Gearing up for change and the challenge of ‘radical uncertainty’

THE last 12 months have been full of changes. Existing trends are accelerating and others are emerging more clearly. Here are the most significant.

Acceleration in geopolitics

The “radical uncertainty” mentioned in 2022 by the European Union’s chief diplomat, Josep Borrell, has become the norm. Geopolitical divisions have widened and a new armed conflict has broken out in the Middle East.

Governments’ involvement in economic decisions has increased significantly, often in a new guise.

Rebuilding military capacity has become an urgent strategic goal for many European countries since the Russian invasion of Ukraine, with the risk of diminished US support for the North Atlantic Treaty Organization (Nato) adding to that sense of urgency.

This is illustrated by the decision made by Finland and Sweden to join the alliance.

Increased spending on defence, on top of already large budget deficits, may at some point create tensions in financial markets, especially as central banks continue to reduce their purchases of sovereign debt.

Where budget deficits are limited by law, increased defence spending could come at the expense of other programmes – unless it is moved off-budget.

In a worst-case scenario, spending on renewable energies could drop down the list of government priorities even as 2023 saw the highest temperatures ever recorded.

Acceleration in re-industrialisation

In the US, the Inflation Reduction Act (IRA) and the Chips & Science Act, both passed in 2022, have brought back industries qualified as strategic by the Biden administration. Investments in electric vehicle (EV) batteries, semiconductors and clean energy production in the US have notably increased, creating a new infrastructure boom.

In Europe too, we are seeing active industrial policies make their reappearance, notably in the area of semiconductors. But after the loss of cheap Russian gas, the continent is suffering from a higher cost of energy compared to the US.

Moreover, some European industries are increasingly challenged by cheaper imports from China as Chinese companies try to compensate for domestic overcapacity by exporting.

Overall, we expect state industrial policy to further gather steam, driven by increased expenditure on defence capabilities.

Acceleration in economic fragmentation

Recent years have seen an acceleration in the regionalisation of supply chains in parallel with the rise in geopolitical tensions. Many multinationals have decided to reduce their presence in China and develop production capacities in other Asian countries instead.

As more Asian countries become production hubs and develop their industrial capacity, the range of investment possibilities in the region will grow.

The negative side of this development is growing overcapacity in several Chinese industries that could lead to a trade war, as developed countries introduce high import tariffs to defend their industries against cheap Chinese imports.

The reshaping of global supply chains will continue to put pressure on already tight labour markets in the West, all the more so given the growing mismatch between the qualifications needed to drive re-industrialisation and the qualifications of resident populations.

Acceleration in technology

Artificial intelligence (AI) has swiftly become a reality for many, including participants in financial markets.

This increasingly accessible technology is spurring a new investment cycle and will probably change many industries in a profound way.

The AI ecosystem is still at an early stage of its development, but many industrial processes are set to be improved.

AI may also alleviate the high labour costs facing firms that relocate their production to developed countries.

AI’s emergence has not gone unnoticed by financial markets, with recent equity gains in the US heavily concentrated in AI-related tech companies.

Acceleration in divergences

The events of the past three years have profound implications for economies and financial markets alike.

First, we think inflation in the coming 10 years could be structurally higher than in the previous 10. This is because the global trading system could become less efficient given the potential increase in trade tariffs.

Inflation could also result from the re-shoring of some industries in the US or Europe, which will increase labour demand in tight job markets.

AI should allow companies to make productivity gains, but its deployment will likely be gradual and uneven.

Structurally higher inflation implies a different interest rate environment, with financing costs becoming an issue for corporations and governments alike.

Highly leveraged companies will be particularly exposed (depending on their refinancing schedule).

Government spending will be constrained and choices will have to be made between new strategic priorities, such as defence, and the energy transition.

Higher interest rates should be good news for investors’ fixed-income portfolios, but they will need to keep risk at a reasonable level to reach their investment objective. Such a scenario calls for active management and renewed attention to country allocation.

The surge in geopolitical tensions has recently taken centre stage. But other problems continue to fester.

The warmest year the earth has ever experienced was 2023, with a multiplication of extreme weather episodes around the planet.

Addressing the long-term challenge of global warming is not only a human imperative, but also a financial one, potentially impacting portfolios’ risk and return parameters over the long term.

Thus, the term “radical uncertainty” may also apply to climate issues.

The multiplication of extreme weather events leaves corporations facing the prospect of asset impairments, the loss of production facilities and severe operational problems.

Some assets may simply become uninsurable, leading to a sudden increase in financial stress and/or outright exit from some activities.

New climate regulations may force some industries into costly reorganisations, with immediate consequences for valuations.

Need for active management

Understanding, identifying and mitigating these risks will be a challenging task for those involved in asset allocation and portfolio construction in the coming years.

We are convinced that a thorough analysis of companies’ and industries’ exposure to event risk will be an integral part of the investment process.

We think that understanding the origins, effects and particularly the interconnection between the rapid changes in the geopolitical, investment and environmental landscape we are experiencing should be the starting point of any investment journey.

The writer is chief Asia strategist and head of Asia research, Pictet Wealth Management