing countries, particularly in the emerging world.” This suggests a competing bloc picture could well be more nuanced and not so easily divided into pure dogmatic blocs. At least, if this picture prevails.
Moreover, it comes at a time when emerging market assets appear attractive for long-term investors. Valuations are inexpensive, in absolute terms and relative to developed markets and particularly relative to US equities.
“After a decade of underperformance, investor positioning is very light,” Irwin says. “After a difficult few years, key economies in emerging markets are stabilising and should grow faster than developed markets over the next several years, and many factors should act as a medium tailwind for growth,” he says.
In addition, it will be harder for global investors to act as ‘tourists’ in emerging markets, Irwin says. “The regional, country and company dynamics have become more complicated and much more expertise will be required to be successful in emerging markets.”
Here a granular, bottom up understanding of company fundamentals will be critical for investment success, Irwin says. “Each company will be impacted by regulatory and geopolitical moves in a different way, and will react based on their unique competitive advantages,” he says. “Without understanding these drivers, investors will find it hard to take advantage of geopolitical trends.”
Vickers notes the challenge of looking at the changing geopolitical picture. “Everything is a possibility. Your job as an investment professional is to think about all the possibilities, about the probabilities and about the magnitude. It could be high probability but low impact, so worry less about that. It could be a reasonable probability, but real high impact, so you have to think about that.”
Chinese influence
On the prospect and the damage of the bloc stand-off scenario, Vickers says it is important to separate between Russia and China, geopolitically and in investment terms.
“As Russia put boots on the ground in Ukraine we asked managers to exit where they could. And that was quite easily done,” he says. “You start to think about China – it is 40% of the MSCI Emerging Markets index – its influence is much greater and the number of global companies involved in the country much larger. It is much more important in terms of the global economy. That would be hard to unpick.”
This is a point shared by Irwin. “The rapid and nearly complete severing of Russia from the global financial system offered a glimpse of the worst-case scenario for how this new world order could evolve. However, despite Russia’s size and importance in the commodity market, it was largely irrelevant to most areas of global trade.
“China and its allies are significantly more integrated into the global economy,” Irwin adds. “A similar complete break with the West would be far more destabilising and is unlikely. Instead, heightened competition for resources and the push for economic self-sufficiency will have implications for investors. The cost of capital is likely to rise, competition for secure supplies of commodities will put a floor on their price, and trade friction will increase.”
Looking beyond the range of disruption outcomes, Graham tries to put a positive slant on the narrative, highlighting that, as serious as it may be, it could lead to good outcomes. “Trying to look at things more from a glass-half-full point of view, would be that in the developed market economies the challenges that are caused by higher inflation caused by dependence – for example – on Russian gas should be a spur for innovation to facilitate moves away from these sorts of dependency, which should present opportunities for investors, as well as hopefully accelerating progress to decarbonisation.”
There is though room for a big downside, returning to the example of China, especially if tensions between China and the West continue to increase. Taiwan will remain a potential flashpoint for the foreseeable future.
But Irwin urges caution on such an analysis, which in turn could limit a blanket bloc scenario. “Both sides appear to be looking for ways to ratchet down the tension, as progress on the American depository receipts delisting issue shows,” he says. “China is not Russia, and we think it will look for ways to work with the West wherever possible.”
Hopefully such an upbeat outlook proves correct.
But in this fraught geopolitical environment it would not take much for things to wrong and a disruption to take a turn for the worse.
Comments