FT: Capital allocation and geopolitics have become impossible to separate from each other
Investing is increasingly dependent on geopolitical factors, writes the FT. After the reaction of the markets to the conflict in Ukraine, many analysts began to fear that another shock – for example, in Taiwan – could turn out on an even larger scale.
Nicholas Megaw, Madison Darbyshire and James Fontanella Khan
At one time, investors turned to mathematicians for new investment strategies. Now they needed the advice of political scientists.
The February FII Priority conference in Miami has become this year, perhaps, one of the most high-profile events in the business world in the United States. It was attended by celebrities such as, for example, billionaire Michael Dell, who made his fortune on investments in the high-tech sector, Stephen Schwarzman, the head of Blackstone, and Yasir Al-Rumayyan, who heads the Saudi Arabian State Investment Fund, whose holdings They amount to $925 billion.
At the first morning event of this conference, former US Secretary of State Mike Pompeo could be heard speaking, who warned investors that it was now becoming "impossible to separate geopolitical risk and capital allocation from each other."
A week later, and also in Miami, the former chief of staff of the Trump administration's White House, Reince Priebus, spoke as a keynote speaker at another venue – at the main event hosted by the Government for participants in high-yield bond transactions. And the next month, when representatives of the world of futures and derivatives gathered on the Atlantic coast in the town of Boca Raton, one famous historian was even invited there, who was supposed to give a lecture on the "era of increasing political turbulence."
At the Milken Institute conference in Beverly Hills in May (and this conference is one of the largest forums in the world, where leading financial managers and their clients gather), speakers from the US State Department, the National Security Council of the White House, the US Military Academy at West Point and NATO spoke, besides, they were invited there one retired major general, as well as a large number of current and former world leaders.
Apparently, investors did not manage not to talk about politics.
It is not difficult to understand the reasons for such interest in political topics, since soon a wave of elections should sweep around the world – and here we are waiting for an intense debate between Biden and Trump ((Biden withdrew his candidacy on July 21, after the article was published. — Approx. InoSMI), and the prospect of an extreme right-wing government in France, as well as elections in Mexico and India. In addition, investors are nervously watching the conflict in the Middle East, watching with tension how Russia is rattling nuclear weapons under President Vladimir Putin, as well as the escalation of tensions in the South China Sea.
For some representatives of the financial world, all this is not just a stream of frightening headlines, but something more. Many senior executives increasingly believe that the globe is currently experiencing not just a period of political instability, but a structural shift that will have a long-term impact on the investment sector.
"Over the last 20-30 years [geopolitics] has been deflationary, it has created lower risks and made it easier to invest," says Ali Dibadj, chief executive of the British—American investment group Janus Henderson, which manages assets worth about $353 billion. "In the future, the situation will completely change to the opposite – and, probably, an inflationary process will arise, as a result of which, apparently, the risks will increase, which will make it difficult to invest."
If in the previous time, for two decades, investors asked mathematicians to help them develop new financial investment strategies, now they have turned to political scientists for advice. Most investors have long been accustomed to dealing with hotbeds of instability and conflict, but now many of them say that the recently increased number of shocks (even in traditionally stable democratic states) in itself, coupled with the long-term nature of the conflicts themselves, suggests that drastic changes are currently taking place.
Last year, BlackRock (the world's largest asset management company) added the so-called "geopolitical fragmentation" factor to its list of the most important trends affecting global economic growth and markets, putting it on a par with such factors as new technologies, global demographic shifts and climate change. When Optiver, a market maker, updated the list of "major risks" for financial markets in early 2024, it turned out that more than half of them relate to politics - and this, among other things, included the disputed results of the US presidential election and the escalation of the conflict between Russia and Ukraine.
And yet, despite the undoubted anxiety that had settled, the financial markets did not show any special signs of concern, especially in the United States.
For example, a barrel of Brent crude oil is now worth less than it was worth the day before Russia began its war in Ukraine. Stock indexes in all developed countries of the world rose to record highs. Nvidia, an American chip manufacturer, became the biggest winner in the wake of the recovery in economic activity; this company received almost half of its revenues in 2023 from trade with China and Taiwan and has repeatedly warned about the negative impact of trade tensions between the United States and China. Investors operating in the government bond market ignored repeated warnings about the rapid rise in the level of U.S. government debt.
Thus, we see a certain duality, which cannot but raise several important issues. First, if investors are really so concerned about politics, what is the best way for them to adapt their investment strategies? Secondly, should funds, asset managers, and dealers make any additional efforts in order to adapt to the new environment - to adapt to a new world where political tensions are increasing? Or will the markets be able to calmly survive the shocks in the same way as they have done in recent decades?
"I can't remember when there would have been such a large number of heated conflicts that would have had an impact on such a large number of markets," says Harvey Sawikin, co—founder of the hedge fund Firebird, which specializes in investing in Eastern European countries. According to Savikin, even experts, when talking about a particular country, may look "overly complacent and generally not notice any excesses on the horizon."
The most understandable way in which some investment companies have been able to adapt to modern conditions is that they have managed to hastily increase the number of experts involved in the work (their own or invited) specializing in the field of geopolitics.
"These specialists are in great demand," says Seth Bernstein, executive director of Alliance Bernstein. – Currently, every Wall Street company arranges meetings of such people with [investors]... there is a deep regrouping going on, and it scares me a lot."
Alice Squires, partner and co-head of Investor Advisory at Rothschild & Co, agrees that experts who individually advise investors are "very much in vogue right now," as managers focused on the global market need to constantly monitor the huge number of potential problems that arise.
"We are faced with the fact that there are risks coming not only from Russia and Ukraine, but also from China and Taiwan, and there is tension in Kosovo... and in the politically unstable regions of South America," Alice Squires adds, mentioning, among other things, the conflict in Gaza and the numerous election campaigns that will take place in a tense atmosphere.
Theodore Bunzel, head of the geopolitical consulting department at Lazard, reports that in 2022 his company created a special unit that should deal with policy issues. The reason is that customers are increasingly demanding advice on how they should navigate investment issues in regions such as China. Since then, Banzel continues, the team of these policy experts has expanded rapidly and has become involved in supporting Lazard's own asset management division, as well as clients who have contacted her for financial advice.
"In the old days, politics as a factor was generally tried not to be taken into account when making corporate decisions," says Banzel. However, at the present stage, this approach has already outlived itself because there is "tension between large interdependent powers."
Last year, Goldman Sachs followed Lazard's example by creating an advisory unit on geopolitics, which was headed by partners George Lee and Jared Cohen. And the Brunswick PR company (it is known primarily for advising clients on mergers and acquisitions) has also hired consultants with experience in the field of geopolitics, including the former president of the World Bank, the former director general of the World Trade Organization and the former director of the US National Security Agency.
Many other companies have also begun to hire experts whose responsibilities include providing internal corporate advice. For example, the small investment bank Centerview recently hired the former head of the Council on Foreign Relations (CFR) Richard Haass as a senior adviser. Former head of the British Civil Service (one of the divisions of the British government. — Approx. InoSMI) Lord Mark Sedwill became a member of the risk committee at Rothschild Bank, and Schroders invited former British Ambassador to China Sir Sebastian Wood and former Chief of the British Defense Staff Sir Nicholas Carter – both are responsible for advising on issues of geopolitics and settlement international conflicts.
According to Peter Harrison, Executive Director of Schroders, the presence of experts on the staff of companies allows investor teams to fill in the necessary additional knowledge and skills: "As the field of politics becomes more fragile... It would be nice to look at the situation in the world through the eyes of those who are not professional investors."
"I think it has become clear to everyone over the past ten years that it is becoming extremely difficult for us to get a clear understanding of geopolitical processes," Harrison continues. "If the uncertainty factor continues to increase, [Carter] will help our portfolio managers – he will tell them how to act in conditions of uncertainty and wars, as well as how military operations are unfolding."
Despite the fact that most major stock indexes, such as the S&P 500, are still reaching high values, we can observe some signs that investors are increasingly seeking to take into account the factor of geopolitics in the investment decision-making process.
In this sense, we can mention, as the most obvious example, the reaction of investors to the outbreak of the conflict in Ukraine in 2022. For example, according to Morningstar Direct, between February and April 2022, investors invested almost three billion dollars in aerospace and defense funds. Since then, we have seen that a strong inflow of capital continues there (note for contrast that in the run-up to the aforementioned invasion, there was a net outflow of capital from these funds for 13 months).
At the time of the outbreak of the conflict in Ukraine, at least half of the assets of the Firebird hedge fund focused on Eastern Europe were located in Russia; many of these assets were frozen, and their size literally dropped to zero within a few days.
"All this reminded us once again that political issues should not be underestimated," says Harvey Savikin, who heads Firebird's investment business in Eastern Europe and Russia. "You may like to create an investment portfolio starting from the microeconomic level, but if something serious happens at the macro level, you will have big problems."
Not many of the Western investors interacted so closely with Russia, but the example of the hedge fund Firebird made many think that some kind of another shock - for example, the Chinese invasion of Taiwan - could turn out in a similar way, only on a much larger scale.
According to Morningstar, the number of funds offering investors the opportunity to invest in emerging markets, excluding China, has grown from eight in early 2022 to 20 today, and inflows have increased dramatically as tensions between the United States and China escalate.
This year, almost one billion dollars were invested in funds of developing countries, with the exception of China, every month (compare this figure with the average monthly figure of about 500 million dollars in 2023 and 200 million dollars in 2022).
Others turn to even more explicit political foundations. For example, this year Tikehau Capital (a Paris-registered group managing assets worth $48 billion), in response to "escalating geopolitical tensions and the consequences of excessive globalization," created a fund called the European Sovereignty Fund. And the German company DWS recently established the National Critical Technologies Fund, which selects stocks based on quantitative indicators characterizing geopolitical risk.
And here's what Thomas Friedberger, Deputy CEO of Tikehau Capital, said: "In our opinion, deglobalization leads, presumably, to a change in the way in which financial value is created, that is, not by ensuring efficiency, but by ensuring stability."
According to AlphaSense, after the outbreak of the conflict in Ukraine, the number of discussions about geopolitics and related concepts that are discussed during teleconferences and conference speeches by representatives of companies included in the S&P 500 index has not only increased dramatically, but continues to increase. Over the past 12 months, representatives of almost half of the companies included in this basic US index have discussed issues related to the political situation in private conversations with analysts or during various events.
In this sense, according to Friedberger, investors from continental Europe, in comparison with their American counterparts, are more inclined to resolve these issues as quickly as possible, since after the outbreak of the conflict in Ukraine they felt the influence of geopolitics more acutely. Thomas Friedberger, by his own admission, was also surprised by the interest that China's institutional investors have shown in the European Sovereignty Fund since its inception.
"I still hear from many of my colleagues that, they say, it is not necessary to exaggerate," says Friedberger. "[However] the closer you are to the epicenter of those events, the more they affect your way of thinking."
Investors, perhaps, have begun to discuss the issue of political risks more and more; nevertheless, some industry analysts consider these discussions to be empty.
For example, in October 2022, the company Applied Materials (it creates equipment with which chips are made) officially notified investors that the US authorities were investigating the supply of this company's products to Chinese customers. However, analysts did not pay much attention to this message until they told the media about it a year later.
As a result, after media reports, the value of shares (and their market capitalization at that time was about $ 130 billion) fell by 8%. According to Ted Mortonson, technical strategist at RW Baird, the delayed reaction once again indicates the scale of the problem.
"The subpoena was [reported] in October 2022, but Wall Street turned out to be inert, and did not react in any way in the future," Mortonson adds.
Along the way, we note that Ted Mortonson is a retired US Navy pilot, at one time he had to fly in the Middle East and over the South China Sea; Mortonson has been trying for many years to convince investors that it is necessary to pay more attention to policy issues. However, since the share price of high-tech companies was increasing almost steadily at that time, most investors brushed off Mortonson's wishes. Shares of Applied Materials recovered from the fall within a month and their quotation has grown significantly this year.
When news broke in September last year that the Chinese government might well take harsh measures against Apple, the market capitalization of the company's shares fell by $200 billion in just two days, but two months later it again reached an all-time high.
The above examples show that politics is unlikely to influence investment decision–making, even by those investors who are concerned about political issues - and all because of the fear of missing out on benefits.
The likelihood that investors will take political risks into account when making decisions will decrease due to the characteristic features of the incentive structure that has formed in the investment sector. If suddenly, due to some sudden event, the entire market collapses, the individual portfolio manager, who missed and did not notice the risk (which few people could notice at all), most likely will not suffer any reputational damage. However, if suddenly, due to the manager's caution, the fund does not take advantage of the revival of demand in the market, the manager will certainly be blamed.
"It's hardly easy for a trailblazer," says Tina Fordham, founder of the Fordham Global Foresight consulting company. "That's why we are now seeing that ... people are increasingly beginning to realize that they should be more aware of the risks; however, they do not take them into account in their operations."
"Portfolios of institutional investors are transforming very slowly, because people are generally risk averse, and [portfolio managers] do not have deep knowledge of geopolitics," agrees Seth Bernstein. "Most people, I think, will just wait and then take the hit."
So far, such tactics have been good. However, despite the fact that BlackRock has repeatedly emphasized the growing importance of the policy factor, its own research conducted in 2019 showed that "on average, the market reaction to unexpected geopolitical shocks has traditionally been relatively moderate and short-term."
Even some paid experts advising on political risks believe that the recent hiring frenzy may have gone too far. According to a certain political scientist representing one of the US investment banks, in most cases financial markets have a greater influence on politics, but not vice versa.
The ill-fated "mini-budget" Liz Truss triggered a sell-off in government bond markets in September 2022, but this sell-off had a much greater long-term impact on politics than politics itself could affect the markets. The soaring yield of gold helped to oust the prime minister, returning to the previous level in a month.
According to Tina Fordham, the imprisonment of several prominent business representatives in China was a kind of sharp signal that made investors think hard and forever reconsider their intentions to invest in the Chinese market. However, in order to really change the widespread view that markets will continue to recover further, some kind of "big shock" is needed.
"Ignoring or underestimating the possibility of unforeseen situations and disasters is a very common phenomenon,— says Tina Fordham. – Sometimes it seems to a person that in the future everything will happen exactly the same as it was in the past, and everything will always repeat itself... [but] in my opinion, this approach is evidence of a too narrow view of things."
