With the power struggle between China and the U.S., geopolitics has returned to the forefront. This has led to a so-called “lose-lose dynamic,” where each player prioritises its own interests above all. For investors, this translates to a more volatile cycle. Experts recommend scenario planning and risk management as the daily prescription.
Roelof Salomons, professor of investment theory at the University of Groningen, on the lack of historical knowledge among investors (in Dutch):
The year 2014 may well have been a revolving door in recent world history. That year saw the bold and shocking entrance of the West’s geopolitical rivals onto the world stage: Russia annexed Crimea, China staked claims on islands in its extraterritorial waters, and Iran formed alliances with Syria and the Hezbollah movement to expand its sphere of influence in the Middle East.
For the United States and Europe, these provocations were a major shock. After the collapse of the Soviet Union, the West had embarked on a different path, focusing on managing a world order that was supposed to bring a win-win situation for everyone. This vision centered on globalisation, free global trade, respect for the rule of law and human rights, and nuclear non-proliferation.
The surprise of the United States and the European Union at the return of geopolitics stemmed from their complete misinterpretation of the Soviet Union’s collapse in 1991. Although the dissolution of the Soviet Union marked an ideological victory of capitalism over communism—”The End of History,” as political scientist Francis Fukuyama wrote in 1992—this triumph did not mean that the iron fist of power politics had lost its significance. On the contrary, the frustration over the West’s claimed ideological victory fueled revisionism, particularly in Russia and China. Since 2014, the dynamics of international relations have been subject to seismic shifts.
The ‘lose-lose dynamic’
With the benefit of hindsight, it is evident how immense the naivety, especially in Europe, has been. This realisation is affirmed in the Munich Security Report 2024, with the conference held in the eponymous city from February 17 to 19. The report’s authors note that “amidst growing geopolitical tensions and increasing economic uncertainty, many governments are no longer focusing on the absolute benefits of global cooperation but are increasingly concerned that they are gaining less than others.”
This so-called “lose-lose dynamic” has led more governments to prioritise relative gains over collaboration that benefits the whole. An example of this is the unilateralism championed by Donald Trump during his presidency with his slogan “America First.” Proponents of the post-World War II “rule-based model,” such as many European countries, still maintain that expanding the proverbial pie is preferable.
However, according to the Munich Security Report 2024, these countries face another challenge: the perspective of those living in poverty or suffering from prolonged conflicts. They see the West’s call to defend the abstract, rules-based order and share its costs as proof of tone-deafness. The West’s emphasis on the “rules-based order” is also seen as evidence of its hypocrisy, serving no other purpose than to maintain the status quo of Western dominance, including over the global south, critics argue in the report.
Francis Fukuyama on the rise of populism. (Munich, 2020)
See: Munich Security Report 2024
Not just the Global South
Not only the countries of the Global South but also China, arguably the biggest beneficiary of the liberal economic order, feel that the United States is curbing its legitimate aspirations. China is thus demanding a larger share of the pie. Louis Gave of the Asia-focused research firm GaveKal points out that China is no longer exporting cheap consumer goods but is increasingly focusing on capital goods such as (electric) cars, solar panels, railways, and nuclear power plants. By climbing the value chain, China poses a direct threat to exporting countries like Germany, Japan, and South Korea.
This Chinese success has provoked reactions in the West, including calls for trade restrictions. Traditional guardians of the world order see their share of the global economy shrinking. Simultaneously, people in all G7 countries, surveyed for the Munich Security Index 2024, expect China and other players from the southern hemisphere to become much more powerful over the next decade, while they see their own countries stagnating in growth and prosperity.
As more states measure their success in relation to others, there is a risk of a vicious cycle of relative thinking, loss of prosperity, and increasing geopolitical tensions. The resulting “lose-lose dynamic” is already unfolding in many policy areas and affecting various regions.
The return of the ‘zero-sum game’
This situation threatens a revival of the so-called “zero-sum game,” defined by economist and merchant Thomas Mun in 17th-century England to combat the Dutch Republic’s hegemony in world trade: one’s gain is another’s loss. This led to a series of naval wars that eventually broke the Republic’s power.
The return of geopolitics has significant consequences for investors and financial markets. For years, investors and asset allocation strategists largely disregarded these factors. But that has changed, says Andy Langenkamp, who focuses on geopolitics for ECR Research. Langenkamp notes that the demand for understanding geopolitical risks in business and markets is rising sharply. In this context, he points out that Deutsche Bank and Citi have established geopolitical divisions, while BlackRock has introduced a Geopolitical Risk Indicator.
And this month, Amundi, Europe’s biggest asset manager, joined with the publication of its first Geopolitical Sentiment Tracker as a tool to support the investment process. “We expect geopolitical risk will remain elevated for the next several years as a result of the growing number of actors involved, the tectonic geopolitical and technological shifts underway, and deteriorating bilateral relations,” the firm said.
See: Geopolitical Sentiment Tracker
In its February publication, BlackRock states that geopolitical risks are at their highest level in 18 months. Fragmentation between geopolitical and economic blocs is increasing, volatility is rising, and the world order is becoming less predictable. According to the American asset manager, the number of conflicts has reached its highest level since World War II. Top-ranked calculated risks include cyberattacks, terrorist attacks, and escalating tensions between China and the U.S. over Taiwan and/or the South China Sea.
Blackrock’s Geopolitical Risk Indicator:
BlackRock’s primary strategic investment recommendations include private credit, which offers an attractive risk-return ratio, inflation-linked bonds (in light of expected inflation around 3%), and short- to medium-term government bonds, given the uncertainty about inflation and limited investor interest.
On a tactical level, with a three- to six-month horizon, BlackRock favors equities from developed markets. In the bond market, the preference is for short-term bonds, maintaining a neutral stance on long-term U.S. Treasuries. Geographically, BlackRock prefers Japanese equities within developed markets and Indian and Mexican equities within emerging markets.
Geopolitical risks and rising inflation
BlackRock’s recommendation for inflation-linked bonds aligns with the understanding that geopolitical risks heighten inflation risk, says Roelof Salomons, professor of investment theory at the University of Groningen. He refers to the recently published study “Do Geopolitical Risks Raise or Lower Inflation?” in the authoritative journal The American Economic Review. In this study, four scientists, using a unique dataset of historical macroeconomic data since 1900 for 44 countries, demonstrate that geopolitical risks are associated with high inflation and lower economic activity. Additionally, geopolitical tensions lead to increased military spending, government debt, and money supply, as well as supply chain disruptions and a decrease in international trade.
See: Do Geopolitical Risks Raise or Lower Inflation?
Salomons: “In the long term, the geopolitical impact is relatively manageable, but in the short term, there is indeed an increased (geo)political risk. And then you can ask yourself what consequences this has for investors. You see, investors often lack historical knowledge. Many generations, including myself, grew up after the fall of the Berlin Wall in 1989. That was the era of the peace dividend, characterized by a very stable environment with low inflation and low volatility in both the economy and financial markets. Now, investors will likely have to contend with more volatile growth, lower growth, and a higher risk premium. In short, the cycle is simply becoming more volatile.”
“You don’t know what will happen, but you can think about what could happen.”
Professor Roelof Salomons, Groningen University
Professor Salomons adds: “So, if you look at the last 30 to 40 years, we’re no longer accustomed to dealing with significant geopolitical risks. We’ve had the Iraq war, 9/11, and Russia’s invasion of Ukraine. But we are not used to longer periods of instability. As an investor, you can approach this from two perspectives: the economic and the financial aspect. To separate these, I’ve always been a fan of scenario planning. You don’t know what will happen, but you can think about what could happen. That makes a world of difference.”
From just in time to just in case
“If you fully explore this, it’s not so much about ‘return on capital’ but ‘return of capital.’ So, will you get your money back? Take investors in Russian stocks, for example—they couldn’t access their money for a while. Can you capture that in your asset allocation decision? Very difficult, I think, because those are quite binary circumstances. So, I think you need to look at it more that way. And when it comes to companies, you need to carefully examine the supply chain. You see, after the fall of the Berlin Wall, it was all about just-in-time management. But now it’s become just in case. In other words, make sure you have adequate buffers and ensure your suppliers can actually deliver to you.”
Professor Roelof Salomons on the ‘binary’ circumstances under which investors make decisions. (in Dutch)
In response to these developments, countries worldwide are starting to pursue industrial policies and trying to bring companies back to their home countries. “A consequence of this is reduced globalization. Consequently, you’ll have to pay higher prices because everything is slightly less efficient. This means a bit more inflation, which translates into higher prices for consumers. In other words, today’s geopolitical developments are about long-term undercurrents. Companies with pricing power will pass on their costs. Companies with less or no pricing power won’t be able to do so. And this brings investors to the core question: what is the return on capital? What are the costs of capital? That’s what the coming period will be about,” concludes Salomons.
Author: Cees van Lotringen. Editor: Raymond Frenken. Design: Vincent Wielders.
This article was originally published in Dutch on InvestmentOfficer.nl.