Geopolitical imperatives for investors amid a changing world order
Global Investment InsightsSpotlight
with Matthew Gertken (PhD), Chief Strategist, Geopolitical Strategy, BCA Research
Matt is currently Chief Strategist, Geopolitical Strategy, at BCA Research. He oversees the firm’s coverage of market-relevant geopolitical, political, and policy developments across the world. He holds an MPhil from the University of Cambridge and a PhD from the University of Texas at Austin.
In this exclusive interview with Global Investment Institute (GII), Matt shares his perspectives on the biggest geopolitical challenges facing the US, from the future of the US dollar as the world’s reserve currency and the changing balance of power with China’s rise, the impact geopolitics is having on the pursuit of net zero and the opportunities global investors could seek to capture in their portfolios presenting from geopolitical developments.
Q. What are the biggest geopolitical risks facing the US today and how can they be managed?
First, the biggest internal or political risk that the US still faces is “peak polarisation,” which means that society is historically divided and faces more civil strife before it can achieve a new national policy consensus. The gap between the ruling party’s support of the president and the opposition party’s support is just short of 80%, likely to re-test 2020 levels as the highest since World War II. Polarisation has contaminated US foreign policy, making it more difficult for the US to achieve durable diplomatic solutions with rivals like China, Russia, and Iran.
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Polarisation has contaminated US foreign policy, making it more difficult for the US to achieve durable diplomatic solutions with rivals like China, Russia, and Iran.
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Generational change, combined with the US fear of these foreign rivals, will probably reduce polarisation, at least marginally, over the long run. But, over the 2024-28 political cycle, US internal instability continues to pose a significant geopolitical risk by reducing the US’s role as global coordinator and creating opportunities for autocratic governments to challenge the post-WWII world order.
Second, the biggest external or geopolitical risk facing the US is the de facto alliance of Russia and China. Russia severed relations with Europe and must court Chinese investment and consumption. China cannot reject Russia’s overture because to do so would be to reject an essential ally that can help China to reduce commodity insecurity, carve out a sphere of influence in Asia, and undermine US influence. Therefore, China and Russia will grow closer and closer and try to build an alternate global system around themselves.
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The biggest external or geopolitical risk facing the US is the de facto alliance of Russia and China.
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The result is that the US cannot re-engage with China’s economy on a deep level – it cannot afford to transfer capital and technology to a Russo-Chinese behemoth. Without US-China engagement, all of Asia Pacific and the Middle East will become less stable. China will pursue greater influence in these areas, generating proxy conflicts with the United States and its allies. Supply shocks will persist as a result of geopolitical struggles for influence over critical resources and production.
Q. What implications will the changing balance of power, and particularly the rise of China, have on global capital flows and economic growth? How can the US respond?
The US share of geopolitical power has stayed relatively stable since 1973, with US GDP falling from 28% to 25% of global GDP, despite numerous examples of US mismanagement. China’s share has risen from less than 5% to nearly 20%, but its economic growth rate has slowed from an annual average above 10% in the 1980s-2000s to around 4%-5% today, weighing on its strategic rise. Russia’s potential growth had collapsed even prior to the military debacle in Ukraine.
Meanwhile, the European Union has consolidated across multiple crises while remaining allied with the United States. As such, the US and its allies have shown chinks in their armour but are very far from being subordinated by the emerging world. The emerging world is rising in status, but it is not a unified entity. From an investment point of view, Chinese stocks have underperformed global stocks since the Great Recession. Russian stocks are no longer listed in the MSCI equity universe.
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The US and its allies have shown chinks in their armour but are very far from being subordinated by the emerging world.
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Emerging markets continue to grow faster than developed markets and to acquire a larger share of global industrial capacity. However, leadership in technology and governance remain in the developed world. The US has governance problems, but showed its continued tech leadership by producing the best Covid-19 vaccines, helping Ukraine’s military repulse Russia, and achieving recent breakthroughs in artificial intelligence.
Global capital flows have responded to the changing balance of power since 2008 by flooding into the United States and the developed world. US stocks, currency, and bonds have greatly outperformed global rivals. Similarly, developed markets have outstripped emerging markets. The conflict between the US and autocratic states like Russia and China has driven capital away from the latter. Until China finishes its debt-deleveraging, recommits to liberalization and structural reform, and negotiates a strategic détente with the US, cheap Chinese equity valuations will persist.
Eventually, global capital will pursue emerging markets due to their faster growth rates, creating a period of US underperformance. We are optimistic about India and parts of Southeast Asia and Latin America. But for now emerging markets need to stabilise. Tight global monetary policy, weak manufacturing activity, Russian aggression, Chinese debt-deleveraging, and US-China conflict do not create a favourable context for emerging markets. Later a Ukraine ceasefire and US-China détente could be agreed, which would open up the emerging world for large capital flows, namely when global growth is also stable or rising.
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Global capital flows have responded to the changing balance of power since 2008 by flooding into the United States and the developed world. US stocks, currency, and bonds have greatly outperformed global rivals.
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Q. What is the likelihood of the US dollar losing its status as the world's primary reserve currency, and what implications would this have for the global economy and US foreign policy? Do you see a credible replacement for the USD as the global reserve currency, a digital currency perhaps and over what time horizon?
The US dollar will remain the premier global reserve currency for the foreseeable future, but its share of the global reserve basket has fallen from 72% to 58% since the turn of the century. It could continue to lose market share on the margin to various competitors, particularly if there is a conflict in the Middle East with Iran, but it will likely remain the single largest currency in the reserve basket because of its unique geopolitical strengths.
The US is both economically and strategically insulated. Only around 10% of US output comes from trade. So, when the global manufacturing cycle and commodity prices fall, investors pile into the safety of the US economy and assets. At the same time the US is strategically isolated because it is the most powerful military in a secure position within North America, so other countries cannot attack it. Thus, the US offers protection from global recessions and geopolitical conflicts. Dollar-denominated assets are therefore in high demand for foreign companies and governments, other than systemic rivals like Russia and China. But even within these countries private actors often seek dollars.
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The US dollar will remain the premier global reserve currency for the foreseeable future. The only viable alternative is the euro. It would require a global cataclysm to dislodge the US dollar from its preeminent position.
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China will diversify from the US dollar, buying gold and investing in natural resources around the world. But other countries will buy US assets, seeing a rising probability of US-China conflict. China’s debt-deleveraging and the US’s technological leadership ensure that the dollar continues to benefit from this conflict with China.
The only viable alternative to the dollar is the euro, and the euro may eat away at the US’s reserve status marginally, but the euro will not replace the dollar as the premier reserve currency. Europe relies on the US for national defence and energy security. Europe cannot compete strategically with the US and Russia at the same time, so it remains allied with the US. Europe has no interest in holding its savings in the renminbi because China is not an open economy, its long-term political stability is uncertain, and it lacks rule of law and property rights. The euro has staying power because the EU is a successful geopolitical project but the US is an even more successful geopolitical project.
It would require a global cataclysm to dislodge the US dollar from its preeminent position, much like the two world wars shattered the British pound as the premier global reserve currency. When the US abandoned the gold standard, the world stuck to the dollar because of US geopolitical preponderance. The dollar can suffer a cyclical bear market but its structural leadership position will persist until a cataclysm reduces the US to a secondary geopolitical rank, and that is not likely to happen anytime soon based on military and technological trends.
Q. What role is geopolitics playing in the global pursuit of net zero and how is it impacting progress towards decarbonising the global economy?
Major industrial powers that fear political instability as a result of foreign energy shocks are highly incentivised to stimulate their manufacturing industries and improve their energy security. Europe and China will invest heavily in renewable energy for this reason – they cannot rely solely on Russia or the Middle East to provide reliable energy. They also want to promote domestic manufacturing.
The United States will do the same even though it is more self-reliant in energy. The US does not want to lose technological leadership or security. Foreign renewable energy breakthroughs could cause that to happen. The US has also seen socio-political unrest as a result of de-industrialisation. A renewable energy program is one of several aspects of a return of government involvement in the economy to re-industrialize and ensure domestic stability. While the Republican Party is less supportive of renewables than the Democratic Party, the Republicans will ultimately support renewables for the same strategic reasons cited above (great power competition).
The renewable share of total energy consumption has risen to roughly 13% for the EU, 8% for the US, and 7% for China. However, the pace of progress toward net zero will be slower than expected, interrupted by the business cycle.
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The pace of progress toward net zero will be slower than expected, interrupted by the business cycle.
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Downturns will prompt reactions against governments and changes of party, resulting in disjointed and uneven government fiscal support for energy transition. This is especially true if high energy prices and inflation contribute to downturns or changes of government since the public will demand lower energy prices. Even in states without elections, like China, the need to fall back on fossil fuel energy during times of economic weakness will be pronounced, since social unrest will pose challenges to the regime.
In short, geopolitics is driving governments to intervene in their economies to promote renewable energy for purposes of domestic stability and international security, but the same drivers do not encourage governments to impose radical climate measures that would hurt growth and get the ruling party removed from office. If central banks fail to quell inflation, then it will return in a dramatic fashion, which will prompt a popular backlash against net zero policies.
Q. What opportunities do you see on the horizon from a geopolitical perspective which global investors could seek to capture in their portfolios?
The best opportunity for investors today is to prepare for the next recession by buying quality stocks and safe-haven assets such as US and developed market government bonds. At this moment, late May 2023, the market is pricing a “soft landing” of the economy, as central banks are lowering core inflation without raising the unemployment rate. Before long, however, recession will rear its head.
High interest rates will restrict the growth of the economy and generate greater financial instability. Central banks will try to save banks while still fighting inflation. Consumers will run out of the pile of savings leftover from pandemic-era cash handouts, yet governments will lack the political capital to provide new helicopter money. Meanwhile global industrial activity and trade growth will remain weak, as Europe’s domestic demand will be subdued, while China’s economic reopening will give way to continued property bust and weak household consumption. While a recession can be delayed, policy uncertainty and geopolitical risk will intensify, suggesting that risks to the economy lie to the downside.
The US 2024 election will generate a new spike in global policy uncertainty. The US and its rivals cannot possibly reduce tensions prior to the election – and it is unclear if they will do so afterwards, especially since either a 2023-24 recession or a 2024 Republican victory would likely lead to more offensive US foreign policy. The Russia-Ukraine war will probably escalate before it de-escalates due to Ukraine’s counteroffensive and both sides’ desire for maximum leverage ahead of any ceasefire talks. Russia will not return the annexed territory so sanctions will remain in place despite any ceasefire and the Russian sphere will be a permanent source of instability and risk for Europe.
The US-China trade and tech war is escalating as Beijing is taking advantage of the US election cycle. And, if Iran continues pursuing nuclear weapons, the US and Israel will need to decide whether to impose strict containment or launch air strikes, which is a crisis looming over global energy supply in the coming 12-36 months.
In short, investors face growth disappointments combined with continued supply shocks, which is to say a stagflationary or recessionary environment. They should favour the US, developed markets, and low-beta assets in the short run, as disinflation runs its course, but they should also be wary of the persistent inflation problem over the long run.
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The best opportunity for investors today is to prepare for the next recession by buying quality stocks and safe-haven assets such as US and developed market government bonds.
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Matthew Gertken (PhD), Chief Strategist, Geopolitical Strategy, BCA Research
Matt is BCA Research’s Chief Strategist, Geopolitical Strategy and US Political Strategy. He oversees the firm’s coverage of market-relevant policy developments across the world. He has 16 years’ experience in the field and appears frequently in global news media.
Prior to joining BCA in 2015, Matt worked as a Senior Analyst at STRATFOR (Strategic Forecasting) and in a range of academic and publishing roles.
Matt holds an MPhil from the University of Cambridge and a PhD from the University of Texas at Austin.
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For more information about BCA’s geopolitical strategy please email: contactbca-apac@bcaresearch.com.