Geopolitical Escalations and Investment Implications

  |   Geopolitics, Asset Allocation

Article from Beat Wittmann, Chief Investment Strategist @ Key Family Partners

Geopolitics Dominate Economics and Business

The single most important factor when it comes to investment decisions is to understand today’s bi-polar world with the US on one side and China on the other, ruled first by geopolitical and national security factors and then by economic and business. This marks a sharp reversal from the end of Cold War in 1989 to Russia’s invasion of Ukraine in 2022 dominated by globalization and the dominance of trade and business.

The conclusion of Chinese president Xi’s recent trip to Europe and Russian president Putin’s trip to Beijing subsequently was crystal-clear. China’s prime objective is to politically divide Europe while supporting Russia’s military attack and ongoing escalation on the European post WW ll security order, meanwhile preserving and benefitting from its huge trade surplus. Russia’s objective is to support China politically to pursue a multipolar world order and secure maximum support for its hot war at Europe’s Eastern Front.

The Rising Cost of Compounded Miscalculations in Moscow and Beijing

Both China and Russia keep miscalculating Europe and the US politically, militarily and economically. Nonetheless, neither China nor Russia appear to change their course of assertive policies and hostile actions. It is crucial for Europe to accept that Russia will only understand the language of military defeat in Ukraine while China will only understand the language of sanctions against their support of Russia’s war in Europe and tariffs against damaging trade practices with a focus on strategically sensitive sectors.

The macro ramifications mean a rapidly worsening geopolitical backdrop, a deterioration of European-Chinese trade relations, upcoming second round sanctions and tariffs from the US and Europe against China and a massive tightening of sanctions against Russia including western businesses continuing to pursue their Russian activities.

Normalizing Global Economic Cycle – Potholes and Bright Spots

A direct economic consequence of the fast worsening geopolitical outlook and strategic rivalry regarding China and Russia will be a tight and bitterly fought race of the upcoming US presidential election by November and the European Parliament election by June.

Throughout 2024 and into 2025 we expect a risk of declining world trade and growing protectionism resulting in weaker growth and in the rather unlikely but possible event of an oil price spike due to Russian and Mideast supply disruptions resulting in a stagflation environment.

On the other hand, the underlying forces of a new structural growth and productivity cycle in the US driven by investments in technology and artificial intelligence, manufacturing, defense and critical infrastructure are of generational proportions.

On that note, the current decade could be driven by an eclectic economic policy-mix of Keynesian-type macro and of Schumpeterian creative destruction dynamics of investments in productive capital and innovation cycle – often triggered and reinforced by armed conflicts and their aftermath of re-construction.

Testing Times in Europe – Elections and Draghi’s Report on Competitiveness

Europe needs a real crisis to reform and to progress in relevant institutional ways – and the 2020s have seen a multitude already. In other words, there are no excuses nor time to be wasted for Europe to decisively address political and economic paralysis and fragmentation. First and foremost, there is no alternative to counter Russia’s threat to Europe other than decisive steps towards strategic autonomy with a focus on collective defense and a sustainable energy transition.

In early June Europe will be holding elections and, most importantly, ensuing appointments to EU institutions, notably the president of the EU commission. What we all watch out for and will be studying closely is Mario Draghi’s report on the future of European competitiveness. The next European Commission is set to put competitiveness at the top of its political agenda.

The FED’s Dual Mandate – Stable Prices and Maximum Employment

The monetary policy goals of the FED are to secure economic conditions characterized by stable prices and by maximum sustainable employment. Finally, sustained progress at the inflation front has allowed the FED’s focus to shift from inflation rates to labor market conditions.

The number one factor to watch regarding the outlook for global capital market developments remains the FED’s policy against the backdrop of US growth and the inflation outlook. In recent months, inflation and interest rates have stayed put, yet normalizing cyclical forces will at some stage prevail and declining numbers will follow weakening labor market indicators and easing wage pressures.

At the same time, the global inflation outlook is favorable and therefore supporting the US as European economic conditions remain anemic and China’s economy with little hope for improvement and a continuing deflationary bias.

The conduct of monetary policy and its transmission into the real economy including predictions regarding inflation and interest rates have become ever more difficult. A multitude and often overlapping cyclical and structural cross currents and event risks including wars and proxy conflicts have led to this.

More specifically, we mean the end of globalization as we know it, the growing impact of transformative technologies and ai, the re-industrialization through on-shoring and friend-shoring and the onset of huge investments in all areas of critical infrastructure against a backdrop of excessive and unsustainable debt burdens and unfavorable demographics.

Asset Allocation – Preserve and Grow Strategy

It is a fact that financial markets are not good at anticipating and pricing important geopolitical shifts and events. Typically, respective reactions and adjustments are lagging, yet, suddenly, swift and brutal, particularly in less liquid capital markets.

Equities, fixed income and gold have performed very well, a correction is overdue and would be healthy from a longer term perspective. Investors’ sentiment is rather complacent given the worsening geopolitics as manifested and measured by market volatility which is still low and correspondingly equity insurance cheap.

We remain defensive regarding exposure to corporate bonds as they have experienced extraordinary spread tightening, are expensive, have a poor risk/reward balance and are not justified by macro economic conditions. We would particularly avoid corporate high yield credit exposure all together for valuation reasons and focus on either cash or high grade government bonds.

Favored Equity Theme – Defense, Security, Industry and Technology

Global equity markets have performed well despite the headwinds of the FED’s interest rate policy due to sticky inflation but well supported by the tailwind of improving and strong corporate earnings. Structurally, equities remain the asset class of choice, and we would use any correction or consolidation to buy investment exposure to our preferred geographies US, Europe, Japan and ASEAN.

Regarding investment themes, our favored sectors are the defense-industrial-technology space, key areas of critical infrastructure, particularly climate change-energy transition and consumer sub-sectors focused on healthy lifestyle and longevity.

Attractively valued special situations can be found in private markets, especially in listed real assets that are trading at extraordinary discounts to net asset value.

Top-Down Risk Stagflation and Bottom-Up Risk Western Firms in Russia

Needless to say, sudden and generally unexpected news have an impact on capital markets. We advise to think of two risks to investments, one on the top-down side and one on the bottom-up side.

The importance of the FED and US policymaking at large to the global economy and capital markets cannot be overstated. Should the US unexpectedly slide into a recession in 2025 while at the same time oil prices spike due to a geopolitical crisis, risk taking and financial investments would be severely punished by an ensuing stagflationary environment.

Concerning bottom-up risk – we advise to firmly stay away or disinvest from firms still doing business in Russia. Just think of the US Treasury threatening Raiffeisen Austria to cut their access to the US financial system because of their ongoing operations in Russia – a crystal clear warning to all Western firms still operational in Russia.

Furthermore, we expect an overdue revision of ESG criteria. It is an enigma that for example companies like Swiss Nestlé, the world’s largest food and beverage company, are considered ESG compliant despite continued operations in Russia and as such indirectly supporting Russia’s war against Europe. On the other hand European defense and technology groups such as German Rheinmetall are not considered ESG compliant and therefore for many not (yet) investable.