A light thesis on why geopolitical events don’t translate into market events.
“GEO-MACRO “: A new Investment Framework
We tend to get caught up on what is going on in the world of geopolitical tensions and events, but they don’t have the impact on markets that we expect. Over time, long term alpha (investment returns over and above the benchmark) are generated by market fundamentals and large scale geopolitical events. The shorter term is influenced by smaller economic events and smaller geopolitical events, such as whether we think there may be a recession, or what the outcome of the US elections may be. Look at this chart which explains this phenomenon:
The green line is an objective measure of geopolitical risks – for example the number of Hezbollah rockets being fired on Israel, the number of Covid hospitalisations during the pandemic or the number of civilian casualties in the Ukraine/Russia conflict. We rely on journalism, social media and organisational data to gather this information. However, we do not read newspapers for a living, nor do we opine on the morality or significance of these events, we are trying to make a call on how the markets will react. The market is a brutal, inhumane discounting mechanism, so when the market senses that the objective data has turned, the risk premium of the geopolitical event reduces. The impact of geopolitical events is much shorter than people expect. People still talk about the Ukraine/Russia war, but the impact on financial markets has all but been priced out. The market has moved on from the conflict.
An interesting study is to look at crude oil and natural gas at the beginning of the conflict. The assumption was that there would be an increase in prices due to the embargo placed on Russia by the Western world. Although prices went up initially, there was very little impact on the price of crude oil, because the embargo was more an exercise in Public Relations, not an actual embargo. And if you looked closely, prices were more impacted by the fact that in 2022 the US had two quarters of negative GDP growth (which usually signals a recession) and China implemented their Zero Covid policy which effectively locked China down. The actual conflict in Ukraine was less important to the oil price.
So what are the longer term trends that we should be looking at? From an economic perspective, let’s revisit the basic GDP growth equation:
GDP = Consumption + Investment + Government Spending + Net Exports or GDP = C + I + G + NX
C = private consumption expenditure by households I = business expenditures by businesses, and home purchases by households G = expenditure on goods and services by government NX = a nations exports minus imports
What is important to realise here is that Consumption makes up 68% of US GDP growth. During Covid nearly $2 trillion dollars was paid out to American consumers (which is geopolitical event), and this cycle is being driven by consumer spending. What is also interesting is that the consumption boom has been driven by the drawdown of savings and not leverage. House values in the US have gone up significantly over the past four years, and as interest rates fall, consumers may look to re-mortgage their homes and leverage up their biggest asset and continue to spend. Interestingly, in 2008/09/10 the value of mortgage debt was more than the value of house prices. This has changed over the past decade and house values are now more than double than the amount of debt.
This may translate into a disaster in five or ten years’ time, but it is not an issue now.
And what are the larger macro geopolitical events that we should be watching? The US election will definitely add volatility to the market, but the larger, long-term issues that will have a lasting impact on markets the factors that affect the “G” in the GDP growth equation. These are politically driven decisions affecting long term themes. Think about the Infrastructure Investment Jobs Act and the CHIPS Act, which are looking to reduce the USA’s reliance on China. The climate change agenda is forcing the building out of capital expenditure to facilitate the transition to greener energy. Capex cycles are not impacted by interest rate cycles, and short term economic factors. Longer term however, they will have quite large effects on commodity demand, the lowering of energy prices and could be inflationary over time.
Economist consistently underestimated GDP growth before 2020. So what changed? Politics changed, not economics. Prior to 2020 the world had a view on austerity and managed the fiscus using monetary policy to guide their decisions – when growth was high and translated into inflation, they raised interest rates, when growth was slow, they cut interest rates and stimulated the economy. But in 2020 the US government spent trillions of dollars on individual consumers, not because the economy was in trouble but because they feared social unrest and income inequality. After 2020 the US abandoned the Washington Consensus and the guidelines of the Maastricht Treaty and threw massive fiscal stimulus at the economy. We need to be careful that we don’t underestimate the economic growth that will come from this stimulus.
A recession will not end this paradigm, but over the long term, growth will continue as a result of the capex cycle. Assets such as global equities and commodities are expected to do well rather than high tech financial assets. They are expected to do well because of growth differentials, which is starting to happen where low growth in the rest of the world is catching up (from a low base) to the US, as the US slows moderately. The shift away from the US will be because the capex cycle is a product of geopolitics. When investors collectively see that the US safe haven is overstated, because there are small geopolitical events all the time, but they don’t affect markets as much as we think.
If there is a cognitive adjustment that realises that the US is not a safe haven from geopolitical uncertainty, and people move away from the US market dominance to look for opportunities in the rest of the world, it could be a good time for global equities and emerging markets. We need to get through the next high volatility period which will be the election in the USA, but after that it will be interesting to see what the next five years hold.
Asset Class Returns
The table below represents a rolling year view of the major asset class returns that we track. It offers a view of the asset classes we use to diversify your portfolio.
“GEO-MACRO “: A new Investment Framework
We tend to get caught up on what is going on in the world of geopolitical tensions and events, but they don’t have the impact on markets that we expect. Over time, long term alpha (investment returns over and above the benchmark) are generated by market fundamentals and large scale geopolitical events. The shorter term is influenced by smaller economic events and smaller geopolitical events, such as whether we think there may be a recession, or what the outcome of the US elections may be. Look at this chart which explains this phenomenon:
The green line is an objective measure of geopolitical risks – for example the number of Hezbollah rockets being fired on Israel, the number of Covid hospitalisations during the pandemic or the number of civilian casualties in the Ukraine/Russia conflict. We rely on journalism, social media and organisational data to gather this information. However, we do not read newspapers for a living, nor do we opine on the morality or significance of these events, we are trying to make a call on how the markets will react. The market is a brutal, inhumane discounting mechanism, so when the market senses that the objective data has turned, the risk premium of the geopolitical event reduces. The impact of geopolitical events is much shorter than people expect. People still talk about the Ukraine/Russia war, but the impact on financial markets has all but been priced out. The market has moved on from the conflict.
An interesting study is to look at crude oil and natural gas at the beginning of the conflict. The assumption was that there would be an increase in prices due to the embargo placed on Russia by the Western world. Although prices went up initially, there was very little impact on the price of crude oil, because the embargo was more an exercise in Public Relations, not an actual embargo. And if you looked closely, prices were more impacted by the fact that in 2022 the US had two quarters of negative GDP growth (which usually signals a recession) and China implemented their Zero Covid policy which effectively locked China down. The actual conflict in Ukraine was less important to the oil price.
So what are the longer term trends that we should be looking at? From an economic perspective, let’s revisit the basic GDP growth equation:
GDP = Consumption + Investment + Government Spending + Net Exports or GDP = C + I + G + NX
What is important to realise here is that Consumption makes up 68% of US GDP growth. During Covid nearly $2 trillion dollars was paid out to American consumers (which is geopolitical event), and this cycle is being driven by consumer spending. What is also interesting is that the consumption boom has been driven by the drawdown of savings and not leverage. House values in the US have gone up significantly over the past four years, and as interest rates fall, consumers may look to re-mortgage their homes and leverage up their biggest asset and continue to spend. Interestingly, in 2008/09/10 the value of mortgage debt was more than the value of house prices. This has changed over the past decade and house values are now more than double than the amount of debt.
This may translate into a disaster in five or ten years’ time, but it is not an issue now.
And what are the larger macro geopolitical events that we should be watching? The US election will definitely add volatility to the market, but the larger, long-term issues that will have a lasting impact on markets the factors that affect the “G” in the GDP growth equation. These are politically driven decisions affecting long term themes. Think about the Infrastructure Investment Jobs Act and the CHIPS Act, which are looking to reduce the USA’s reliance on China. The climate change agenda is forcing the building out of capital expenditure to facilitate the transition to greener energy. Capex cycles are not impacted by interest rate cycles, and short term economic factors. Longer term however, they will have quite large effects on commodity demand, the lowering of energy prices and could be inflationary over time.
Economist consistently underestimated GDP growth before 2020. So what changed? Politics changed, not economics. Prior to 2020 the world had a view on austerity and managed the fiscus using monetary policy to guide their decisions – when growth was high and translated into inflation, they raised interest rates, when growth was slow, they cut interest rates and stimulated the economy. But in 2020 the US government spent trillions of dollars on individual consumers, not because the economy was in trouble but because they feared social unrest and income inequality. After 2020 the US abandoned the Washington Consensus and the guidelines of the Maastricht Treaty and threw massive fiscal stimulus at the economy. We need to be careful that we don’t underestimate the economic growth that will come from this stimulus.
A recession will not end this paradigm, but over the long term, growth will continue as a result of the capex cycle. Assets such as global equities and commodities are expected to do well rather than high tech financial assets. They are expected to do well because of growth differentials, which is starting to happen where low growth in the rest of the world is catching up (from a low base) to the US, as the US slows moderately. The shift away from the US will be because the capex cycle is a product of geopolitics. When investors collectively see that the US safe haven is overstated, because there are small geopolitical events all the time, but they don’t affect markets as much as we think.
If there is a cognitive adjustment that realises that the US is not a safe haven from geopolitical uncertainty, and people move away from the US market dominance to look for opportunities in the rest of the world, it could be a good time for global equities and emerging markets. We need to get through the next high volatility period which will be the election in the USA, but after that it will be interesting to see what the next five years hold.
Asset Class Returns
The table below represents a rolling year view of the major asset class returns that we track. It offers a view of the asset classes we use to diversify your portfolio.