Geopolitical considerations and the impact of China

In recent commentaries we have focused heavily on the fundamental risks to asset markets. Our emphasis has been on the risk posed to asset prices by relatively demanding valuations in many asset classes and the risks posed by rising inflation pressure and the implications of this for medium-term central bank accommodation. None of this has materially changed.

One thing we have said relatively little on has been geopolitical risk, not because it isn’t important, but simply because forecasting geopolitical outcomes — especially in the Trump — era is difficult. By and large, geopolitical risks are rarely triggered — at least the big ones anyway. Last year was case in point, where US and North Korean “shirt-fronting” and the seemingly heightened risk of miscalculation by either party did not derail markets. In fact, despite climbing the “wall of worry”, volatility was amongst the lowest on record and market gains outsized. Why? Firstly, because of the low odds of it actually escalating; and, more fundamentally, because the macro-economy was humming (where greed trumped fear).

There are though several important developments that suggest geopolitical considerations will loom larger in coming years. Research by the US Federal Reserve confirms a broad uplift in geopolitical risk, consistent with (among other things) a lessening of the dominance of US economic and political leadership, the growing significance of China as both an economic and political superpower, and exacerbation of wealth inequality as a result of the economic policies pursued by major developed economies post the GFC. Populist politics has become the global norm and this is reshaping the economic and political debate. Given the pervasiveness of the drivers of these developments, this trend is only likely to increase.

The challenge from a portfolio management perspective is how to properly reflect these considerations in our portfolios. While each potential flashpoint will have its own nuances, it is worth considering (as an example) how we are thinking about China.

China’s rise has been dramatic. In the year 2000, China’s economy was US$3.7tn (36% of the US) in PPP terms; it has risen to be currently US$23tn (120% of the US), and by 2023 the IMF forecasts it to be US$37tn (150% of the US). This rise has had a profound impact on the global economy and will continue to be a dominant feature in the future.

We view these impacts through three broad lenses: the re-entry of China into the global economy, the geopolitical implications, and the Chinese economic and financial structure.

Firstly, with respect to China’s re-entry to the global economy, we see the biggest impact as the contribution of Chinese workers to the global labour force, contributing to a sharp fall in the capital-to-labour ratio. This has increased the supply of labour and placed downward pressure on global wages, impacting both inflation and the ability of central banks to maintain low/positive inflation,  extending the business cycle, and lowering economic volatility (although at the potential cost of more financial instability). Internally, we have seen China focus on its lack of capital and embark on an historical investment program, supporting both commodity exporters and countries that produce and export significant amount of capital equipment (Germany is a good example).

Secondly, the rise of China has so far been benign in a geopolitical sense, as the doctrine of “hide your strength, bide your time” (Deng Xiao Ping) has been dominant. However, the ascent of President Xi Jinping has led to a much more aggressive China on the global stage. The two main implications of the political rise of China are a partial de-globalisation of the world economy as it breaks into two strategic blocks — one centred on the US and one on China. Another impact will be an increase in global defence spending as geopolitical tensions rise between the two superpowers. The upside is the boost this is likely to provide for innovation and future productivity. The downside is the increased risk of military conflict. 

Finally, the rapid rise of debt financing of the Chinese economy has seen episodic fear of a financial crisis, with rising debt generally viewed as a precursor to crisis. The unusual nature of China’s credit boom is that it was not driven by excessive demand, but by excessive supply. This is not an inflationary environment and has allowed authorities flexibility to step in whenever Chinese growth begins to disappoint. Losses must be borne from malinvestment at some time, but as long as inflation remains subdued, it suggests that it will be a lowering of growth over time, rather than a big bang approach. If a financial crisis does occur, the chance of a big bang approach is low and it is more likely be a long, drawn out process similar to that of Japan, given the highly interventionist approach of Chinese authorities.

These views have been expressed into our portfolio in several ways. At times we have seen the fear of a Chinese financial crisis rise and we have used this as an opportunity to add risk when this has spilled into financial markets. However, given the uncertainty over the outlook for China, and the potential impact on Australian assets, the portfolio has tended to diversify away some of this risk via a short Australian dollar exposure. We believe the deflationary impacts of the re-entry of China into the global economic system have mostly passed and think markets are underestimating the risk of rising inflation and the portfolio currently is hedged against this potentiality. Lastly, we see the risks of geopolitical shocks rising and believe that in this environment it is more crucial than ever to be cautious about overpaying for assets.

Rising geopolitical risks are likely to present both risk and opportunity in financial markets. Trying to guess the potential of a low probability but high impact event (such as a military escalation) is a mug’s game. That said, markets will episodically overreact and having a more fundamental anchor to our process does allow us to position around these risks.