Investment portfolios yet to come to terms with new world order
The world is grappling with huge geopolitical change and transformative technologies like AI, but few institutional investors have adapted their approaches.
Earlier this week, just ahead of the UK’s AI Safety Summit, the White House announced it would require all major AI model developers to share the process and results of their AI model tests, in a bid to rein in the safety of how companies are using AI and in particular their geopolitical implications.
Companies have not always been tangled up in geopolitics, but the advent of both a new world order, and the rise of new transformative technologies like AI, brings the two together. This is however lost on many corporates today. Indeed, it might also be lost of the world’s top diplomats.
Strategic decisions
An example is the clear statement of US foreign policy that appeared last week authored by Jake Sullivan, the US national security adviser in the Foreign Affairs Journal, where he lays out the broad sweep of America’s diplomatic views, and the strategic challenges that lie ahead to the ‘sources of American Power’, and frankly the number of foreign policy issues the US is managing.
In the article he notes that beyond geography and natural resources, “it is the strategic decisions countries make that matter most — how they organise themselves internally, what they invest in, whom they choose to align with and who wants to align with them, which wars they fight, which they deter, and which they avoid”.
Smaller states and notably small, advanced economies, may well appreciate his thinking — they are more exposed, vulnerable to international geopolitical forces and need to adjust nimbly to them. In this respect the imminent entry to Nato of Finland and Sweden are critical examples as is the overly complicated web of alliances that Qatar has made for itself. In addition, larger countries are being forced to ‘choose sides’.
If states are grappling with the new world order, there is mixed evidence that corporations and investors are facing up to it.
Many are used to a world where geopolitics was interesting to read about and debate but owing to the soporific effect of quantitative easing on markets, mattered little in the scheme of things until the monetary battleships retreated. A few investment firms, such as Sequoia, have changed their structure to better fit the multipolar world but the majority of banks and asset managers are simply still talking about geopolitics rather than acting on it.
How to respond
If geopolitical risks are rising, then what should investors and companies do?
To start with investors first, there are two practical elements to consider. The immediate risk is that the macro world becomes more volatile, notably as currencies and bond markets are undercut by political risk. Turkey is the extreme example and the UK bond market wobble of 2022 signalled that when market impatience runs out, they can treat developed countries like emerging markets.
In this regard, the single biggest macro risk for 2024 is that extremely high debt levels (across continents and balance sheets) are ‘ignited’ by a political or geopolitical risk. This might be a dramatic climate event, the prospect of a second, even more unorthodox Trump presidency, or an event in the South China Sea.
A more intellectually demanding element is to accept the assumption that the world order is changing for good (i.e. globalisation is gone) and to imagine who will be the financial power houses of the 21st century. The thought experiment is aided by research work by professors Elroy Dimson and Paul Marsh, that compares the percentage of world equity market capitalisation held by different countries in 1899.
In 1899, the UK was the biggest stockmarket, accounting for 24 percent of world equities (measured in dollars), but now comprises 4 per cent, Germany had 13 per cent of world equities in 1899 and now has 2.3 per cent while Russia has dropped from 6 per cent to near zero. In contrast, the US made up only 15 per cent of world equities in 1899, but is now 60 per cent. Thus, the thought experiment goes as follows – might the US drop to 40 per cent, could Chinese bonds comprise 33 per cent of developed world bond portfolios by 2040, and might a bitcoin/crypto ETF take up 3 per cent of a typical investment portfolio?
The reality is that very few institutional investors – in either asset or wealth management – have tried to adjust portfolios for the prospect of a new world order, and in the long run this puts client capital at risk to the shifts in the rise and fall of nations.
Many institutions run portfolio structures that are very similar in their intellectual underpinning to those constructed 20 years ago. The outbreak in inflation and the ways in which it caught fixed income managers and asset allocators off-guard (it meant that many ‘conservative’ portfolios lost a lot of money) should qualify as a stark warning to institutional managers of the ways in which geopolitical fault lines can catch investors off-guard.
Michael O’Sullivan is author of ‘The Levelling – what’s next after globalization?’ Follow him @levellingbook
