Investors Wary of a Fragmented World?
A long and challenging list of geopolitical risks already existed before COVID-19 began shaking up the world order. US-China rivalry, weakened global institutions, fragmentation in the EU and a growing intertwining of climate and geopolitics to name a few.
For sure, a rebalanced global order and commitment to multilateralism could return with Biden’s presidency, while a vaccine for the virus will end its rampage of destructive volatility. But as geopolitical risks increasingly stalk developed markets, asset owners sifting through the noise for long-term trends believe a fragmented world is here to stay.
For example, the US election result won’t alter growing US-China tension and accelerating disengagement and de-globalisation trends.
“China remains a problem for the US; that hasn’t changed,” said a bleary-eyed Chris Ailman, speaking at CalSTRS’ board meeting the day after the US election and Biden’s emerging lead.
“The US and China will continue to move apart in a Biden presidency,” agreed David Ross, managing director of the capital markets group at Canada’s C$22 billion OPTrust who notes that China’s path to disengagement was made clear in its objectives for economic self-reliance set out in its 14th Five Year Plan (2021-2025) in October.
Disengagement has also been accelerated by other economies seeking a new self-sufficiency in the wake of COVID-19, said Ross.
“The shift to increased fiscal spending embraced by governments around the world as they sought to buffer their economies to the COVID-19 pandemic is generally inward looking and nationalistic. Overall, this should be expected to increase both geopolitical and economic volatility.”
Others note how the pandemic will also accelerate de-globalisation trends following its exposure of vulnerabilities in global supply chains.
“COVID-19 clearly revealed the implications of having heavy reliance on China as the manufacturer of the world. If there was ever a time to rethink supply chains and regulate changes for strategic and national security purposes, this is the time,” said Bruno Serfaty, head of dynamic asset allocation at the United Kingdom’s £67 billion USS Investment Management.
Disengagement between the US and China is manifesting in technology, as well as trade. US sanctions make working with China’s tech sector increasingly difficult for multinational companies. Elsewhere, OPTrust’s Ross warns disengagement and divergence could lead to investments becoming stranded due to legal or regulatory changes. It could leave pension funds with large and growing allocations to the engines of Chinese growth exposed.
Witness Canada’s C$420 billion CPP Investments, moving towards a 20 per cent allocation to the country which Geoffrey Rubin, senior managing director and chief investment strategist, recently described as “imperative” for both returns and diversification.
“China matters,” said Ailman, pointing to the Chinese companies like Tencent and Alibaba now in CalSTRS top 10 equity holdings. In recognition of the possible risks of holding Chinese assets, the pension fund is about to begin a six-month deep dive analysis.
“This is a risk we want to focus on,” said Ailman.
The East-West trade and tech divide is also fuelling the emergence of separate economic spheres. Asia-centric and intra-Asian trade and investment flows are increasingly more significant than investment flows into Asia from Europe and the US.
Similarly, total Chinese investment in the US has fallen sharply. However it’s a trend asset owners’ believe could hold exciting opportunities – particularly around diversification.
“As long as the US continues to dominate the reserve currencies and China and its neighbours contribute the most to global growth, a well-balanced currency diversification approach should prove resilient to the emerging geopolitical tensions,” suggested Serfaty. “At USS we have recently reviewed our currency allocations with a view to improving diversification and increasing portfolio resilience at times of stress.”
New economic spheres could also manifest in manufacturing and production opening in alternative countries, he added.
“It could lead to more localisation of supply chains which may have a favourable impact on industrial production for some: for the Americas, some US states and Mexico could benefit, providing their business leaders prove capable of manufacturing as good quality products as their Chinese competitors. Similarly, some nations of Europe – Poland, Czech Republic – could sustain their industrial revival,” he said.
Away from China-US relations, the other geopolitical risk top of mind is COVID-19. Of course, not all investors view the pandemic through a geopolitical lens.
“Geopolitical risks are still elevated, despite the US election outcome,” said Kasper Ahrndt Lorenzen, group CIO of PFA. “But when it comes to running investment portfolios, the COVID-19 development, and the policy reactions in particular, are more important.”
For others however, the pandemic has heightened risk.
OPTrust’s Ross is mindful that unprecedented government spending might soon unravel with geopolitical consequences.
“The market will eventually judge which countries have the credibility and balance sheet to get away with it and which don’t,” he says, predicting that the distinctions will appear in emerging markets first. Kurt Schacht, head of policy at the CFA Institute in Washington is also convinced the pandemic is morphing into significant geopolitical disruption.
“A clear and present danger is its impact on not just public health, but entire economies,” he said. “Predicting the course of biology, vaccines and human behaviour has fundamental investment analysts on their heels.”
OPTrust’s Ross also believes the geopolitical climate could lead to higher inflation. Huge stimulus to counter COVID and reduced capacity due to lingering COVID issues or global trade friction, mixed with populism-fuelled higher labour and wages, has all the ingredients for stagflation.
“This is something we are spending a lot of time thinking about in our Risk Mitigation Portfolio,” he said. Inflation worries and the collapse in yields has already led the pension fund to reduce its allocation to nominal bonds – running counter to the traditional idea investors favour assets like cash, gold and government bonds in times of crisis.
Elsewhere, CalSTRS is also contemplating changes to its asset allocation in response to volatility. Citing a recent paper from the pension fund’s consultant Meketa advising how best to navigate uncertainty, Ailman said one idea includes a new opportunistic portfolio.
CalSTRS already has an innovation portfolio but abandoned an opportunistic allocation in the 1990s. Unconvinced if the giant fund could ever be nimble enough to be opportunistic, Ailman said his focus remains on diversification, actively managing risk and focusing on fees by pushing a collaborative manager model over expensive traditional partnerships.
Investors also note a growing intertwining of geopolitical and climate risk, particularly since the pandemic (seemingly easier to solve by cooperation than climate change) has highlighted the challenges inherent in global cooperation.
“The lack of COVID 19 cooperation – perpetuated by many countries, both in the east and west alike – is a bad omen for other problems which are less knowable and less immediate,” said the head of a US corporate pension fund.
“The continued geopolitical shift away from global cooperation to national or regional approaches would pose direct risks to the coordinated efforts that are necessary to address climate change. We believe that the sustainability of the Plan and the planet are inextricably linked, and we are increasingly focussed on risks that climate change poses to our portfolio,” concluded OPTrusts’ Ross.
Geopolitical risk and the impact on portfolios will be a topic of discussion at the Fiduciary Investors Symposium online on December 8. For more information click here.
Great article, provides a lot of food for thought.
First, I never met or spoke with David Ross, managing director of the capital markets group at OPTrust but I do appreciate someone who can discuss the bigger picture in a very clear and cogent manner.
Of course, some of his views here do not jive with those of his boss, James Davis, CIO at OPTrust.
I recently chatted with James and Peter Lindley, OPTrust's CEO, on their total portfolio approach, a topic which I'll come back to after Mihail Garchev and I finish our series on integrated Total Portfolio Management (Part 5 is coming up tomorrow but since it's long, we decided to cut it into three posts).
Anyway, when James Davis spoke with me, we both agreed that secular stagnation is here to stay and we have yet to see to the secular lows on long bond yields.
I referred to an older (2017) comment of mine on deflation coming to America where I discussed the (then) seven structural factors that led me to believe we are headed for a prolonged period of debt deflation:
- The global jobs crisis: High structural unemployment, especially youth unemployment. Permanent job losses are on the rise and there are less and less good paying jobs with solid wages and benefits like a defined-benefit plan.
- Demographic time bomb: A rapidly aging population means a lot more older people with meager savings spending less and costing the healthcare system more as they age and get sick.
- The global pension crisis: As more and more people retire in poverty, they will spend less to stimulate economic activity. Moreover, the shift out of defined-benefit plans to defined-contribution plans is exacerbating pension poverty and is deflationary. Back then, I discussed his in my comments on the $400 trillion pension time bomb and the pension storm cometh. Any way you slice it, the global pension crisis is deflationary and bond friendly.
- Excessive private and public debt: Rising government and consumer debt levels are constraining public finances and consumer spending, impacting overall growth.
- Rising inequality: Hedge fund, private equity gurus and Big tech moguls cannot appreciate this because they live in an alternate universe, but widespread and rising inequality is deflationary as it constrains aggregate demand. The pension crisis will exacerbate inequality and keep a lid on inflationary pressures for a very long time.
- Globalization: Capital is free to move around the world in search of better opportunities but labor isn't. Offshoring manufacturing and service sector jobs to countries with lower wages increases corporate profits but exacerbates inequality.
- Technological shifts: Think about Amazon, Uber, Priceline, AI, robotics, and other technological shifts that lower prices and destroy more jobs than they create and keep a lid on inflation.
Interestingly, this week Amazon launched its online pharmacy:
Amazon Pharmacy allows U.S. customers to order prescription medications for home delivery, including free delivery for Amazon Prime members. https://t.co/4hG4FOuHZq— CNBC (@CNBC) November 18, 2020
This is just another example of massive disruption occurring across all sectors, including healthcare.
Power is being concentrated in the hands of fewer and fewer mega tech companies or mega retailers and this competition among monopsonies is actually benefiting consumers, for now.
But what is good for consumers isn't necessarily good for the overall economy as inequality rises to unprecedented levels.
Importantly, the pandemic has only accelerated the structural trends I warned of back in 2017.
And a Biden administration will not change this.
In fact, while Larry Summers' tax advice for Joe Biden is to collect on the $7 trillion owed by 'the richest taxpayers, my advice is far simpler: levy a special "pandemic tax" on the S&P 500 companies that benefited the most from the pandemic and use the proceeds to help small & medium sized businesses and their employees that were impacted the most.
Of course, there is no appetite whatsoever for any taxes in the United States, even ones that make imminent sense.
Instead, the Power Elite keeps repeating the same mistakes. After every crisis, Uncle Fed comes to the rescue, lowering rates and now digitally printing trillions to effectively bail out Wall Street speculators, Big Tech moguls and corporate titans who benefit the most from all this "digital printing".
Oh sure, a few stimulus packages here and there to make sure the masses don't starve to death but to the victor go the spoils and let's not kid ourselves, the pandemic has been a boon to Big Tech moguls, corporate leaders and Wall Street speculators.
That's why while some worry about a fragmented world, I worry a lot more about a fragmented and increasingly divided society and its effects not only on markets but on our civil society:
For The First Time, Wall Street Admits That "Civil Unrest" Could Crash Markets | Zero Hedge https://t.co/RC1hdEVQHX— Leo Kolivakis (@PensionPulse) November 18, 2020
Here we go again: Panic buyers across U.S. empty shelves of toilet paper, food and disinfectant as 40 states see record daily increases in cases and 20 states report all-time highs in deaths— Jon Najarian (@jonnajarian) November 17, 2020
via https://t.co/vyiNBXFspX https://t.co/mfN7rHmbEj
Jon Najarian's tweet prompted me to respond: "We live in a society of animals who love to hoard, no consideration whatsoever for their common citizens. Breaks my heart watching seniors trying to shop at stores as animals buy up everything they can."
By the way, I don't think there will be civil unrest, at least I hope not, but we can't dismiss it. Trump is riling up his base one last time and who knows what he's cooking up now that the courts have slammed his chances of contesting the election results and state election officials are moving to final certification of the results in the coming days:
Pres. Trump's bid for a possible Supreme Court election intervention has yet to materialize as state election officials move toward final certification of results in the next few days. https://t.co/mPoVGuUBSj— ABC News (@ABC) November 18, 2020
The United States remains more divided than ever. Trump will more than likely be back in four years, and that's why I don't see any major policy shifts down south even if the Democrats take over the Senate provided they win the Georgia run-off election in early January.
Getting back to the comment above, both Chris Ailman and David Ross warned of deteriorating US-China relations and Ross went a step further, warning that disengagement and divergence could lead to investments becoming stranded due to legal or regulatory changes. This could leave pension funds with large and growing allocations to the engines of Chinese growth exposed.
Recall, in late October, the Ontario Chamber of Commerce (OCC) brought together the heads of three major Canadian pensions to discuss the future of institutional investing in Canada. The panelists included Blake Hutcheson, President and Chief Executive Officer, OMERS, Jo Taylor, President and Chief Executive Officer, Ontario Teachers’ Pension Plan and Jeff Wendling, President and Chief Executive Officer, Healthcare of Ontario Pension Plan.
In that discussion, the three CEOs covered "The China Factor" and here is what I noted:
The conversation then got interesting because they talked about direct investing in China.
Jo Taylor brought up an great point stating: "It's really easy deploying capital in China but really challenging extracting it. The rule of law isn't there, the regime can basically take actions which impact your investments overnight."
He said OTPP is doing direct investments there along with local partners, but they're also looking at Asia Pacific more broadly as other countries will benefit from China's growth (they recently opened up their Singapore office).
He also said China impacts companies here, like Apple, citing increased nationalism there and how it can impact these giant tech companies in North America.
Blake Hutcheson agreed, "you can't ignore China but it's tricky". OMERS is currently invested 3% in Asia and looking to go to 10% but it's a "long game, a relationship game".
Jeff Wendling said HOOPP has 2-3% of its assets in emerging markets and it will increase them as growth will be there but they will do so mostly through public markets.
Still, HOOPP did a private equity deal in China and will look at all private market deals there if they make good sense and if they have the right local partners.
It's clear China is an important factor in Asia Pacific and it has ripple effects all over the world.
Every major Canadian pension that has done deals in China's private markets has done so using local partners and this will not change going forward.
CPP Investments' Chief Investment Strategist Geoff Rubin is right, it is " imperative" to invest in China for returns and diversification, but every large institutional investor is thinking the same thing: China is a communist country run by the Chinese Communist Party and that makes Western investors very nervous.
Now, let me just state flat out, in my opinion, China needs the US (and the West) now more than ever and they wouldn't dare nationalize a major investment from a foreign investor, that will send the country back to the Dark Ages.
I'm not saying it isn't possible, it sure is, but highly unlikely.
Why? While China's rule of law is questionable, we all need to remember certain economic laws.
First and foremost, China runs a massive current account surplus exporting goods all over the world and the US runs a capital account surplus, accepting foreign investments into Wall Street and other areas.
Got that? China's current account surplus necessarily means a US current account deficit and a capital account surplus. That will not change over the next decade(s).
The Chinese exert immense power, especially over their regional neighbors where they just signed another favorable trade deal, but in global affairs, the United States still dominates the world, including China.
There's a mutually symbiotic relationship there and you're seeing private equity giants moving aggressively to invest more in China. That tells me the power elite are very comfortable with the balance of power the US still exerts over China.
Again, I'm not saying China-US relations are perfect and cannot deteriorate more under a Biden administration but I take any doomsday scenario of China nationalizing investments foreigners invested in with a shaker of salt. That's just a dumb long-term move and the Chinese are always thinking ten steps ahead.
Lastly, as far as climate change, I agree with the person who stated this in the article above:
“The lack of COVID 19 cooperation – perpetuated by many countries, both in the east and west alike – is a bad omen for other problems which are less knowable and less immediate.”
We are not doing enough to address climate change and I'm not one who believes the Paris Accord will save our planet.
Moreover, while the Quebec Government is looking to eliminate gas vehicles by 2035, I remain highly skeptical:
Importantly, it simply can't be done, not in 15 years and most likely not in 25 years as Hydro Quebec will tell you our electric grid can't handle it, not to mention you need a lot of coal to generate all this electricity.
What I see going on right now is policies based on "ESG fervor", and unfortunately it's seeping into our pension investments.
Everyone is touting "wind farms" and "solar farms" but the real solution to addressing climate change is building more nuclear power plants.
Of course, that takes a long time but if pensions are truly long term investors, they'd team up with large engineering companies and build nuclear power plants and generate great long term returns.
If done right, it's safe (never mind Chenobyl and Fukushima, the engineers screwed up royally!) and will deliver power for decades and significantly reduce carbon emissions.
But in order for this to happen, you need the political will to be there and you need everyone to be on board.
Anyway, those are my thoughts on the fragmented world we live in. If you have anything to add, feel free to email me at LKolivakis@gmail.com.
Below, in this episode of Talks At GS, CalSTRS Chief Investment Officer Chris Ailman discusses leading the country’s second largest public pension fund through the pandemic, his long-term outlook on investing, and how he has incorporated ESG into his investing strategy.
Great discussion, take the time to listen to Chris Ailman and also remember to watch the discussion between Jeff Wendling, Jo Taylor and Blake Hutcheson here (scroll to the end and click the link).
Lastly, Jeff Gundlach was recently interviewed where he shared his thoughts on markets, stating volatility will persist in the coming years and investors are ill-prepared for a "fat-tailed event".
Interesting comments, not sure why he's still dubbed "the bond king" given his fund is underperforming Dan Ivascyn's PIMCO fund for years and I don't agree with his call that rates are artificially low but he always makes me think. Right or wrong, it is always worth listening to Gundlach.
I actually like his comments on work productivity and shifts in housing market which are "disinflationary for wages" (so bond friendly and supportive of lower long bond yields) but I disagree with his bearish views on the greenback, he's got that all wrong (look at what the ECB is doing!!).