In today’s markets, geopolitical and geo-economic events have consequences that extend far beyond the place where they occur – it is a complex world and it has never been more intriguing. Most of today’s super funds have significant overseas investments and even those with a domestic bias may see their returns impacted by events unfolding elsewhere.
Geopolitical risks are poorly understood in financial markets and are often mispriced. The key is to understand the transmission mechanism into the global economy, trade and markets.
Placing such events into context helps price both risk and the timing of taking an investment decision. For active managers, the challenge is to structure the market ‘noise’—the plethora of prices, news and events—into useful data sets and information.
Yet true alpha lies in turning knowledge into insight. This requires, for want of a better word, imagination. For imagination to be effective, we need to understand the context which, combined with deep analysis, enables the construction of investment strategies. But it doesn’t stop there; you then need to trade and risk manage that investment.
There are many crosscurrents facing investors today. The major themes we at CQS are looking at are populism, challenges to the world order, growth and other emerging issues. We seek to identify events and their transmission mechanisms into markets as we construct portfolios. Amongst the major themes presently affecting global markets are China’s Belt & Road Initiative (BRI), the changes in the Gulf region, the moves to restructure the European Union and Eurozone in a post-Brexit era, the course of global economic growth, inflation and interest rates, and unfolding trade tensions, primarily between the US and China.
All these events have brought with them heightened volatility, exacerbated by changes to the market structure, which resulted in the Dow Jones experiencing its biggest fall in six years during February, triggering a sell-off around the world, as well as the volatility experienced over the last few weeks.
These unfolding geopolitical changes are presenting both risks and opportunities to investors. We believe active portfolio managers have a responsibility to closely analyse these risks.
Australia’s built-in advantage
The world is an incredibly competitive place and is getting more so. However, in our view Australia is well positioned to benefit from growing global demand as the world’s population grows from seven billion, forecasted to reach over nine billion by 2050.
The world is an incredibly competitive place and is getting more so. However, Australia is well positioned to benefit from growing global demand.
Geographically, Australia provides a bridge to China and the rest of Asia. In the coming years China is set to become Australia’s most important economic partner. This means Australia is well placed to benefit from continuing growth with the superpower on its doorstep.
Australia also has a built-in advantage provided by its natural resources and its strong agricultural sector. We believe its future edge will also be driven by education and having the right regulatory and structural framework to allow for efficient market functioning.
China to shape the world’s future
In 2018 and beyond, China will remain an engine for global growth. While President Xi Jinping’s plan for ‘Socialism with Chinese Characteristics’ means domestic governance may look less Western, China’s focus on economic reform, environmental improvement and rule of law is also set to create improving conditions for entrepreneurial enterprise, as was set out in the Five Year Plan during 2017’s 19th National Congress of the Communist Party of China.
China’s BRI is expected to be one of the most significant contributors to global growth in the coming years. One of the largest infrastructure projects in history, it aims to strengthen China’s economic leadership by linking Europe to China through countries across Eurasia and the Indian Ocean.
The BRI is ambitious, taking in 65 countries, which make up 60 per cent of the global population and 30 per cent of global GDP. To put this in perspective, $8 trillion was invested in quantitative easing following the GFC, while BRI is estimated by some to invest $10 trillion into the real economy, albeit over a longer period of time.
The scale and character of Chinese activity is extraordinary and, if successful, China may not just be set to dominate the region but remould the world order. It is China’s strategic intent, clarity of vision and long-term planning and execution that are the keys to its success.
Changes in the GCC region
Turning to the Middle East, the Gulf Cooperation Council, made up of six oil-producing nations including the United Arab Emirates, Saudi Arabia, Qatar, Kuwait, Oman and Yemen, has seen enormous change over the past few decades as these nations seek to diversify their economies away from oil.
Leading the way is Saudi Arabia, which in its Vision 2030 outlined a program to improve economic diversification, wean the Kingdom off oil and grow a vibrant private sector to generate wealth and create employment for its young population. Spearheaded by Mohamed bin Salman, I believe this strategy is potentially a massive game changer and disrupter for the region.
Saudi Arabia’s program of domestic change includes a Public Investment Fund, which is focused on building strategic sectors of the economy, as well as a program to achieve budgetary balance. The key insight for me lies in the oil price. In the short term the oil price could have further upside and stay higher for longer. Structurally, based on our analysis, the oil price should remain in a US$40 to US$60 trading range, although short-term moves above or below this central range are probable. However, the fiscal demands placed on the proposed reforms and the diplomatic tensions within the region as well as regional instability, means the oil price is likely to remain above this range for the short term. Despite the decline in oil’s importance to global GDP, the oil price is an important transmission mechanism to monitor.
The growth of European populism
The Eurozone region continues to face a number of political challenges. Populism is alive and well. It is directly impacting some of Europe’s largest countries – and it is not just about Brexit. In fact, Brexit has become a catalyst for European Union and Eurozone reform.
Populism is alive and well. It is directly impacting some of Europe’s largest countries – and it is not just about Brexit. In fact, Brexit has become a catalyst for European Union and Eurozone reform.
Migration has played a significant role in the European political landscape. The September 2017 elections in Germany created unprecedented difficulties in forming a stable coalition government, which was only sworn in last month. And following the recent elections, Italy is facing another weak coalition with little appetite for structural reform. Should the Northern League be part of a coalition, it would likely place Italy on a collision course with the European Central Bank.
In France, despite Macron’s stunning success in last year’s elections, over 40 per cent of French people voted either Far Right or Far Left, and right-wing parties have also made significant parliamentary gains in the Netherlands and Austria. Macron’s political star is on the rise, however, he faces confrontation with unions over reforms. He has ambition, vision and strategy, and has taken the EU’s leadership role from Merkel. The question is whether Germany will continue to effectively underwrite the EU and Eurozone at a time when centrifugal forces causing stress within EU about economics, national and cultural identity, and the type of EU model—from Federation to an economic community only—are being debated.
As such, we will be keeping a close eye on the growing stresses in the EU and Eurozone, with the potential for more politically-inspired volatility on the horizon.
The US
US monetary policy and investor confidence continue to be important drivers of global financial markets.
With fiscal stimulus from US tax reform and BRI, investors are focused on inflation and the course of interest rates. Wage inflation is key and in the US it has been trending up. Federal Reserve chairman Jerome Powell appears to have a more hawkish agenda and we continue to expect markets to be volatile in the short term as they adjust to a higher rate environment, notwithstanding our constructive view of markets in the medium term.
We believe investor portfolios should seek to mitigate rising rates. At CQS we continue to favour short duration and floating rate assets. Inflation, the course of interest rates and trade wars are the elephant in the room. Developments on these fronts deserve to be monitored closely.
Trade
A potential escalation of trade tariffs between the US and China has rightly concerned markets. President Trump is using aid, sanctions and trade as instruments of foreign policy. Indeed, he is fulfilling electoral promises and there may be political posturing ahead of the US midterm election. Both recent tariff announcements – Section 232 (steel and aluminium of approximately US$3bn, with several exemptions having been granted) and Section 301 (intellectual property) suggest further challenges and tensions are coming.
Section 301 in particular relates to geopolitical and geo-technological rivalry between the US and China. In the case of the latter, there is likely to be a short-term effect both on China’s and the US’s trade, economies and on markets given estimates of US$50-$100bn of traded goods being targeted by tariffs. However, we do not believe the medium-term effect will be enough to knock global GDP growth materially. In our view, China may in the long term be a beneficiary of a trade spat as the US becomes a more self-sufficient economy. In the case of Section 301 there will be greater clarity following the consultation period.
The outlook
Despite the many geopolitical situations currently unfolding worldwide, we remain constructive on global growth. All 45 OECD countries’ economies are expanding, with 33 accelerating. Estimates for global GDP growth in 2018 are 3.4 per cent and for 2019 are 3.3 per cent.
While QT is an effective tightening, the excess reserves in the banking system continue to provide sufficient liquidity to the global economy.
In the short term there are pockets of stress, distress and dislocation. The dispersion in valuations is an opportunity for active managers to generate returns for super fund members. However, as asset managers we need to remain aware of potential potholes and be prepared to be nimble in trading such opportunities. Volatility provides opportunity for active investment managers.
In today’s markets, geopolitical and geo-economic events have consequences that extend far beyond the place where they occur – it is a complex world and it has never been more intriguing. Most of today’s super funds have significant overseas investments and even those with a domestic bias may see their returns impacted by events unfolding elsewhere.
Geopolitical risks are poorly understood in financial markets and are often mispriced. The key is to understand the transmission mechanism into the global economy, trade and markets.
Placing such events into context helps price both risk and the timing of taking an investment decision. For active managers, the challenge is to structure the market ‘noise’—the plethora of prices, news and events—into useful data sets and information.
Yet true alpha lies in turning knowledge into insight. This requires, for want of a better word, imagination. For imagination to be effective, we need to understand the context which, combined with deep analysis, enables the construction of investment strategies. But it doesn’t stop there; you then need to trade and risk manage that investment.
There are many crosscurrents facing investors today. The major themes we at CQS are looking at are populism, challenges to the world order, growth and other emerging issues. We seek to identify events and their transmission mechanisms into markets as we construct portfolios. Amongst the major themes presently affecting global markets are China’s Belt & Road Initiative (BRI), the changes in the Gulf region, the moves to restructure the European Union and Eurozone in a post-Brexit era, the course of global economic growth, inflation and interest rates, and unfolding trade tensions, primarily between the US and China.
All these events have brought with them heightened volatility, exacerbated by changes to the market structure, which resulted in the Dow Jones experiencing its biggest fall in six years during February, triggering a sell-off around the world, as well as the volatility experienced over the last few weeks.
These unfolding geopolitical changes are presenting both risks and opportunities to investors. We believe active portfolio managers have a responsibility to closely analyse these risks.
Australia’s built-in advantage
The world is an incredibly competitive place and is getting more so. However, in our view Australia is well positioned to benefit from growing global demand as the world’s population grows from seven billion, forecasted to reach over nine billion by 2050.
The world is an incredibly competitive place and is getting more so. However, Australia is well positioned to benefit from growing global demand.
Geographically, Australia provides a bridge to China and the rest of Asia. In the coming years China is set to become Australia’s most important economic partner. This means Australia is well placed to benefit from continuing growth with the superpower on its doorstep.
Australia also has a built-in advantage provided by its natural resources and its strong agricultural sector. We believe its future edge will also be driven by education and having the right regulatory and structural framework to allow for efficient market functioning.
China to shape the world’s future
In 2018 and beyond, China will remain an engine for global growth. While President Xi Jinping’s plan for ‘Socialism with Chinese Characteristics’ means domestic governance may look less Western, China’s focus on economic reform, environmental improvement and rule of law is also set to create improving conditions for entrepreneurial enterprise, as was set out in the Five Year Plan during 2017’s 19th National Congress of the Communist Party of China.
China’s BRI is expected to be one of the most significant contributors to global growth in the coming years. One of the largest infrastructure projects in history, it aims to strengthen China’s economic leadership by linking Europe to China through countries across Eurasia and the Indian Ocean.
The BRI is ambitious, taking in 65 countries, which make up 60 per cent of the global population and 30 per cent of global GDP. To put this in perspective, $8 trillion was invested in quantitative easing following the GFC, while BRI is estimated by some to invest $10 trillion into the real economy, albeit over a longer period of time.
The scale and character of Chinese activity is extraordinary and, if successful, China may not just be set to dominate the region but remould the world order. It is China’s strategic intent, clarity of vision and long-term planning and execution that are the keys to its success.
Changes in the GCC region
Turning to the Middle East, the Gulf Cooperation Council, made up of six oil-producing nations including the United Arab Emirates, Saudi Arabia, Qatar, Kuwait, Oman and Yemen, has seen enormous change over the past few decades as these nations seek to diversify their economies away from oil.
Leading the way is Saudi Arabia, which in its Vision 2030 outlined a program to improve economic diversification, wean the Kingdom off oil and grow a vibrant private sector to generate wealth and create employment for its young population. Spearheaded by Mohamed bin Salman, I believe this strategy is potentially a massive game changer and disrupter for the region.
Saudi Arabia’s program of domestic change includes a Public Investment Fund, which is focused on building strategic sectors of the economy, as well as a program to achieve budgetary balance. The key insight for me lies in the oil price. In the short term the oil price could have further upside and stay higher for longer. Structurally, based on our analysis, the oil price should remain in a US$40 to US$60 trading range, although short-term moves above or below this central range are probable. However, the fiscal demands placed on the proposed reforms and the diplomatic tensions within the region as well as regional instability, means the oil price is likely to remain above this range for the short term. Despite the decline in oil’s importance to global GDP, the oil price is an important transmission mechanism to monitor.
The growth of European populism
The Eurozone region continues to face a number of political challenges. Populism is alive and well. It is directly impacting some of Europe’s largest countries – and it is not just about Brexit. In fact, Brexit has become a catalyst for European Union and Eurozone reform.
Populism is alive and well. It is directly impacting some of Europe’s largest countries – and it is not just about Brexit. In fact, Brexit has become a catalyst for European Union and Eurozone reform.
Migration has played a significant role in the European political landscape. The September 2017 elections in Germany created unprecedented difficulties in forming a stable coalition government, which was only sworn in last month. And following the recent elections, Italy is facing another weak coalition with little appetite for structural reform. Should the Northern League be part of a coalition, it would likely place Italy on a collision course with the European Central Bank.
In France, despite Macron’s stunning success in last year’s elections, over 40 per cent of French people voted either Far Right or Far Left, and right-wing parties have also made significant parliamentary gains in the Netherlands and Austria. Macron’s political star is on the rise, however, he faces confrontation with unions over reforms. He has ambition, vision and strategy, and has taken the EU’s leadership role from Merkel. The question is whether Germany will continue to effectively underwrite the EU and Eurozone at a time when centrifugal forces causing stress within EU about economics, national and cultural identity, and the type of EU model—from Federation to an economic community only—are being debated.
As such, we will be keeping a close eye on the growing stresses in the EU and Eurozone, with the potential for more politically-inspired volatility on the horizon.
The US
US monetary policy and investor confidence continue to be important drivers of global financial markets.
With fiscal stimulus from US tax reform and BRI, investors are focused on inflation and the course of interest rates. Wage inflation is key and in the US it has been trending up. Federal Reserve chairman Jerome Powell appears to have a more hawkish agenda and we continue to expect markets to be volatile in the short term as they adjust to a higher rate environment, notwithstanding our constructive view of markets in the medium term.
We believe investor portfolios should seek to mitigate rising rates. At CQS we continue to favour short duration and floating rate assets. Inflation, the course of interest rates and trade wars are the elephant in the room. Developments on these fronts deserve to be monitored closely.
Trade
A potential escalation of trade tariffs between the US and China has rightly concerned markets. President Trump is using aid, sanctions and trade as instruments of foreign policy. Indeed, he is fulfilling electoral promises and there may be political posturing ahead of the US midterm election. Both recent tariff announcements – Section 232 (steel and aluminium of approximately US$3bn, with several exemptions having been granted) and Section 301 (intellectual property) suggest further challenges and tensions are coming.
Section 301 in particular relates to geopolitical and geo-technological rivalry between the US and China. In the case of the latter, there is likely to be a short-term effect both on China’s and the US’s trade, economies and on markets given estimates of US$50-$100bn of traded goods being targeted by tariffs. However, we do not believe the medium-term effect will be enough to knock global GDP growth materially. In our view, China may in the long term be a beneficiary of a trade spat as the US becomes a more self-sufficient economy. In the case of Section 301 there will be greater clarity following the consultation period.
The outlook
Despite the many geopolitical situations currently unfolding worldwide, we remain constructive on global growth. All 45 OECD countries’ economies are expanding, with 33 accelerating. Estimates for global GDP growth in 2018 are 3.4 per cent and for 2019 are 3.3 per cent.
While QT is an effective tightening, the excess reserves in the banking system continue to provide sufficient liquidity to the global economy.
In the short term there are pockets of stress, distress and dislocation. The dispersion in valuations is an opportunity for active managers to generate returns for super fund members. However, as asset managers we need to remain aware of potential potholes and be prepared to be nimble in trading such opportunities. Volatility provides opportunity for active investment managers.
