Geopolitical shifts in a fragmented world and their consequences for investors
9 AUG, 2024
By Azad Zangana
Authors: Azad Zangana, European Senior Strategist and Economist & Philip Chandler, Fund Manager and Head of UK Multi-Asset, Schroders
Economic and market risks of the "fiscal policy of fantasy".
One of the main unknowns is whether in the new make-up of the European Parliament the currents of popular discontent will be integrated into the existing framework, as happened with Italian Prime Minister Giorgia Meloni, or whether they will become destructive.
These new nationalist political currents could mean a more populist drift in fiscal plans, which usually means more spending, tax cuts and a looser fiscal policy. However, this should be quite positive for economies and stock markets, as long as they do not lose confidence in the bond market, and the bond market continues to perform reasonably well.
Ultimately, however, asset returns depend on demographics, technological innovation, investment, artificial intelligence (AI) or climate change. These are the facets that affect long-term returns. It is often observed that most elections do not have a big impact on long-term return drivers, but they can create short-term volatility that we need to take into account.
Time mismatch and obstacles to decision-making
One of the developments that could happen is that Europe's green industrial policy could be slowed down.
We have analysed the impact of climate change, rising temperatures in different countries and their impact on production and productivity. If Europe does not lead the climate agenda, countries may emerge to take the lead. Presumably China, which has done far more than most realise. The slowdown in the fight against climate change will have an impact on long-term profits and on some companies. There will be some winners and losers in a way that we have not had in the last 15 years, which has often seen very high correlation within sectors.
You start to see some discounting in certain areas, because the market is already pricing in the move away from green commitments. For real estate, it could be flood risks. For insurers, it could mean having to pay much more than they used to for certain climate-related events.
A new direction for Europe's green policies?
One of the big mistakes Europe made in the last decade was to focus too much on carbon pricing and essentially coercion to push people away from fossil fuels and towards green energy. The introduction of the Inflation Reduction Act (IRA) in the US taught us a lesson: subsidies are more popular than taxes and have the same effect: they close the gap between the cost of renewables and fossil fuels. The EU's Carbon Emissions Adjustment Mechanism is a possible solution, especially if a multilateral agreement is reached.
Ignored markets and beneficiaries of the new world order
As the world becomes more and more fragmented economically, there are a few countries that gain incredibly, and Vietnam is one of them. It benefits them to be friends with the whole world. Vietnam has very close relations with the United States, where it invests in building microchips. It has very close relations with China, where it is setting up many of its factories to export to the United States. It also has a very long-standing relationship with Russia, which provides much of its military technology and much of its energy technology.
Vietnam, in fact, is one of those interconnected countries. Obviously, so is Mexico. Morocco, meanwhile, is often overlooked, but it has free trade agreements with both the US and the EU, making companies there eligible for IRA (Inflation Reduction Act) credits. Morocco also exports more cars to the EU than China.
Risks of economic regime change
For some companies it makes sense to stop producing everything in China and move production to countries like India. We are seeing a lot of changes in supply chains across the board, and that inevitably means that there are going to be some very interesting opportunities. It also means that there will be some losers. Naturally, that really lends itself to being a more active fund manager.
We had the booming period from 2010 to 2020 of low inflation, where central banks were able to come to the rescue and cut interest rates whenever there was a problem. The resulting negative correlation between equities and bonds acted to suppress volatility. The deterioration in the relationship between growth and inflation as a result of the 3D Reset (referring to trends such as decarbonisation, demographics and de-globalisation, which will have a global impact) means that we expect central banks to be more constrained in the future. Investors will not be able to rely on diversification between equities and bonds to manage volatility.
There will also be divergences between companies. There will be some that move production from China to other locations and do a very good, seamless job. Other companies will fail.
