Headlines of late seem to describe two different planets at once. In the financial pages, we have seen equity indices march to new highs, and indications of volatility trend toward historically low levels. Yet in the geopolitical sphere, we see a reawakening of concerns not entertained in some cases since the Cold War—and in others since the days of Smoot-Hawley.
Amid such newfound political uncertainties, is it wrong to ask if complacency might be elevated among market participants? At Clear Harbor, we believe it is irresponsible not to.
The conventional wisdom anticipates that U.S. fiscal policy will provide a tailwind for growth, ultimately catapulting earnings higher over the next several quarters. Internationally, improved economic data, such as gauges of manufacturing activity, are likewise providing reasonable hope that growth and inflation expectations can bounce markedly higher in calendar 2017.
We do not refute the empirical data: indeed, we continue to favor equities for investors who can easily resist emotion, sleep through the ebbs and flows of the market, and avoid any need to draw directly on their corpus in the foreseeable future. However, we do question the degree to which the Fall 2016 equity market rally has already discounted improvements in the business and economic environment.
Perhaps more importantly, investing—like life itself—is not so easily divorced from a myriad of personal and emotional variables. As advisors we must consider these risks, as well as those affecting the marketplace, even when it is unfashionable to do so. In fact, the current moment may represent a generational shift in the type of geopolitical uncertainty that dominates global affairs—and with them, business and investment prospects.
In the immediate post-Cold War era, most major conflicts were remarkably limited in their long-term economic impacts beyond their immediate neighborhoods. The first Gulf War, the mutually destructive conflicts in Bosnia, Rwanda and Somalia, the change of power in Venezuela or Argentina: while all were important, and some locally devastating, none had lasting impacts on the global economy. Even the second Gulf War, though more destructive and costly in blood and treasure, was for years less destabilizing to developed markets than the financial crisis.
Today, geopolitical risks seem to be shifting from comparatively well-contained conflicts in the Middle East and the emerging and frontier markets to the largest economies in the world. The defining issues of our day instead are Brexit, the future of the euro, America’s posture toward trade and tariffs with its top trading partners, and China’s repudiation of existing trade arrangements and aggressive pursuit of territorial claims. Even in the Middle East, conflict has grown more widespread and strategic in nature, with Putin’s Russia aligning with Shia Iran and Assad’s government in Syria—and the heartbreaking stream of refugees across the region placing direct strain on the politically ecumenical project that is the European Union.
In the past, I have on balance tended to downplay the implications of geopolitical uncertainty for long-term investment plans. Indeed, recent developments may again prove as irrelevant to profits in 2020 as the outcome of the Falklands conflict was to investors in Apple Computer. However, the nature of the game has shifted enough for the thoughtful asset allocator to contemplate the potential repercussions of unfamiliar, and rather negative, global uncertainties.
While still unlikely, the goalposts have moved—and candidly, they now encompass possibilities extending to a global trade war and conceivably even military conflict between major powers. The headlines in the political sections of the paper have sparked a significant reconsideration on the Clear Harbor Investment Committee of where geopolitical uncertainty is poised to wreak the most havoc.
- A Case In Point: China
One of the most significant areas of geopolitical uncertainty at the moment is the status of relations between the U.S. and China. The relationship may well be at its most precarious point since Nixon first engaged with the Communist nation in 1972. Since the Great Recession of 2008-09, the relationship has seemed to shift as China sought to cooperate less and compete more. Cooperation in areas such as climate change and global pandemics have continued. But recently, China has significantly ratcheted up military exercises in the South China Sea and East China Sea coupled with a deterioration in human rights, elevated cyber espionage, and a seemingly elevated disregard for trade agreements.
Just yesterday, our team had the opportunity to listen to the Asia Society Task Force on U.S.-China Policy. The Task Force members present ranged from Winston Lord, former U.S. ambassador to China under President Ronald Reagan and a special assistant to Henry Kissinger during the 1970s, to Susan Shirk, the former Deputy Assistant Secretary of State from 1997-2000 with responsibility for policy toward China, Taiwan, Hong Kong and Mongolia.
Ambassador Lord attended every meeting that Presidents Nixon and Ford and Dr. Kissinger had with Chairman Mao, Premier Zhou and Deng Xiaoping. In fact, he was one of the two American drafters of the Shanghai Communique, the document agreed upon by the U.S. and China during Nixon’s historic visit to China establishing that neither nation would seek hegemony in the Asia Pacific region.
In summarizing their formal recommendations to the Trump Administration, the Asia Society Task Force highlighted an important reality: the relationship between the two nations has deteriorated over the last several years and is now “precarious.” These co-architects and stewards of our two nations’ peaceful and productive relationship over the decades pointed to several important considerations.
First, the world’s two largest economies are more interdependent than ever. In 2016, the U.S. traded more goods and services with China than any other country. Even as the U.S. imports more goods from China than we export there, China is nonetheless our third-largest export market,after our neighbors Canada and Mexico.
Further, 95 percent of the world’s population resides outside the U.S.,along with 80 percent of its purchasing power. Approximately one-third of S&P 500 revenues originate from outside the U.S., with China already the largest international contributor to U.S. corporate revenue. China and Asia generally will remain of critical importance to U.S. trade and economic growth for some time to come.
We highlight these points to emphasize the economic impact that any skirmish between America and China could present for the U.S. and global economy. More than in many inherently unstable parts of the world, leadership will prove as determinative to the shared futures of these two giants as it was when ties were first formed a generation ago. A steady hand guided by informed and rational approaches and responses to the complex and challenging issues ahead will be critical.
As market participants, we believe it is more important now than perhaps at any time within the last half-century to assess the evolution of diplomatic and political events around the world.The parlor game of the election is well behind us. The years ahead will require constant evaluation of how geopolitical events and trends affect the risks and opportunities of the global investment landscape.