Market Review Q124

Key change

In short, while monetary policy has remained an important factor, it has been joined by other forces impinging on markets as well. As a result, the investment landscape has become more complex and more complicated than can be easily explained by monetary policy alone.

For starters, Covid created an opportunity for governments, especially in the US, to rediscover their power to spend. That changed things by igniting inflation and therefore by also imposing new constraints on monetary policy.

In addition, Russia’s invasion of Ukraine also marked an important inflection in the investment landscape. Most immediately, the invasion raised awareness of the potential for geopolitical conflict and the risk to supplies of vital commodities such as oil. More fundamentally, however, the event helped illuminate an even broader geopolitical conflict emerging between China and Russia on one side and Europe and the US on the other.

Stepping back even further, the election of Donald Trump as President in 2016 can be seen as another important break from the past. As much as anything, that election signified growing political discontent with the broad policy prescriptions of the neoliberal order. The benefits of free trade and cheap goods from China had become outweighed by the costs of stagnant real wages and ever-increasing levels of debt.

Initially, each of these events came across as striking, but isolated. With the benefit of hindsight and a little more perspective, however, it is easier to see how they interrelate.

The election of Trump can be seen as the swing of the political pendulum from “capital” to “labor”. Covid can be seen as a trigger that reawakened the ability and willingness of governments to be more muscular with public policy. The Russian invasion of Ukraine can be seen as the crystallization of broader geopolitical conflict that catalyzed the more aggressive use of the dollar-based financial system as a strategic tool by the US.

“Profound structural change”

Taken together, these events signal more than just incremental global developments. They represent elements of a bigger picture of “profound structural change in geopolitics and in how the international monetary system works”, as described by strategist Russell Napier in his recent Solid Ground newsletter.

In an important sense, this reckoning was inevitable. The neoliberal order promoted free trade with a general world view of “live and let live”. That was all fine and good as long as it basically worked for everyone.

In recent years, however, China got bigger, stronger, and more determined to dictate its own terms of engagement. In addition, while having the dollar as the global reserve currency certainly provided benefits to the US, increasingly it also came with undesirable side effects — such as absorbing China’s vast quantities of exports. In short, the neoliberal order was unsustainable.

As a result, the two geopolitical superpowers are now at an impasse. The old system doesn’t work for either of them anymore, and they have different views as to what should replace it. This implies an ongoing struggle for the foreseeable future at the very least. More specifically, it is likely the global financial system will splinter into two systems, one for China and the countries in its orbit and one for the US and the countries in its orbit.

Perspective

For investors looking for guidance into the investment landscape, a couple of things happen when the geopolitical perspective is incorporated. One is that some phenomena which had appeared mysterious as viewed solely through the lens of domestic monetary policy start making more sense. That’s because geopolitical goals trump purely domestic goals.

This can probably be seen most clearly in regard to US monetary policy. For example, in 2021, after long debating whether inflation even needed to be addressed, the Fed quickly and dramatically changed tune in 2022.

While inflation was certainly coming in higher than the Fed expected, it’s interesting to note the change in sentiment also coincided with Russia’s invasion of Ukraine. In other words, the policy change makes more sense in the context of both higher inflation and a geopolitical agenda that involved tightening financial conditions on global competitors like Russia and China.

The impact of geopolitical forces on US monetary policy was explicitly recognized by Michael Kao in a recent Substack post ($) when he said, “I am watching BOJ and PBOC closely, because what they do may actually determine Fed policy more than anything …”

In a similar vein, a geopolitical perspective enables one to see how different pieces fit into the puzzle. For example, Michael Howell recently posted on X, “Seems like 'weak Yen' is deliberate? It must be hurting #China? Capital Wars??!” Such comments portray monetary policy actions as being deeply entwined in a giant geopolitical chess game, and not just a function of domestic policy goals.

Long live the Fed!

Given the improved explanatory power of geopolitics, why do so many strategists and investors still focus on domestic monetary policy? Surely, one reason is inertia. During the heydays of the neoliberal order, geopolitical squabbles could be faded by investors because it was in almost everyone’s interest to carry on as usual. Dustups were quickly resolved. That has changed.

Another reason is the power of monetary policy to drive financial assets has been exaggerated. Other forces have also been at work that have amplified the impact of monetary policy. The proliferation of passive investing and the use of share buybacks both created strong feedback loops which added fuel to the fire. Unusually strong returns for financial assets made it easy for investors to ride the wave, made it easy to overestimate the role of central bankers, and also made it hard to do anything else.

In addition, a lot of investment careers, retirements, early retirements, and personal portfolios have been made on the back of easy monetary policy. As a result, it will be very hard for any of these people to seriously consider an alternative explanation to what has worked so well for them in the past.

The road ahead

In the short- to medium-term, faith in monetary authorities probably won’t cause investors too much harm. Given the upcoming election and the historical patterns of the political economy, there will likely be a broad push to ensure the re-election of the incumbent administration.

Longer-term, however, namely beyond the election in November, the faith in monetary authorities to dictate the investment landscape looks misplaced.

For one, as the geopolitical struggle between the US and China grows, so too do those priorities elevate over those of purely domestic price stabilization. For another, a lot of factors that affect inflation are outside the control of the US. The signals from historic domestic inflation trends are becoming progressively less useful.

Finally, what happens to investors is not just a function of new developments and actions, but the cessation of dynamics that investors have grown accustomed to and often taken for granted.

As Russell Napier highlights in the FT, “This forced buying [of US Treasuries by emerging market countries], regardless of price, effectively decoupled the risk-free rate from the nominal growth rate in the developed world.” This had the effect of creating “a persistent and artificially large gap between nominal growth rates and the discount rate, thus inflating asset prices and facilitating a rise in gearing.”

With China being a big part of that trend, and now charting a different course for the future, it is reasonable to expect not only a different outcome, but the mirror image. That would be deflating asset prices and forcing a reduction in gearing.

Implications

In a general sense, the heightened level of geopolitical conflict and the reformation of the global financial order increase the baseline level of uncertainty in the investment landscape. With two heavyweight global competitors going at it and lots of moving parts, a lot of different things can happen. Over the medium term, this can be expected to weigh on financial assets.

Further, as Napier explains, “The loss of access to Chinese productive capacity brings with it higher global inflation.” Higher inflation means higher yields will be demanded for bonds which will result in lower prices.

There is likely to be a mixed reaction in stocks. The need for the US to rebuild industrial capacity will result in abnormal growth in key strategic industries. However, higher inflation threatens to lower valuation multiples.

Also, amid ongoing geopolitical conflict and the splintering of the global financial system, gold is likely to be increasingly useful as a store of value.

​Finally, as to the question, “What should investors be on the lookout for?”, the answer is “profound structural change in geopolitics and in how the international monetary system works”. No amount of parsing FOMC press releases or recent CPI data is going to accomplish that. What can help navigate the new landscape, according to Napier, is “a deep understanding of financial history”.

David Robertson, CFA is the CEO and founder of Areté Asset Management

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