Geopolitical Risks Threaten Exuberant Stock Market

Impacts on investing of China's next move, departure from globalization
June 14, 2017 Updated: June 14, 2017

MONTREAL—Geopolitical risk is running high despite all seeming well with U.S. stock markets, but evaluating broader trends, which include “de-globalization” and China’s economic transition on asset prices and inflation, is critical at this time.

Volatility—the degree of fear in the market that can be measured by the VIX (S&P 500 volatility)—is extremely low. Meanwhile an elevated level of policy-related economic uncertainty prevails; investors have little confidence that impending government actions will work.

“It’s a little bit spooky how disengaged the two have been to each other,” said Lisa Emsbo-Mattingly, Fidelity Investment’s global asset allocation director of research, at the International Economic Forum of the Americas on June 12.

While it seems the world is heading for a period of synchronized economic growth, geopolitics—or non-market factors—such as aging populations and rising inequality remain headwinds.

Diversification has always been critical for investors to smooth market ups and downs on a path to achieving financial goals. In times of market stress, asset prices tend to move together (increased correlation) and it becomes costly to change a portfolio’s investment mix due to greater costs for buying and selling (worse liquidity).

Domestic Focus

With globalization having distributed economic growth toward emerging and frontier markets, the U.S. hegemony has been eroded, said Marko Papic, senior vice president of Geopolitical Strategy at BCA Research, a 68-year-old Montreal-based independent investment firm.

“We know from history, when more countries get to say and pursue what they want, it is a less stable world,” Papic said. “Today we have the highest number of conflicts going on at the same time.”

China has its eye on filling the void left by the United States as the post-Cold War order crumbles. Under Donald Trump, German Chancellor Angela Merkel said the United States can no longer be a reliable partner.

Knowing what’s going on in China now is more important than ever.
— Paul Podolsky, partner, Bridgewater Associates

And Canada intends to play a bigger role on the international stage, based on recent comments from Foreign Affairs Minister Chrystia Freeland.

“We worry that East Asia will be the powder keg of the 21st century,” Papic said. Chinese and American economic symbiosis is tenuous at best.

In a more multi-polar world, Papic argues that it will be smaller and medium-sized businesses that will benefit relative to the large multinationals that prospered as globalization took hold.

“Any economy, sector, or particular stock that derives most of its final demand from within the jurisdiction in which it is domiciled will be the [investment] theme of the next 15 to 20 years,” Papic said.

The China Factor

“Swings in the global economy come from the swings in China’s economy,” said Paul Podolsky, a partner at hedge fund Bridgewater Associates.

China’s boom came from its cheap cost of plentiful labor; however, that’s less true today than it used to be. Its more recent rapid buildup of debt has propped up the world economy.

The issue is that plenty of economies—Canada, South Africa, Australia, Brazil—depend on China’s continuing to operate a credit-driven economic model. However, if the Chinese authorities are able to pull off the difficult transition away from a debt-fuelled investment model toward a domestic consumption model, it will be painful for emerging markets and commodity-driven economies. But China will benefit in the long run.

“Their domestic economy, that really needs to be resolved before they start thinking about global domination,” Papic said about China, whose 19th communist party congress takes place in the fall.

The International Monetary Fund (IMF) revised its forecast for Chinese GDP to grow 6.7 percent in 2017. This is up from a prior estimate of 6.6 percent. Chinese credit growth slowed in May under the tighter supervision of policy-makers.

We worry that East Asia will be the powder keg of the 21st century.
— Marko Papic, senior vice president, Geopolitical Strategy, BCA Research

“Knowing what’s going on in China now is more important than ever,” Podolsky said. He added that the short-term prognosis for China looks good—at least the rapid debt buildup is denominated in its own currency, of which more can be printed.

Specter of Inflation

As globalization grew, production moved to cheaper sources of labor—China and emerging markets. Among the reasons the populist wave rose is the failure of globalization to boost incomes for the middle class in developed world nations like the United States and United Kingdom.

Canada’s finance minister, Bill Morneau, has targeted helping the middle class in his two budgets. “We need to deal with the sense of anxiety people are facing,” he said in discussing the rejection of the status quo seen by the Brexit vote, Donald Trump’s election, and the Liberals returning to power in Canada in 2015.

As the global economy moves away from peak globalization, an upside risk for inflation develops. If free movement of capital and labor is restricted, supply is more costly to produce, resulting in higher prices.

“Our view is that we are exiting a deflationary period and entering an inflationary one slowly but surely,” Papic said. “And then gold will realize its role as a safe haven.”

U.S. stock markets have been in a “Goldilocks” scenario, supported by low interest rates, low inflation, good corporate earnings, and a low threat of an imminent recession.

“I would not say there’s a lot of complacency in the market. The VIX is reflecting a very exuberant market,” Emsbo-Mattingly said, adding that the recovery emanated from a Chinese recovery, which has been good for cyclical stocks globally.

“My concern is we’re at peak valuations, peak growth. A lot of things are as good as they’re going to get,” Emsbo-Mattingly said.

Follow Rahul on Twitter @RV_ETBiz

Follow Rahul on Twitter: @RV_ETBiz