Geopolitical themes shaping the macroeconomic backdrop

Key points

• In relation to our big government theme, we have seen the rise of ‘national champions’ across certain strategic sectors, with more evidence of state-picked winners in the technology and defence sectors.
• Over the last 12 months, we have witnessed our great power competition theme play out powerfully through breakdowns of trust, stronger alliances, Western sanctions, and China’s reluctance to condemn Russia for its invasion.
• One of the standout features of the last two years is how well countries in Asia have dealt with inflation; central banks have been proactive and fiscal policy has been conservative.
• It may be too early for many Western countries to declare victory over inflation, and geopolitics and deglobalisation also mean that inflation is likely to remain sticky and higher.

At Newton, themes are important in helping us understand the investment backdrop, providing us with a long-range lens through which to view the structural changes that are taking place across the globe. Our themes include micro themes, which capture key technological, social and environmental trends, and macro themes, which encapsulate geopolitical and economic shifts. In this blog I discuss recent geopolitical developments in the context of our current macro themes – big government, great power competition, financialisation and China influence, and consider the implications for investors.

Key geopolitical trends of the last year

Big government

This time last year, my key message was that we had entered a new paradigm in which economic resilience and national security trumps economic efficiency. My view was that this would result in more large-scale fiscal incentives for the private sector in sensitive industries. Things did play out as expected with the passage of the Inflation Reduction Act last summer in the US, which provided approximately US$370bn of funding. This was the largest-ever piece of federal legislation in the area of climate security and energy transition.

I also made the case, in relation to our big government theme, for the rise of ‘national champions’ across certain strategic sectors. I think we are increasingly starting to see this with more evidence of state-picked winners in the technology and defence sectors, for example through Biden’s CHIPS 4 alliance, intended to improve cooperation between the US, Japan, Taiwan and South Korea on the design and production of sophisticated semiconductors.

Great power competition

Even before Russia’s invasion of Ukraine, I had spoken about a Cold War 2.0 and the split of autocrats and democrats. Clearly, we have seen this play out powerfully over the last 12 months through breakdowns of trust, stronger alliances, Western sanctions, and China’s reluctance to condemn Russia for its invasion.

What is the West missing in terms of the macro-geopolitical landscape?

One fascinating observation is that the ‘China+1’ strategies of multinational corporations (in which companies diversify their supply chains into other countries, while still maintaining a presence in China) are starting to accelerate. I think there was a tendency to believe that great power competition would be negative for Asia, but the reality is quite the opposite. The resulting supply-chain realignment could mean there are more country winners in Asia, be it India, Indonesia, Vietnam or Malaysia. This may therefore create many more opportunities for equity investors.

In addition, one of the standout features of the last two years is how well countries in Asia have dealt with inflation. Central banks have been proactive and fiscal policy has been conservative. Despite the strong US dollar in recent years, conditions in Asia are very different to 1997; lessons have been learned and the scarring is deep. It is expected that 70% of global growth will come from Asia this year,¹ highlighting the relative resilience of the region.

Is the macro-geopolitical backdrop conducive to getting inflation back to 2%?

I think it’s too early for many Western countries to declare victory over inflation. The challenge is not so much in headline inflation, which will come down with food and energy base effects, but in core inflation, in which costs of labour and services remain elevated. The new reality in labour markets is a function of demographics (retiring baby boomers) and geopolitics (more protectionism and lower labour mobility). Geopolitics and deglobalisation also mean that inflation is likely to remain sticky and higher, in my view.

From the 1990s and early 2000s onwards, China was an unlimited source of very low-cost, skilled manufacturing labour, the scale of which cannot easily be found elsewhere. India has a vast labour market, but the country’s comparative advantage in manufacturing is not as favourable as China’s was. Essentially, in the absence of a deep recession and slackening of Western labour markets, it is hard to see the dampening of inflation and prices being restored back to 2% as early as next year.

Asia’s inflation experience has been much more benign (China, for example, recently entered consumer price deflation) because governments did not commit the same magnitude of stimulus as the West during the Covid pandemic. The output gap has remained more negative than in the West, and food inflation has been targeted with fiscal measures in some cases.

Translating macro-level issues into themes

While our macro themes are, by their very nature, long term, we continuously proof check them to ensure they capture the changing macro dynamics, and the themes will naturally evolve to reflect shifts in the economic and geopolitical backdrop. We believe they provide a useful tool for sifting through the noise and distilling what is truly relevant for actionable investment ideas.

While all our macro themes are valid and relevant, at any one point in time there could be a particular theme that is especially pertinent. For instance, with last year’s Russian invasion of Ukraine, great power competition took centre stage. Following this, with the passage of the US CHIPS and Science Act and the Inflation Reduction Act, it was big government. Subsequently, with China’s post-Covid reopening and diplomatic reassertion, it was China influence. Most recently, the challenges in the US regional banking sector and the failure of some of these institutions has brought our financialisation theme back to the fore – the theme’s premise is that there is excessive financial leverage in the system which can result in financial shocks if the cost of debt reprices. Fortunately, our long-standing recognition of the theme meant that we as a firm were cognisant of this, and highlights how our themes can help us to avoid risks and blow-ups, just as they can guide us to potential opportunities.

Source:

1. International Monetary Fund, Asia Poised to Drive Global Economic Growth, Boosted by China’s Reopening, 1 May 2023.

Analysis of themes may vary depending on the type of security, investment rationale and investment strategy. Newton will make investment decisions that are not based on themes and may conclude that other attributes of an investment outweigh the thematic research structure the security has been assigned to.

Authors

Richard Bullock

Portfolio manager, Fixed Income team