Ask portfolio managers these days about what keeps them up at night, and the answer is likely to be surprisingly consistent: geopolitics. Wall Street’s more pedestrian fears – the Fed, the economy, regulation, etc. – have been superseded by worries about an increasingly fluid and interconnected set of global hot spots.
Indeed, at Bloomberg’s Buy-Side Week 2017 New York event, a whopping 74% of those attending a panel on global asset allocation picked geopolitics as the element that poses the single greatest risk to their baseline forecasts. And even more telling, those traditional areas of concern, such as a slowdown in economic growth, or monetary and fiscal policy, barely polled above 10%. Regulatory risk, which loomed so large just a few years ago, didn’t even register. Geopolitics has always been on the radar of portfolio managers, but the risk of being blindsided by some geopolitical curve ball clearly weighs more heavily on their minds these days.
That said, it is important to delineate between what is a risk for the world and what is a risk for your portfolio. In the former case, the chance of a miscalculation with China in the South China Sea seems to increase by the day, while North Korea has been consistently described as the “single greatest threat” facing the United States by a wide range of senior U.S. government and military officials on both sides of the political spectrum. Meanwhile, a host of smaller regional fires simmer – Syria, ISIS, Venezuela, Iran, etc. – below the surface and, at least from a portfolio manager’s view, have the potential to flare up at any moment.
That’s where a key distinction lies. For portfolio managers, a key question is not whether risk in a region or country exists, but whether it is appreciably more or less than what is considered “normal” and thus already reflected by asset prices. Tension in the Middle East may be rising at the moment due to the dispute with Qatar, but it’s the same hot spot it has always been – no portfolio manager is going to suddenly realize there is geopolitical risk in that region and start to hedge. Same for Venezuela, which has been locked in a long, chaotic descent towards disintegration – no surprise there.
In contrast, risks that could swiftly and specifically impact a portfolio are much more nuanced. China dominates this discussion as well, according to Bloomberg’s polling during Buy-Side Week. Replying to the question of which region holds the most investment risk over the next year, 30% of respondents chose China, followed by the Middle East at 20% and, surprisingly, the United States itself at 14%.
This latter point is partly because U.S. trade policy under President Donald Trump is now a much more visible geopolitical topic, noted Gary Huffbauer of the Peterson Institute for International Economics. And a protectionist U.S. brings a relatively novel set of considerations to the table that few active on Wall Street are old enough to remember. Moreover, added David Dollar from the Brookings Institution, this shift is occurring relatively late in one of the longest credit cycles on record at the same time as the new administration is promising tax cuts and heavy investment into infrastructure. As a result, while it will be tempting (and politically expedient) for some to blame the onset of higher deficits and rising interest rates on poor trade relations with China and others, they are also the result of deep macro and fiscal trends.
For investment managers, Hufbauer and Dollar agreed that China’s complex mix of threats is the largest geopolitical challenge at the moment. As it relates to Wall Street, they outline three what-if scenarios that pose the greatest threat of escalation: An uncontrollable capital outflow driven by a 10%+ devaluation in the renminbi, a collapse of China’s shadow banking system, and an implosion in China’s rickety real estate market. And, as one would expect, all three are intertwined such that the arrival of one probably sparks the onset of the other two.
And the biggest geopolitical risk your average portfolio manager is probably not focused on? Emerging market debt levels, according to Dollar. The substantial rise in emerging market debt since the financial crisis has been driven by developed-world ZIRP and NIRP monetary policies that induced the issuance of trillions in dollar-denominated debt encouraged by an insatiable global demand for yield. In the rush to take advantage of the situation, total emerging market debt skyrocketed to a total $56 trillion last year, or 216% of emerging market GDP, according to the Bank for International Settlements. Indeed, emerging markets raised nearly $40 trillion of debt between 2006 and 2016, compared to the approximately $9 trillion issued in the ten-year period beforehand.
The problem? As U.S. interest rates go higher, that debt will become increasingly burdensome and vulnerable to exogenous shocks from commodities, currencies or global events that send investors fleeing to safe havens. Meanwhile, EM debt is increasingly priced to perfection – yield spreads between US dollar denominated EM corporate debt and similarly rated U.S. corporate bonds has hit record lows.
Those on Wall Street a little long in the tooth will recall the kind of contagion that can occur when overbought emerging market debt markets collapse. This time around, the structural conditions in and around EM economies are stronger, reducing the likelihood of an EM-sparked financial crisis a la 1998. Nonetheless, from a geopolitical perspective, the risks with the lowest probabilities often end up having the greatest impacts precisely because they are largely ignored.
