Key Takeaways
- A decade ago there was little sight of the seismic changes that have since occurred; similarly, events that might be impossible to imagine today will undoubtedly jolt financial markets in coming years
- In particular, we believe geopolitics will dominate the investment landscape, with increased tariff and sanction regimes affecting trade
- As a result of this, market volatility will argue for nimble active portfolio management as the best way to navigate potential headwinds
“Sometimes I’ve believed six impossible things before breakfast”
To prepare a presentation on what has changed for long-term investors during the past decade I dug out my notes from 2014. The results were sobering.
In October 2014, macroeconomic factors were at the forefront of investor concerns. The International Monetary Fund (IMF) had forecast global GDP growth at 3.3% in 2014, following 3.3% in 2013. Not exactly exciting stuff.
In 2014 a key consideration for investors revolved around the ongoing decline in US Treasury yields (the five-year note was around 1.5% in October of that year). For Central Bank FX reserves managers this led to a discussion on how best to diversify into higher yielding fixed income such as investment grade credit, public equites, and new currencies such as the renminbi.
By contrast, the primary discussion at conferences this year has been the geopolitical situation, or what has been labelled Cold War 2. The change in the political temperature has triggered military action, political pacts, economic nationalism, sanctions and tariffs.
Adam Smith’s policy objective of maximising the “Wealth of Nations”1 is being swapped for one that maximises the “Security of Nations”. Increasingly rival nations prefer to avoid the risks and forgo the benefits of free trade.
Trade patterns have changed. China has tightened its rules on the imported food to encourage domestic production and achieve food security, while in the US the Biden administration is offering incentives to Taiwan to manufacture chips in America. Profit maximisation and efficient use of capital are no longer the paramount drivers of economic investment.
In 2014 we did not appreciate just how pivotal the year would be for geopolitics. In a cynical move just a few days after the closing ceremony of the Sochi Winter Olympics in the February, Vladimir Putin began his grab for Crimea. Annexation followed in March.
Surprisingly, the IMF world economic outlook in October 2014 did not directly address this annexation, but it did mention heighted tensions between Russia and Ukraine. Hindsight is wonderful, but this is a reminder that although we may see the train in the distance, we don’t always appreciate its size until it hits us.
Sanctions regimes were slowly mobilised after Crimea was annexed, and the election of Trump in 2016 facilitated a snowball effect of tariffs and counter tariffs (Figure 1).
Figure 1: The global backdrop – trade restrictions have risen sharply
Source: Global Trade Alert. *2024 extrapolated from September 2024 data
How do we break the spiral?
We observe that the biggest drivers of financial markets in the past decade have been the impossible things that have overwhelmed our carefully considered medium-term quarterly economic forecasts. In 2014, the Queen of Hearts might have considered the following six events as almost impossible to imagine:
The most significant was the Covid-19 pandemic, a global health crisis that was predicted by nobody as it approached us – even though we know pandemics occur. Forecasting that an active volcano will erupt is easy. But forecasting the timing of the next “big one” is difficult – and Covid was big, being responsible for around 15 million deaths worldwide. For comparison, SARS in 2002/03 was responsible for around 1,000 deaths. Pandemic fiscal policy responses in 2020 were massive and created multiple economic distortions which have not been fully unwound. We now have public deficit and debt numbers that were previously unimaginable. Governments have shown an unwillingness to grasp that nettle, but will markets eventually force them to do so?
Russia’s invasion of Ukraine in 2022 triggered the most devastating war in Europe since the Second World War. Historians may point to the sanguine acceptance of the 2014 annexation of Crimea by the west, typified by IMF commentary, as encouraging later belligerence. The all-out invasion of Ukraine led to sanctions, disrupted supply lines and rapid increases in the price of gas and oil that boosted already increasing inflation rates. Most nations saw a 40-year-high headline CPI print. The war also dislocated and reshaped trade flows in unimaginable ways. Russian oil was banned from the EU but welcome in India, which now takes most of the oil that used to be exported to the EU. India pays for a lot of it in UAE dirhams. Who would’ve predicted this?
Third on the list of impossible things would be a TV personality winning the presidency of the United States in 2016 and becoming the leading contender to do so again in 2024. In 2014 the name of Donald Trump did not feature highly on a list of likely presidential candidates. In a world of frosty relations with China, Trump was a willing actor when it came to taking the trade war to China and agreeing a policy of tariffs and sanctions. The portents are for more of the same in 2025 if he wins the election in November.
Next on the list would be President Xi of China engineering a job for life in 2018. Securing his domestic political situation might have encouraged Xi’s appetite for foreign policy adventure. The rollout of the Belt and Road Initiative began in 2013 when it was announced as a trade policy. Over the past decade it has taken on the appearance of an increasingly strategic geopolitical project. Trade and military alliances go together.
The crisis in the Middle East will not have surprised many, but the Hamas incursion into Israel in late 2023 surprised everyone. That was the trigger for the current extreme tension between Israel and Iran. At the time of writing it is not clear how rapidly and broadly this conflict may accelerate, and just how big the human price and economic consequence may turn out to be. The axis of ill-will is a phrase used by the historian Niall Ferguson to describe the alliance between Russia, China, Iran and North Korea.2 Evidence of their increased cooperation and deepening relationship is evident in the exploded materiel on the battlefields of Ukraine. In which military theatres of operation might this axis operate next? Will a confrontation with NATO be inevitable?
Finally, don’t overlook Brexit. A local story, but one that opened the sores of populist and nationalist sentiment that have been bubbling in the UK for many years. View the UK as a petri dish experiment because other western nations have similar undercurrents that could come to the fore and complicate investing. Although the idea of a referendum was introduced in 2013 by David Cameron, the hard Brexit that was eventually delivered in 2020 required several things to happen. Firstly, the Conservative Party needed to win an election in 2015 in which they lagged in the polls; second, the UK had to vote “leave” in the subsequent 2016 referendum, a result which confounded pollsters; and finally the Conservatives needed to deliver a hard version of Brexit that for years was not viewed as likely.
Boris Johnson, a key player in the story and the prime minister who finally “delivered” Brexit, has claimed the development and delivery of Covid vaccines as the best example of the success of Brexit. It is disappointing that a policy of ring-fencing lifesaving drugs and an explicit “my country first” philosophy is today being celebrated as a policy success.
The economic nationalism that ties all these events together has consequences. “Just in case” replacing “just in time” in global supply chains has implications for trade patterns and the price of goods. It will often mean paying more to ensure greater security of supply (ie a higher floor for CPI in future cycles).
For FX reserves managers, who let’s not forget are government institutions, it may also have implications for constructing portfolios – ie building your friends into the asset allocation for what is effectively a national wealth portfolio, and perhaps having to choose which political bloc you want to belong to (for example, towards the US or, for some, towards China).
What about the next 10 years?
Events that might today be impossible to imagine will come to be a feature and will jolt financial market volatility when they occur.
It’s perhaps advisable to think the impossible. There will always be astonishing stories in equity space (for example, Nvidia), but events in fixed income can also be extraordinary. Who would have forecast that over a period of 10 years the Chinese five-year government bond versus the US five-year would swing from +200bps to -200bps?
We can’t forecast unknown unknowns, but we can highlight known unknowns. In 10 years from now Iran’s supreme leader, Ali Hosseini Khamenei, will be 95, Putin will be 81 and Xi will be 82. Although North Korea leader, Kim Jong Un, will only be around 50, his health status is not clear. We predict that regime change in any or all of these countries is coming, but we don’t know what it will look like. Succession planning is not transparent. This will be difficult for financial markets to price accurately and suggests that we will continue to see bouts of amplified volatility.
When will the rubber band on fiscal policy – stretched like never before in 80 years – finally break? Led by the US, fiscal laxness argues for a higher floor for long rates in the longer dated future, ie at the end of the current Fed-inspired bond yield cycle. Will bond investors refuse to buy, or will a first mover on fiscal consolidation enjoy a market response that eventually forces others to follow?
Economic nationalism looks as though it is baked in. As we saw in the 1930s, tariffs and sanctions tend to lead to tit-for-tat responses, and a vicious spiral. It is very difficult to see how this problem can de defused and it will likely be an important theme for the next decade. The question is how best to incorporate the theme into investment strategies.
In 2024 we are in a much more complicated world than in 2014. We should take a page from the Queen of Hearts and try and imagine another six impossible things for the next decade.
The argument is for a nimble approach to portfolio management. Periods of heightened market volatility will be an environment in which active management should beat passive. Investors should make their investible universe as wide as possible, utilise as many investment tools as their guidelines allow, and work with investment managers that have a strong track record.
