Geopolitics: A new global policy consensus- Independent Thought Roundtable

By Jayson Forrest

To better navigate the complexities of geopolitics, investors need to anchor themselves in the big trends taking place globally. Matt Gertken (BCA Research) explains how to apply geopolitical thinking to the macro environment

Whilst geopolitical events can create massive volatility in markets, it’s not always the case that major volatility events have anything geopolitical to do with them. Take for example the Asian Financial Crisis and GFC. However, although both events were not considered geopolitical risks, according to Matt Gertken — Chief Geopolitical Strategist at BCA Research— most financial crises and volatility events typically are geopolitical in origin or have a geopolitical contributor.

Speaking at an IMAP Independent Thought Roundtable (in association with the Pendal Group), Matt says geopolitics are not about random events that occur but rather, are significant tectonic developments that happen.

“As an investor, a major part of understanding geopolitics is remembering to anchor yourself in these big trends or developments,” says Matt. “These trends do eventually have major market consequences.”

As an example, he points to Russia, where there has been a strong correlation of Russia engaging in aggression when the oil price is strong.

“In 1979, there was a peak in the oil price and Russia invaded Afghanistan. In 2008, there was a peak in the oil price and Russia invaded Georgia, and in 2014, coinciding with another peak in the oil price, Russia invaded Ukraine and subsequently annexed the Crimean Peninsula. 

“And in early 2022, when we saw the most recent peak in the oil price, that’s when Russia stepped up its invasion of the Ukraine. Why? Because Russia feels emboldened when it has a significant inflow of money coming into the Treasury with its oil exports.”

According to Matt, if investors had identified that Russia was taking an aggressive approach to reclaim lost Soviet territory, then investors would have known that Russian equities were not a good overweight and that the BRICS (the five regional economies of Brazil, Russia, India, China, and South Africa) narrative was fundamentally flawed. Therefore, investors should not have been surprised when Russia invaded Ukraine in 2022.

However, he concedes for that to have happened, investors would have needed to have paid attention to the underlying major movements in geopolitics, which aren’t always obvious on a day-to-day basis.

“And the same applies for China,” says Matt. “Like Russia, China has sent very important signals to the world about its disposition for private entrepreneurship within the state. It’s very clear Beijing feels threatened by the likes of the tech sector.”

Matt specifically references the disappearance in 2020 of Chinese billionaire business magnate and the co-founder of Alibaba Group, Jack Ma.

“That was a very important signal from Beijing and subsequently, Chinese equities dropped dramatically as a result of the disappearance of Jack Ma,” he says. “Beijing provided a clear signal that it feels threatened by private entrepreneurship, and particularly in the technology space, which can create social networks that aren’t controlled by the Chinese Communist Party (CCP). As such, there is concern by investors that future tech success stories in China can also be interfered with by the CCP.”

According to Matt, the world we live in is shaped by geopolitics. It’s a world of Russian aggression; a world where the U.S. and China have disengaged with each other; a world of heightened nuclear build-up, as Iran seeks to develop a nuclear weapons capability; and it’s a world where the Middle East remains extremely volatile. These factors, he says, must be considered when constructing and managing investment portfolios.

When constructing portfolios with a geopolitical lens, Matt says investors need to be acutely aware that countries do have a tendency to make irrational decisions, as they pursue agendas of national interest. A prime example he points to is military conflict. A country’s prosperity and economic success does not prevent it from making irrational decisions and pursuing military action, as both the U.S. and Russia have done during periods of economic prosperity.

In addition, Matt adds that countries will often sacrifice economic growth in order to achieve other objectives. An obvious example is North Korea, which has invested heavily in its nuclear weapons program to the detriment of its economy.

“And if you think that countries that trade with each other and are economically integrated will not engage in conflict with each other, then think again,” he says. “This view is fundamentally flawed. Economic integration does not prevent countries from engaging in conflict with each other. Even a country involved in a civil war will often result in the entire collapse of that country. The very existence of civil wars means that economic integration cannot always prevent conflict.”

Matt believes that despite Russia’s ill-fated invasion of the Ukraine being the type of geopolitical conflict that other countries might learn from and avoid replicating, he concedes that won’t dissuade some countries from engaging in geopolitical conflict. Specifically, he points to three key examples.

1. China and Taiwan

While Matt believes China was probably not on the brink of invading Taiwan, and even if it was considering a move, having now seen how disastrous the Ukraine situation has played out for Russia and the global support Ukraine has garnered, China will need to reappraise its approach to Taiwan.

“That means the risk of China invading Taiwan over the short-term is not very high. And while we might see some other disruptions with Taiwan, like a trade war, it’s unlikely we’ll see a full scale invasion by China,” he says. “However, over the long-term, there does remain a fair chance of conflict.”

2. Russia and Ukraine

With Ukraine poised to launch a counter-offensive against Russia, Matt believes it’s important to remember that the Russia/Ukraine conflict isn’t over yet. Without a resolution, significant risks remain, which will continue to upset markets going forward.

3. U.S. and China

According to Matt, both the U.S. and China have internal issues facing them, which is creating instability in both countries. The Americans face a period of internal confrontation, as they head towards the 2024 Presidential Election. This follows on from the highly contested 2020 U.S. Presidential Election, and is likely to create a period of considerable polarisation between Democrat and Republican supporters.

Meanwhile, China is having a major problem with its economy as it slips into a ‘middle income’ and liquidity trap.

“With China reopening from COVID-19, many people thought that would immediately revitalise the global economy. It hasn’t,” says Matt. “We’ve forgotten that China’s population is shrinking, the corporate sector is over indebted, households are in debt, and there simply isn’t a large appetite for risk in the private sector.

“So, with the U.S. and China both unstable at home, it will be dangerous for either of these countries to engage in political brinksmanship.”

Matt says the world does need major diplomatic solutions and leadership in order to enable investors to feel more confident, but it’s unlikely we’ll see that until at least November 2024 following the U.S. Presidential Election.

“That’s because everybody wants to know whether the U.S. — the most powerful country in the world — has a stable hand at the tiller. So, for now, the world faces a major security dilemma. The U.S. still seeks to dominate the world, Russia and China are attempting to carve out spheres of influence to prevent U.S. domination in their regions, and the U.S. doesn’t want any country to create a regional sphere of influence. That problem won’t be resolved anytime soon.”

Matt refutes the notion that geopolitics are just random exogenous events. Instead, he believes geopolitics sit firmly inside the macro economic landscape as part of a new global policy consensus, and that consensus is that countries want more national security.

“When countries pursue an agenda of increased national security, this has considerable macro economic implications,” he says.

As an example, Matt refers to two pacifist countries — Germany and Japan — which have begun rebuilding their military capability. Germany is doing so to counter Russian aggression, and likewise, Japan is reacting to China’s growing strength.

“We know that Russia and China have both invested heavily in their military, and the U.S. is not cutting its defence spending. But can other smaller unaligned countries, like Vietnam — which has had nine wars with China throughout its history — afford to reduce their defence spending, when they don’t have a treaty alliance with the United States?

“And how will countries like Poland and South Korea feel when they see Germany and Japan rebuilding their military capabilities,” he asks.

Along with military build-up, many countries are also faced with maintaining social stability at home, as part of their overall national security. Matt says if a country is unstable and people begin agitating or revolting against the incumbent government, then that country becomes weakened relative to its foreign competitors.

“To counter this, countries are going to spend a lot more to incentivise and ‘bribe’ their people not to rebel. This means there’s more spending on a larger social safety net as well, because you need to bribe the people to be calm and not rebel. And this comes on top of spending to build your military, and investing in renewables to reduce your reliance on Russia and Middle Eastern oil,” he says.

“This will create gigantic debt and deficits for countries, as they seek to balance national security and maintain economic growth. But unfortunately, most countries won’t do a very good job balancing those two things.”

Matt believes that when considering the effects geopolitics has on the macro environment and on investment portfolios, there are a number of structural investment takeaways that investors need to be aware of when managing their portfolios. These include:

* War and the preparation for war are inflationary. They impose large demands on the world’s natural resources, as governments and the private sector compete for those assets.

* A new U.S./China understanding is necessary to stabilise the geopolitical outlook. Investors want peace and prosperity, which is good for corporate earnings. Such an understanding (for example, no war over Taiwan) would reduce geopolitical risk. This means a fall in the risk premium, which is good for equities and risky assets.

* An improved U.S/Russia understanding and U.S./Iran understanding would significantly reduce the risk of major global energy shocks;

* In the current geopolitical environment, defence spending is not likely to be cut, as even smaller nations fear for their safety and security;

* Energy supply shocks will persist. This is largely due to Russia’s conflict with Ukraine, and continuing instability in the Middle East, including Iran’s pursuit of nuclear weapons.

* Central banks will continue to have trouble increasing interest rates as much as they need to. The increasing politicisation of central banks is a direct consequence of the challenges facing countries today, including the foreign policy objectives of governments.

“Over the short-term, we will start to see inflation moderate but over the long-term, I believe we have entered into a permanently more inflationary paradigm,” says Matt. “As investors, that’s something we need to get used to, as we seek to navigate the complexities of geopolitics in the macro environment.”

Matt Gertken PhD is Chief Geopolitical Strategist at BCA Research.

He spoke on geopolitics at an IMAP Independent Thought Roundtable in association with the Pendal Group.