The confluence of high valuations and geopolitical risks indicates potential overheating and future uncertainties. Europe, with its heavy dependence on third-party suppliers for essential goods and raw materials, finds itself particularly vulnerable. The pressing question remains: Can Europe sustain its economic power and prosperity while effectively merging ambitious climate policies with a resilient industrial sector?
Optimix Asset Management’s investment team is not at ease. In the second quarter, it announced to swim full steam against the current: the market is far too enthusiastic and complacent. As a result, it is losing sight of the bigger, uncertain picture.
For instance, the S&P 500 is on a plus of about 18 per cent this year, while the Euro Stoxx 600 is heading for a year-to-date return of more than 8 per cent. “Maybe I am just too paranoid. For me, it’s a matter of zooming out. Stepping out of the sentiment and the delusion of the day and then taking a closer look at what is going on,” says Arjen van der Meer, who is responsible for tactical asset allocation at Optimix.
The asset manager, part of Sweden’s Handelsbanken, is not alone in its scepticism: The Buffett Indicator, named after the eponymous value investor, Warren Buffett, argues that the market capitalisation of the S&P is twice the size of US GDP. This was also the case in 2022, when it announced the S&P500’s biggest price drop since 2008, FactSet data show. The Buffett Indicator is not uncontested today, but other popular valuation measures, including 12-month P/E ratios, price-to-sales and company value-to-sales ratios, are all above the 90th percentile relative to history.
The Buffet Indicator: valuations in relation to GDP
The high valuations prompt Optimix to be cautious. “Yes, we are somewhat concerned about the stock market. Especially the US one. Surely there are quite a few signs of overheating. That applies to the valuation of the market, but also to the concentration of the market. There are only a few companies making the performance of the S&P,” warns Van der Meer. “And yet, what we see in the reports is that the market sees very few dangers. Whereas, in our view, the market has a lot of dangers in it.” Optimix has now gone - against the trend - underweight equities. It has also gradually built up a commodities position (in response to inflation) and added interest rate products and duration to the portfolio.
“What we see in the reports is that the market sees very few dangers. While, in our view, the market holds a lot of dangers.”
Arjen van der Meer, Optimix
“The reason for the latter is that we now actually see the risk of recession increasing significantly. Until a few months ago, the market was constantly worried about that recession because of high policy rates. We said: that recession is too premature to be afraid of. Because the economy is supported by consumer savings. But these are now more or less exhausted. At the same time, expansionary fiscal policy is still there, but it is starting to wane year on year.”
Optimix thinks a more difficult period is coming. January to June is often still fine seasonally, but August to October is often a difficult period, especially if the first seven months have been good. In addition, Optimix thinks there will be much more risk aversion in the run-up to the US elections, leading to more uncertainty and turmoil.
‘50% chance of civil war in US’
At the same time, that still does not make the market nervous, which surprises Arjen van der Meer of Optimix. He is not alone in this, either. Ray Dalio, the founder of America’s largest hedge fund manager Bridgewater Associates, published an article on Linkedin last month, partly based on his book Principles for Dealing with the Changing World Order. In it, he examined the last 500 years of world history with the aim of understanding why hegemonies rise and fall. Just as a person has life phases, so do the cycles that states go through. Dalio identifies six phases of “the big internal (dis)order cycle”. The sixth stage is a (civil) war, and Dalio believes the chances of some kind of civil war in the US are currently greater than 50 per cent. He thinks we will know the answer to this assessment by next year at the latest. The assassination attempt on Donald Trump, last 14 July, will no doubt have been grist for his mill.
Dalio did his study of world history because he believes that investors operate with horizons that are far too short, and with data sets that are too limited, to properly assess risk. For his book The Changing World Order, he looked at five interrelated forces that determine the rise and fall of domestic or world orders: the debt, credit and money cycles; the internal cycle of (mis)order, the external cycle of (mis)order; climate developments; and human innovation in the field of technology.
A new world order is looming
See: ‘The Changing World Order’ by Ray Dalio.
These cycles are taking place against the backdrop of new superpowers like China and India, which are challenging the dominant Western post-war worldview. At the same time, they are claiming more influence and control. In a number of countries - China, Russia, Iran, North Korea - revisionist motivations are at play. This makes Europe particularly vulnerable, which has always believed that the rules-based world order makes the cake bigger for everyone. Gradually, an economic model has emerged from that, with a division of labour and location that makes costs as low and revenues as high as possible.
Time horizon of EU far too short
However, it is now becoming clear that the European Union is heavily dependent on third parties in many areas. Consider imports of basic goods and materials such as food and raw materials. Both make Europe vulnerable in the context of a growing global population and the transformation to a carbon-neutral world.
Peter Tom Jones, resource expert and research manager at the Katholieke Universiteit Leuven, asks how Europe can maintain its economic power and prosperity in such a rapidly changing world. He further explores how to combine an ambitious climate policy with a strong and competitive industry. This will at least require the EU to limit its raw material dependence on other countries (in this case China).
Jones’ criticism is that ‘in Europe, everything is based on different parts of a very long chain. They are all different components and each component in the European system has to be profitable on its own. And if a component is not profitable, it irrevocably goes bankrupt and disappears from the system.’
China’s long-term vision
In China, according to Jones, this is looked at very differently. “There, they look at the supply chain from a 20- to 30-year vision, which is also integrally integrated. So they do not look at it with a horizon of two or three years, or with the next elections in sight. ‘That time horizon is far too short to develop such a long-term strategy. And that is precisely what makes China so successful,” Jones said.
“We are in a new phase of history, a phase based on protectionism, on resource nationalism, on a whole bunch of new rules. And the Chinese have understood that very well.’’
Peter Tom Jones, Leuven Catholic University
For instance, the European Union has set itself ambitious climate targets. But to meet those targets, critical minerals, such as lithium and cobalt, are especially needed. Those minerals are now coming to Europe from all corners of the world. But more importantly, the processing of these minerals is dominated by China, making Europe vulnerable against the backdrop of revisionist thinking in the capital Beijing. For instance, import restrictions on Chinese-built electric vehicles (EVs) imposed by Brussels this month could just be hit with an export ban on critical minerals.
‘Europe is experiencing BANANA syndrome’’
Against this background, Jones argues that Brussels should also fulfil its ambition for “strategic autonomy” by opening and exploiting mines in Europe. For example, countries like Portugal, Spain, France and Germany have lithium, while southern Europe has nickel and copper to mine and northern Europe has rare earths available.
While Sweden is already far advanced with mining, in the rest of Europe the BANANA syndrome still prevails: Build Absolutely Nothing Anywhere Near Anything. Jones sees this attitude especially in Belgium and the Netherlands. ‘We live in the dictatorship of the loud minority. For example, a recycling plant for lithium-ion batteries in Flanders has difficulty getting a permit, even though we all realise it is part of the circular economy of the future.’
Nevertheless, Peter-Tom Jones does see good first steps. For instance, the Net-Zero Industry Act (NZIA) and the Critical Raw Materials Act (CRMA) have been passed by the European Parliament. “These are the first steps needed to achieve a larger and long-term strategy. You can therefore see a clear turnaround at the European level.”
Martin Moryson, chief economist Europe at German asset manager DWS, is also moderately optimistic. “Europe showed a high degree of resilience in both the corona crisis and the energy crisis, following the Russian invasion of Ukraine.” That resilience, he said, was shown, among other things, by the fact that Germany, within months, managed to build LNG terminals.
In contrast, Moryson does acknowledge that there is very little public discussion of these developments both in Germany and other EU countries. But at the same time, the population in member states shows a high degree of adaptability, he judges. Not many words are wasted: governments are adapting, without wanting to make “unjustified demands” on the population.
‘Primacy lies with the political interest’
At the same time, he also sees that the global playing field is changing dramatically. “Look, normally, if you follow economic theory on subsidies, you would say, if someone else subsidises their exports that’s great. Enjoy the cheap stuff, consume it and be happy. It’s a gift. But in the case of China, you almost certainly know that the primacy of policy is over economics. So you could say, yes, they do it, but not for economic reasons, but ultimately for political reasons.”
‘‘In the case of China, you are almost certain that the primacy of policy is over economics.”
Martin Moryson, DWS
He also does not rule out that a role in this is that the country wants to become the hegemony of the 21st century. “The fear is that they want to make Europe or the rest of the world dependent and to have something they can use when it comes to political issues. With that, the optimal response from a political point of view is no longer to just enjoy the cheap stuff, but to do something to keep your markets protected and reduce dependence on this kind of development. And you have to do that from a political-economic standpoint. I am afraid that in the current state of the world, there is no alternative to that.”
Listen to DWS chief economist Europe Martin Moryson on the political-economic considerations surrounding Chinese dumping practices in Europe.
Asked why investors still act somewhat haughtily when it comes to geopolitical risks, Arjen van der Meer of Optimix Vermogensbeheer replied in conclusion: “Yes, that is the typical psychology of the market you have to deal with. In 2000, it was much more logical that such a bubble could occur, because the world was then in complete peace and tranquillity. But now, the possibilities are actually not that great at all. With the result that everyone is kind of dancing on the volcano anyway - as long as it lasts.”
Cees van Lotringen is a writer, journalist and entrepreneur. He is former editor-in-chief of Investment Officer.
Geopolitics and investing
This article is part of an Investment Officer series on the impact of geopolitical developments on investments. This topic will also be discussed at Investment Officer’s Fondsevent on 30 September in the Netherlands and was previously discussed at Investment Officer’s Portfolio Day in Brussels.
Further reading in this series:
- China’s sudden electric car boom stirs strategic concerns (1 July)
- An autonomous EU would create a new framework for investors (7 June)
- Europe’s rude awakening: Geopolitics is back (21 May)
Video Ray Dalio on the changing world order: