Private View Blog: Invasion of Ukraine signals death knell for globalisation

On average, markets have a tendency to fall in the build up to geopolitical conflict, and then rally thereafter. To date, this pattern has held as the conflict in Ukraine plays out, though like the aftermath of the outbreak of the Covid pandemic, there is a moral dissonance between human suffering and rising equity prices.

Two years ago, the Covid-related rally in prices (markets doubled from their Covid lows) was sparked by the rationale that aggressive fiscal and monetary policy, in the context of an accelerated digitalistion of economies, would boost valuations. 

Now, the hangover from that stimulus, a multi-decade high spike in inflation, is undercutting bond markets, and arguably should also prove more demanding for equities. While new technology driven trends remain in place, the other change in the narrative is that the invasion of Ukraine has signalled the end of globalisation.

This view is ‘late’ ­– globalisation has been faltering since the early 2010s and has been undercut by events like the snuffing out of democracy in Hong Kong and the failure of large nations to collaborate during the pandemic. Many of the boons of globalisation – low inflation, peace and the spread of prosperity – are now being reversed.

Quality matters

There are several lessons for markets. The first, with respect to emerging markets in general and Russia in particular, is that the idea of resilience or institutional quality is important. In future, I expect that both bond and equity investors across emerging markets will pay greater attention to the role of factors like institutional quality, democracy and the rule of law when making investment decisions with respect to emerging markets. 

In other asset classes, the spike in inflation and the corresponding sell-off in ‘safe’ fixed income is producing a portfolio crisis, the amplitude of which has yet to be fully appreciated.

For the past 20 years or more (during globalisation) the wealth and asset/investment industries have invested trillions of dollars of client money on the basis of corresponding chunks of equities and government bonds (notionally a ‘60/40’ portfolio).

The ‘death of inflation’ in the context of high growth during globalisation meant both asset classes performed, and then both were supported by an overly long period of quantitative easing. 

This era of ‘easy’ returns is likely now coming to an end, and with it the credibility of the investment industry.

While it is well known that few investment managers can consistently earn above average returns and fewer still take the kinds of risk needed to do so, many rely on them to protect wealth. The sell-off in ‘safe assets’ like government bonds undercuts this and begs a number of questions, notably because the performance of bond and equity prices has become positively correlated.  

There will be a debate as to what constitutes a ‘safe asset’ in the context of rising inflation – the issue being that most portfolio frameworks only permit tiny holdings of assets like commodities and inflation protected bonds.

Go private?

Some investors believe the answer lies in private assets, but in the developed world and much of Asia, real estate prices are extremely high (relative to income and GDP) and will likely not withstand rising interest rates. In the US, with long-term mortgage rates rising to 5%, housing-related stocks (and increasingly banks) are performing poorly. My sense is that much of the rest of this year will be dominated by concerns that housing markets have peaked and will ‘roll over’. 

Second, and relatedly private capital assets, notably private equity where there is a large amount of leverage deployed, may also struggle in terms of performance. In venture capital, valuations have followed public markets down, and if you believe in technology driven megatrends this may well be the most interesting time to build exposure to high growth companies, the snag for many investors is that access to these opportunities is difficult to realise.  

In the coming weeks, my sense is that the market narrative will focus mostly on negatives – Europe’s strategic dis-engagement from Russian energy in the context of its brutal war on Ukraine, the risk that high inflation leads to political instability in countries as diverse as Peru and France and the possibility that Asia is entering a recession (lead indicators in South Korea and China are pointing downwards). 

On the positive side, the tech transformation of the world economy will continue, and my sense is that we are reaching ‘peak inflation scare’.

Michael O’Sullivan is author of ‘The Levelling – what’s next after globalization?’