Spotlight on a fragmenting world: geopolitical shifts and the consequences for investors
We explore how geopolitics are impacting the global economy and examine the implications for markets.
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What does the shift towards more nationalist politics in the recent European parliamentary elections mean for global markets and economies? Does it accelerate or dampen changes already seen since 2016, a significant year geopolitically when the UK voted to leave the European Union (EU) and Donald Trump won his first US election.
These, and subsequent events, such as Covid and Russia’s invasion of Ukraine, have tested the world economic order. Philip Chandler, Fund Manager and Head of UK Multi-Asset, Jean Roche, Fund Manager, Pan-European Small and Mid Cap Team, Azad Zangana, Senior European Economist and Strategist and Alex Starritt, Chief Intelligence Officer at Minerva Research, discuss the implications of these shifts.
Economic and market risks of “fantasy fiscal politics”
Alex Starritt: "From the beginning of the Thatcher-Reagan era until 2016, the basic idea of government was stay out of the way of the economy, privatise, liberalise, free trade. Since 2016, we've been in a different world, and nobody quite knows what the outcome is going to be yet, what the new equilibrium is going to be. I think one of the major questions is whether the new currents of popular discontent become integrated into the existing framework, à la Italy’s prime minister Giorgia Meloni, or whether they become destructive."
Azad Zangana: "These new nationalistic political currents could certainly see a more populist tilt to fiscal plans, which typically means more spending, tax cuts, and looser fiscal policy. Now, this should actually be quite good for economies and stock markets, as long as they don't lose the confidence of the bond market, and the bond market continues to be reasonably well-behaved. Everything goes reasonably well, even if the politics gets a little bit messy."
Azad Zangana: "When such plans lose the confidence of the bond market, that's when we end up in a Liz Truss moment, and suddenly we have austerity coming back with vengeance, which ends up being very negative for those economies. There's a very difficult balancing act. Italy seems to have found the correct side of the bond market."
Philip Chandler: "Aside from short-term volatility, the key thing about elections and politics is to think about their potential long-term implications. Ultimately, the returns from assets depend upon demographics, technological innovation, investment, artificial intelligence (AI), climate change. Those are the things that impact long-term returns. You often find that most elections don't have a huge impact upon long-term return drivers, but they can create short term volatility that we have to be mindful of."
“Duration mismatch” and obstacles to sensible decision making
Jean Roche: "Some CEOs are in their jobs for a decade or more, and you can see them delivering over time and making a series of sensible decisions. These are the corporate leaders which in the past might have said “our margins stop at 5%”, but you see them move up to 7% over 10 years. You can believe these CEOs, unlike maybe some government pledges. You can say they have a record. They have delivered. What this comes down to is they don't have that duration mismatch which politicians suffer from."
Alex Starritt: "Unfortunately one of the things that I think will definitely happen is that the European-level push for a green industrial policy is going to get nixed. That is the consensus position, I think, at this point."
Philip Chandler: "That has a huge implication on potential long-term returns. I mean, work that we've done, looking at the impact of climate change, rising temperatures on different countries, and the impact that it has upon output and productivity. If you don't have Europe leading on the climate agenda, who does? Presumably it's China, which has done a lot more than I think most people realise. But if you slow down the move to dealing with climate change, it has implications for long-term returns and some companies. There will be some winners and losers in a way that we haven't had over the last 15 years, where you've often seen very high correlation within sectors."
Jean Roche: "Yes, you might want to think, well, are the insurers taking that into account? Are the property companies taking that into account? You're already seeing some discounts in some areas as the market is already pricing in a move away from green pledges. For the property sector this could be things like flood risks. For insurers it could mean having to pay out a lot more than they have previously for certain climate-related events."
New direction for European green policies?
Azad Zangana: "One of the big mistakes that Europe made in the last decade was focusing too much on carbon pricing and essentially the stick to punish people to push them away from using fossil fuels and more towards green energy. One thing that we learned with the introduction of the Inflation Reduction Act (IRA) in the US was actually subsidies are more popular than taxes. They do exactly the same thing. They close the gap between the cost of renewable energies and fossil fuels. The EU’s Carbon Border Adjustment Mechanism is a potential fix, especially if we can see some multi-lateral agreement here. It’s encouraging that the UK, Canada and even the US are also looking at similar schemes."
Alex Starritt: "The political justification would be that you use the combined market power of the US and the EU to change behaviour in other parts of the world. Because if you have to pay the carbon border tax as a Chinese manufacturer, maybe that pushes you, incentivises you to switch off coal, for example. The real political justification would be that it protects “our jobs”, it protects “our companies”. I do think there's a good chance of that. But the one thing I think is also important here is support for new technologies and moving off old technologies."
New technologies, expectations, and UK defence
Jean Roche: "Defence has been one of the strongest performing sectors within the UK, which punches above its weight in this area. You've had the AUKUS agreement between the US, Australia, and the UK, which shows the power of UK defence and technology. We see defence as inexpensive technology companies, you can see a lot of dual use, so commercial use as well as use within the military."
Jean Roche: "The UK has a really good selection of UK mid-cap defence companies which are securing quite large contracts. While its history has been a little patchy in terms of scale-up, the UK has a very strong STEM (science, technology, engineering, and mathematics) history – don't forget it was the birthplace of the internet."
Philip Chandler: "The question is how meaningful are trends like AI going to be through time? We all agree it’s going to have a big impact, but I suspect we all disagree over what time frame the impact is going to occur. Companies are really only now taking advantage of some of the things which we saw in 2000 around cloud computing, for instance. The ability to work remotely, to store data remotely, and not to have people chained to a PC at a specific desk with a server in the building. That took 20 years to occur. The rate of technological implementation is dramatically faster today than it was 200 years ago with steam and electricity, and compared to the year 2000 even, but probably not as fast as some people are thinking."
Overlooked markets and beneficiaries of new world order
Jean Roche: "When you look at the valuation opportunity and the quality of UK companies you'd be buying all day if you didn’t know they were UK. There are UK companies with the exact same profitability and growth prospects as their US peers but the UK ones gets priced more cheaply. Well, if public market investors won't pay up, somebody will take these companies out on the cheap. In the year to date we've seen two and a half times the normal level of UK merger and acquisition activity. Bid premiums are in the order of 40%. So maybe it's time for the UK to be seen for the high-quality market it is. London has recaptured its crown from Paris as Europe’s largest equity market, another sign perhaps of an improved outlook for UK equities."
Alex Starritt: "As the world essentially fragments more and more economically, there are a few countries which gain incredibly, and Vietnam is one of them. They gain from being friends with everybody. Vietnam has really deep relations with the US, which is investing in building microchips there. It's got really deep relations with China, which is putting lots of its factories there to export to the US. It's got a really old relationship with Russia as well, which provides lots of its military technology and lots of its energy technology."
Alex Starritt: "Vietnam is one of those interconnected countries. Mexico is obviously one as well. Meanwhile, Morocco is often overlooked, but has free trade agreements with both the US and the EU, which makes companies there eligible for IRA credits. Morocco also exports more cars to the EU than China does."
Avoiding losers as the economic regime shifts
Azad Zangana: "It makes sense for some companies to no longer produce everything in China, shifting production to India, perhaps. We're seeing a lot of change to supply chains across the board, and that inevitably means there's going to be some really nice opportunities. It also means there's going to be some losers as well. Naturally, that really lends itself to being a more active fund manager."
Philip Chandler: "We had this wonderful period from 2010 to 2020 of low inflation where central banks were able ride to the rescue and cut interest rates every time there was a problem. The resulting negative correlation between equities and bonds acted to suppress volatility. A deterioration in the growth inflation trade-off as a result of the 3D Reset means we expect central banks to be more constrained going forwards. Investors won’t be able to rely upon that equity bond diversification to manage volatility.
"There is also going to be divergence between companies. There are going to be some companies that move production from China to elsewhere, and do a very good job, and it's seamless. There are going to be some companies that fall over. If you think about how you tackle demographics, if you are a company that's able to automate, then you can deal with a shrinking pool of labour."
For a description of bolded terms, see below
3D Reset Schroders’ characterisation of major shifts occurring in the global economy and markets in the “three Ds” of decarbonisation, demographics and deglobalisation.
Austerity When fiscal policies are principally focused on reducing a country’s public debt, often through spending cuts and higher taxes.
Carbon pricing/taxes The EU has led with mechanisms which put a price on carbon, or carbon taxes to incentivise the decarbonisation of the energy, transport and heating systems.
Carbon Border Adjustment Mechanism, or CBAM Legislation forcing companies that import into the EU to purchase so-called “CBAM certificates” to pay the difference between the carbon price levied in the country of production and the price of carbon within the EU.
Correlation: The degree and direction to which two assets move in relation to each other, as measured by “correlation coefficient”, where -1 is a perfect negative and +1 is a perfect positive correlation.
Fiscal policy Means by which government policy makers attempt to manage the short-term fluctuations in economic activity through taxation and spending decisions.
Green industrial policy: A way in which policy makers attempt to manage long-term competitiveness of their green technology sectors, either through subsidies and tax credits, or carbon pricing/ taxes.
Growth inflation trade-off Lower growth is the consequence of higher interest rates required to slow economic activity and inflation and restoring “price stability” for the smooth functioning of economies.
Inflation Reduction Act and IRA credits US legislation offering subsidies and tax credits to green technology sectors. This is seen as the “carrot” approach to incentivise decarbonisation, in contrast to the “stick” of carbon pricing/taxes historically preferred by the EU.
Merger and acquisitions (M&A) Transactions involving two companies combining, particularly relevant in the UK public markets at present given a high level of “in-bound” bids from overseas companies.
Mid-cap Used to describe the relatively smaller public market companies at the earlier stage of their development, and which perhaps offer better growth prospects than the more mature incumbent “large-cap” companies.
Scale-up The area of capital markets specialising in “scaling up” early stage private companies which may require a number of funding rounds to accelerate their growth. Capital markets describe the broader system which channels savings, or capital, from lenders to borrowers including companies, governments and individuals.
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