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The views expressed are those of the authors at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
Thomas Mucha, Geopolitical Strategist
Earlier this year, I met with a number of senior US, European Union (EU), and NATO officials in Brussels and across Europe to discuss the diplomatic, military, and economic implications of the widening Russia/Ukraine conflict. Here are some of my key takeaways and observations — in particular on the significant impact on US/EU relations — and my latest assessment of where this geopolitical crisis is heading in the period ahead.
The war has completely changed the nature of US/EU relations — for the better. There is now widespread agreement that the transatlantic relationship is energized and is working more effectively, despite the difficulties of the Trump administration and some early stumbles by the Biden administration. Indeed, one of my contacts said: “What we’ve done over the past three months is tremendous, especially after AUKUS and Afghanistan. But when facing a war, we had no choice but to talk to each other.”
There is now also more widespread support for President Biden’s approach to foreign policy, which will likely lead to a larger role for the EU on the world stage. As my contacts said: “Biden has done an excellent job. Imagine if Trump were still in power, the trouble we’d be in right now; sanctions enforcement, export controls, arms deliveries, the humanitarian process — all of this will be done through the EU. It will play a central role.”
In addition, most observers seem to agree that China’s at-times opaque position on the war is helping to drive the US and the EU closer together. As one contact put it: “The US president has said that autocracies versus democracies is the greatest challenge of our generation. And he is right.” Another individual noted: “Everything the US is doing in Ukraine is with an eye towards China — and I think Beijing understands this.”
On NATO’s future, many of my contacts anticipated Finland and Sweden’s formal applications to join the alliance, although the process of making that happen could take “up to a year.” One official noted: “They both fit the criteria for NATO membership — they can contribute to our collective security, they are both interoperable with NATO partners, and they both have sufficient checks and balances with regard to civilian control over their militaries.”
China will also play a role in shaping NATO’s future. As one contact said: “NATO is, and will remain, a regional alliance. But our attention to China comes from the fact that China is expanding its diplomatic reach, its military, its nuclear forces. We are not seeking confrontation with China, but we are trying to understand its intentions. Russia is the urgent threat, but China is the current and future threat.”
There’s a strong sense in Brussels that Europe remains deeply vulnerable to Russian energy exports: “Short term, there’s not much we can do. This dependence has been going on for 50 years and was toxic. So we will try everything we can, but it will take a minute.”
The macro impacts of Russia disrupting energy flows could be significant: “Frankly, we would be in very deep trouble; it will cost jobs, cause social insecurity, and create problems with German politics. So we can’t just stop getting gas from Russia. This is overly simplistic; we need to diversify gas sources from Russia, but we didn’t plan for this; if Russia’s gas pipelines are closed, it’s a real emergency.”
In the short term, we can expect more use of fossil fuels and continued use of natural gas as a bridge to renewables: “Coal use will be greater than previous estimates; our energy system based on Russia needs to shift, but this will require more liquified natural gas investments.” Longer term, US and EU officials remain confident that the Russia/Ukraine crisis will speed the transition to decarbonization, in Europe and globally: “The argument for green energy has never been stronger; climate change and now Russia’s invasion are driving the transition.”
John Butler, Macro Strategist
Arancha Cano, Portfolio Manager
The world looks very different today than it has for the past 20 years. In our view, the new environment of deglobalisation, higher inflation, greater global cyclicality and consistent volatility will disrupt and drive markets for years to come. Here, we outline these key trends and the resulting investment implications.
After decades of global markets interconnecting, we believe globalisation has peaked and in many ways is now substantively reversing. Developed market incentives are changing as policymakers shift their focus to income inequality and other domestic issues. Moreover, politicians in developed markets are blaming domestic instability and market shocks on various forms of “contagion” (e.g., financial, health and energy), which they attribute to globalisation.
This trend has been evolving since the global financial crisis (GFC) nearly 15 years ago and has been accelerated by the Russia/Ukraine conflict, the COVID-19 pandemic and rising tensions with China. The impacts of deglobalisation are far-reaching, including shifting labor market dynamics, evolving supply chains and financial deglobalisation’s effect on liquidity, savings and wealth transferability across borders. Importantly, as deglobalisation accelerates, we also believe fiscal policy is likely to become increasingly dominant over monetary policy.
Developed market inflation reached 7.4% in May 2022, the highest rate since June 1982. Crucially, we think this new inflation era is likely to persist. Over the past 10 years, inflation across the developed world has averaged 1% – 1.5%. Looking ahead, we think it is likely to average 2.5% – 3% over the next decade. That may appear to be a small increase, but it adds up.
In addition, although we believe inflation is at or near peak in many countries — as some bottlenecks ease and growth slows — inflation cycles are likely to be more volatile and frequent. It wouldn’t be surprising to see inflation swing up and down in a range from below zero to more than 5%. We also think there is likely to be much greater dispersion in inflation rates at the country level. All of this could drive significant market volatility in the years ahead.
We believe global cycles are likely to be more frequent and violent as there is now an increasingly explicit trade-off between growth and inflation. This environment means central banks are no longer able to be a consistent savior that drives growth. In fact, they will likely lag turning points, meaning they could at times become sources of volatility rather than compressors of volatility.
Since the GFC, slower growth has generally been a signal to buy risk assets, as it usually triggered central bank liquidity. This is less likely going forward, with central banks needing to be very confident they are able to sufficiently control inflation before they act.
In addition, though the cycle is currently turning over, central banks cannot react as they must carry on tightening because of heightened inflation. In this environment, the market must price a higher and higher probability of recession. At some point, the central banks will likely blink, and when they do, it could turn the tide abruptly.
As investors digest this new reality, they may be underestimating the impact on risk premia. The world of higher inflation, higher cyclicality and much lower cross-border transference of savings signals that risk premia are likely to rise not just a little bit but substantially over the course of the next few years. In addition, localised and idiosyncratic stories will become more important and relative country stories are going to drive opportunities. In our view, this will matter much more than it has over the last 10 years.
In terms of market dynamics, investors have become used to an environment where equities and bonds have a negative correlation, while central banks fuel new gains at every sign of a downturn. But that era is over, in our view. Instead, we think the equity market is going back to pricing cycles and profits. Many companies are facing supply-chain issues, rising costs and the inability to grow revenues. Moreover, we are starting to see price cycles and price correlations breaking down by sectors. Historically, investors have often looked at the S&P 500 Index as one unit, but we are now witnessing different companies and sectors reacting distinctly. Some appear to be significantly pricing in a recession while others are not at all.
In addition, equities are likely to remain very volatile as two key tail risks — potential recessions and rising interest rates — drive markets. However, the return of risk premia and of substantial volatility creates significant opportunities for the active management of equities, in our view. Take European equities, for example, where many investors are currently hesitant to invest. In contrast, we believe Europe has several sectors that are poised to benefit from this kind of nominal world and high inflation.
The world’s markets are rapidly evolving, and many historical relationships are breaking down. As deglobalisation, inflation, cyclicality and volatility drive markets, we believe it is critical to adapt investments to the new reality. In our view, the key trends impacting today’s environment create substantial opportunities for active managers to add value across asset classes.