Globalisation reversal calls for rising risk-premium
William Davies, head of Global Equities at Threadneedle comments on the latest updates from the Ukrainian crisis and other geopolitical events.
Following recent news, investors would be forgiven to think that the Ukraine crisis is de-escalating. However, they can’t afford to take their eye off the ball. In fact they should sharpen their focus on geopolitical tensions in investment decisions and face the reality of rising risk premia.
The reversal of globalisation we have seen recently is likely to head us further towards a low-growth world. This is particularly true in the case of the sanctions between Europe and Russia which retain their potential to escalate. Pressure is above all on European stocks, global companies with European and Russian exposure and those companies which have benefited from the ‘Draghi put’ effect. This may sound alarmist, but I think it’s time to take a more defensive equity position.
At the end of 2013, when we set out our views for the year ahead, I was pretty optimistic, expecting the S&P to rise more than 10% and the euro area economy to grow for the first time in three years, albeit marginally. The US economy was set to expand by a more impressive 2.5% and while Japan was to encounter the headwind of an increased consumption tax, the economic revolution that is Abenomics was likely to lead to similar economic growth to the US.
We were concerned about a slowing Chinese economy, but a growth rate heading down towards 5% should still be attractive. This backdrop led us to earnings growth expectations of around 10% in the US and Europe, higher in recovering Japan and remaining positive in China.
Now I’m not so sure. Such an economic scenario remains a possible outcome, but increasingly I’m becoming concerned about the mounting examples of nationalism around the world. While nationalism is not a new phenomenon, many of the fruits of the past 30 years have been helped by globalisation.
Its reversal could lead to a far less attractive economic picture. Japanese Prime Minister Abe wants to broaden the role of the military in the country; the recent WTO proposals on dismantling trade barriers across its member states were scuppered by India; and Europe has this year seen an increase in votes for more nationalist parties.
In the US, President Obama did not win support to intervene directly in the Syrian crisis. Maybe North American energy self-sufficiency reduces the desire to intervene in oil rich regions, maybe it’s a function of the split Congress, but it certainly gave President Putin the opportunity to garner geo-political influence as the US and Europe prevaricated over Syria.
Putin’s popularity in Russia has risen and the annexation of Crimea was undertaken in the bat of an eyelid as Ukraine slipped into an effective civil war.
My concern is that the Ukraine crisis has consequences beyond its borders. A century on from the outbreak of the First World War, there is much talk about the fluttering of a butterfly’s wings and unintended consequences. The comparison may be farfetched, but it does highlight the dangers of escalation. Let’s hope that the memory of 1914 serves to make this less likely today.
The more imminent danger I see to markets is economic. The US was keen to impose sanctions on Russia and eventually, following the shooting down of MH17, the Europeans escalated their own sanctions on the country. Russians have suggested that Europeans will pay more for energy this winter and that airspace may be limited for European airlines.
Keen not to lose face, they have now implemented some of the retaliatory import bans. There has been evidence of late that escalation may not accelerate as fast as feared, and a combined humanitarian convoy to eastern Ukraine including the participation of the EU and Russia is an indication that cooperation can still take place.
However the risk of further sanctions remains which would threaten European and Russian growth directly, and global GDP implicitly. We don’t know how far the sanctions will go, but the margin for error between growth and recession is pretty narrow in Europe, which represents about a quarter of the world’s GDP.
We are faced with a world where conflict is becoming more commonplace, nationalism is rising, borders are closing, trade is becoming disrupted and economic activity is under increasing pressure. A return to contraction could have serious implications for Europe and ultimately the rest of the world.
With the potential for escalation of sanctions remaining a live issue, equities should command a higher risk premium. It is impossible to judge accurately how high this should be, but as stewards of investors’ capital our job is to protect portfolios. We believe it is time for a more defensive position.