With the world seemingly splitting into two economic and political blocs, led by the US and China, what are the implications for investors?
As General Sir Mark Carleton-Smith addressed wealth and asset managers at a May conference in Luxembourg, stunned delegates pondered the financial implications of his prognosis.
Previous years had seen dramatic on-stage interviews at the same cross-border summit, staged annually by global consultancy Deloitte and local law firm Elvinger Hoss Prussen. They featured the likes of ‘rogue trader’ Nick Leeson and political heavyweight Kenneth Clarke, who served in government under four different UK prime ministers.
But the appearance of General Carleton-Smith – until recently head of the British Army, and previously director of special forces – was both sobering and thought-provoking.
A new global order pitching a nexus of three authoritarian states – Russia, Iran and China – against a US -backed bloc – is in an advanced stage of construction, according to the general.
The current stand-off, he believes, results partly from a “strategic miscalculation” which allowed Russia to first forcibly seize the Ukrainian regions of Crimea and Donbas in 2014, unopposed by Western powers, leading to Moscow’s invasion of its western neighbour from February 2022.
Western leaders had mistakenly assumed “Putin had taken a different set of lessons from the experience of our interventions in Iraq and Afghanistan”, which would dissuade him from trying to amass new territory in Europe.
This invasion, in several stages, has led to the building up of Russia’s military economy, now increasingly supported by China and Iran, says General Carleton-Smith, sharing the view with his investment audience that wars are typically won through economic competition, rather than on the battlefield.
A volatile “combination of artificial intelligence, quantum science and robotics” is further fuelling global conflicts, where cyber-attacks regularly maim strategic national infrastructure.
“We’re living through an age of imperialism where the main players are not countries or even governments,” according to the general. “They’re actually private companies and individuals and there's no law of nature that suggests that they should either be good or even benign in that space.”
The bleak and challenging future which the delegates were left to ponder involved a “hybrid playbook”. This embraces primitive artillery shell bombardment, data-led precise missile strikes and an “immigration tap” that can be switched on and off at the behest of authoritarian regimes to further fuel political polarisation and instability in Europe.
The most senior player in this authoritarian hierarchy is Chinese president Xi Jinping, described by General Carleton-Smith as “Mao with an iPhone”, personally overseeing “the world's single most successful communist party with a very effective strategy of economic modernisation, plus financial, commercial and military mobilisation”.
China’s inexorable rise and “very clear sense of historical destiny” is further facilitated by the terminal structural decline of the West, he believes, although Europe and the US are fortunate that “the Chinese economic miracle is confronting very significant headwinds”.
Investment implications
Most investment players agree that the two powerful economic and political blocs, starkly described by the former British Army leader, will increasingly dominate economic relations. Today they are they looking at innovative ways of playing this trend.
Sanctions imposed by dollar and euro-based countries have played a very high profile role in financial markets, impacting the long-term equilibrium of international currencies in particular, according to Paul de Leusse, CEO of Sienna Investment Managers, a family-owned French firm with ambitious expansion plans in Europe.
“For asset managers, the immediate effect is a renewed interest in investment themes tied to European sovereignty,” he says. “Previous taboo topics such as protectionism and defence are no longer dirty words, as they have been renamed as ‘re-industrialisation’ and ‘reshoring’. Our private credit clients are expressing substantial interest in financing these sectors.”
Clean energy as a theme received a significant boost, at the expense of fossil fuels, after Russia’s latest invasion of Ukraine in 2022. “The invasion of Ukraine has had a significant impact on energy supply channels in Europe. Investors recognised this as an opportunity to associate clean energy and European sovereignty investment theses in their strategy,” says Mr de Leusse.
“Having said this, investors must also apply additional scrutiny when choosing the renewable energy projects they support, especially in such a buoyant market which is awash with liquidity. The emergence of clean energy, because of its inherent intermittent nature, must also be accompanied by the expansion of storage facilities, the absence of which would lead to overcapacity and gridlocks.”
Pivotal point
While private bankers, many of them serving Russian clients, played down the start of the major European war, it was clearly a pivotal point for many large-scale investors.
“Ukraine was a wake-up call. Investors who thought they could conduct ‘business as usual’ with autocracies had a rude awakening,” says Yves Choueifaty, founder of French investment firm TOBAM and inventor of the ‘tyranny risk factor’, which measures how open countries are to investment. “They lost a lot of money in Russia and started looking to China with anguish.”
Most index providers have launched “ex-China” indices, he says, to cater for latest investor sentiment, with a growing number considering China uninvestible. “The Russian aggression of 2022, the spectacular unconditional alignment of China to Russia and events in the Middle East have all increased awareness of the fact that the economic rationality of autocracies is, to say the least, questionable,” believes Mr Choueifaty, who points to a 40 per cent increase in China’s military budget over the last five years.
“After all, Russia is a ridiculously small business and trade partner of China when compared to the US, the EU, Canada, Australia or Germany. For Beijing, being aligned with Russia is a good indication of the absence of economic or business rationality,” he says, an outcome that is very unattractive for investors.
This risk factor, he claims, is independent from all other market drivers, including sectors, value or growth classification, momentum, market cap and beta. Because an ex-autocracy index only focuses on direct exposures it reduces the overall exposure to autocracy by just 15 per cent. Judging indirect exposure through companies listed elsewhere, but investing in autocracies, would further boost the performance of an ESG portfolio, but vastly reducing the risk, he says.
But Jian Liang, head of the China market at Banque Internationale à Luxembourg, majority-owned by China-based Legend Holdings since 2018, believes those Chinese tech companies, including electrical vehicle manufacturer BYD, which are focused on foreign markets will still offer healthy returns. This is despite the geopolitical tension around such enterprises, with president Joe Biden recently applying more punitive tariffs on such firms, as the US trade relationship with China comes under increased scrutiny ahead of the presidential election.
“European investors will return, as their interest rate is so high, they will need to search for new opportunities,” says Ms Liang. “Geopolitics will play a certain role, but it’s more important for people to make money, once these opportunities arise. They will come back to China.”
Co-operation amid confrontation
Despite all the talk of geopolitical confrontation, there are several examples of European investors launching collaborative solar and wind power projects, says Natznet Tesfay, head of analytics at S&P Global Market Intelligence in London. On a recent trip to China, for instance, German chancellor Olaf Scholz noted Sino-German co-operation in hydrogen energy.
“These investments are balanced against prospective changes in policy direction and regulation,” she says. For example, ratification of the EU-China Comprehensive Agreement on Investment (CAI) is on hold. But there is close co-operation, says Ms Tesfay, between the EU Commission and People’s Bank of China on green finance “via the harmonised taxonomy on climate change mitigation, which has opened up cross-border financing for sustainable projects”.
Investment managers among her clientele are currently focused on how geopolitical conflicts are leading to the “weaponisation” of trade. “Following disrupted supply chains due to Covid-19 related restrictions, companies are now trying to mitigate exposures from shifting alliances and the broader scope and use of sanctions and tariffs, among other more prominent trade barriers,” she says.
While fund houses have increased their focus on geopolitical risks and opportunities over the last 15-20 years, this has accelerated recently, with a “notable uptick” in requests globally leading up to the 2016 Brexit referendum, and “steady increase in interest since”.
One infrastructure manager at the Luxembourg event backed these assumptions. “Infrastructure is always a highly political asset class,” he said. “Many of us in Europe have friends and connections in Ukraine, so of course we are keen to do work there. But it’s still too early to talk about specific investment while Russian bombardment continues.”
The fund management community has the responsibility to play a major part in the reconstruction of infrastructure, destroyed in conflicts in both Europe and the Middle East, confirms General Carleton-Smith.
“There's an obligation for the financial community to get over many of their concerns,” he says. “Most of them are couched in the relative priority that ESG has enjoyed, and recognise that FDI and reconstruction in Iraq, certainly in Ukraine, and at some juncture, one hopes in Gaza, is going to fundamentally stabilise those regions.”
But the general adds a major caveat to his call to arms: “It’s difficult to see the right climate emerging as yet.”
This article is from the FT Wealth Management hub
