War in the Crimea and Ukraine. Instability in the Middle East. Conflict between China and the global hegemon. A rapidly rising Eastern power co-opting Western technologies. Social and political unrest shaking the very foundations of the United States. Populist fervour toppling governments across Europe.
These may sound like headlines from today’s newspapers, but they actually describe global developments in the mid to late 19th century . We fervently hope that history doesn’t repeat itself to quite the same extent going forward. However, we believe there are important lessons to learn from studying this and other similar periods in the human story, as we transition from the post-Cold War Pax Americana of the 1990s to a more multi-polar state of global affairs.
In this Observations piece, we dive deeper into the world of geo-politics, one of the key drivers of our secular outlook detailed in our October 2023 Observations piece Asset Allocation in a Changing World. We outline some of the key geo-political theories underpinning our central case for a multi-polar world, as well as some of the long-term implications of this backdrop for investors. We describe the constraints-based framework we apply to evaluate political and geo-political events and present two case studies showcasing how it helped us navigate Israel-Iran tensions and formulate our Trump 2.0 outlook.
Geo-politics is increasingly in vogue amongst global investors as they attempt to navigate an increasingly complicated world.
The term geo-politics has become increasingly popular over the past few years, particularly amongst investors trying to navigate an increasingly uncertain global backdrop. The challenge for most investors is that we have been blessed by most (if not all) of our investing careers residing in the market-friendly post-1990s US-led world. Over the past thirty five years, investors have been able to focus almost exclusively on macroeconomic factors, fiscal and monetary policy, and company fundamentals and valuations. Even the most veteran investors’ experiences extend little further than the Cold War era.
We believe the world we are in today has more in common with the mid to late 19th century or pre-World War period than either the post-1990s or the Cold War. As such, we believe investors need to have a framework for incorporating geo-politics into their investment processes. To do this properly, however, investors should first understand what geo-politics is. Acknowledging that geo-politics and international relations are entirely comprehensive schools of study with centuries of history, we present below an investor-friendly primer on some of the key concepts that drive our approach to the area.
At its core, the study of geo-politics is concerned with how the geography of a location (tribe, country, or empire) influences its politics: including its society, government, and international relations. In practice, these concepts have been in play since the first humans started interacting with each other. As a discipline, it started gaining traction in the 19th century, with the likes of Alfred Thayer Mahan, Halford Mackinder, and Friedrich Ratzel seen as some of the earliest proponents of formally codifying the field. They did so in part to better understand and support their home nations in the ‘Great Game’ that was playing out amongst Europe’s powers at the time.
The discipline, born out of the ‘Great Game’ of the 19th century, remains weakly understood amongst investors.
Scholars of geo-politics and international relations broadly categorise the world under various states of ‘polarity’. In essence, this framework recognises three broad ‘states of the world’:
1. Uni-polarity: A single hegemon has the preponderance of power (military, economic, technological, societal) in the known world. It is virtually impossible for any other state to challenge the hegemon, who has the prerogative to determine the ‘rules of the game’ by which the world operates. This state of the world is the most familiar to us, having experienced the Pax Americana following the collapse of the Soviet Union in the 1990s. Other historical examples include the Pax Romana and the Macedonians under Alexander the Great.
2. Bi-polarity: Two great powers hold the preponderance of power and are relatively evenly matched. The world tends to splinter into two opposing blocs led by each hegemon. The Cold War between the US and the Soviet Union is the clearest example of this world state.
3. Multi-polarity: No single state holds a preponderance of power and no single state is able to fully impose its preferences globally. Rather, multiple powers of varying relative strengths jockey for position (perhaps to become the next global hegemon). This is actually the most common world state over human history, with examples including the pre-World War period, the Thirty Years War period in the 17th century, and the Three Kingdoms period in China.
These broad states of the world have widespread implications for global and domestic conflict, politics, trade, economies, and ultimately, investment returns. As a relevant recent example, the uni-polar world of the 1990s blessed investors with global stability and a lack of economically disruptive conflicts, rapid globalisation of trade and capital flows, moderating inflation and economic volatility, and decisively strong financial market returns. The key question of today is what state of the world are we in now?
At a high level, geo-politics provides a framework for thinking about the world order, under three broad states of uni-polarity, bi-polarity, and multi-polarity.
While somewhat easier in hindsight, it is incredibly difficult to forecast or even measure the current state of world affairs, particularly as we shift away from uni-polarity. Even today, there is much debate in foreign policy circles about whether we are entering a bi-polar or multi-polar world, or if we may be reverting towards US hegemony, given its technological prowess in artificial intelligence (AI), China’s economic struggles, and the Trump Administration’s proposed trade and foreign policies.
This is because there is no universally accepted method for objectively measuring national power, which comprises some combination of military, economic, technological, societal, diplomatic, and other facets. Some of these, like economic measures, are factual, publicly available and readily updated. Many others are subjective, sporadically updated, and may even be state secrets.
For investment purposes, acknowledging that we are no experts in this field, our research and analysis indicates to us that the world state we are in is most likely to be an unbalanced multi-polar system. Coined by American political scientist John Mearsheimer, the term refers to a multi-polar system where one state (in our case, the US) has or had the potential to be the global hegemon.
In coming to this view, we have relied on our own research and leaned heavily on the views and research of our trusted partners including Marko Papic of BCA Research, as well as experts at KKR, BlackRock, PIMCO, and Capital Group. We have also relied on the extensive publicly available body of work on international relations, including the Council on Foreign Relations, the Lowy Institute, the Correlates of War Project, and the Henry L. Stimson Center. Synthesising these sources, our view rests on the following assessments:
• The relative decline in the US’ preponderance of power: While it remains by far the world’s most powerful state on many measures (in particular military and economic), the US has been losing its relative superiority as the rest of the world catches up. While it has its flaws, the primary measure we use to track this is the Composite Index of National Capabilities (CINC) produced by the Correlates of War Project (see below).
• Increasingly unilateral actions taken by other states against the US’ preferences: Examples include the European Union’s vast regulatory power over trade and consumer goods standards (eg forcing Apple to switch to USB-C charging cables), and the various United Nations votes on the Israel-Gaza conflict made in opposition to US preferences.
• Increasing regional conflict: Russia-Ukraine, Israel’s increasingly hot war with Iran and its proxies, and Russia and Iran losing their proxy in Syria, with Turkey potentially involved, are symptomatic of a multi-polar order with a weakened hegemon. Regional powers are tempted to test how far they can push their own war goals before the hegemon pushes back.
• Non-aligned nations practicing ‘strategic promiscuity’: The key example here being India’s continued purchases of Russian oil at below-market rates despite international sanctions and avoiding any punishment for doing so.
LGT Crestone’s view is that we are in an unbalanced, multi-polar world, with a waning global hegemon (the US) and an assortment of competing powers jockeying for global position.
Acknowledging the many moving parts and complex interactions involved in our analysis, we see the following strategic implications for investors looking to build portfolios over a 5-10 year time horizon:
While waning, the US remains the most powerful nation in the world, giving it tremendous incumbency advantages.
While it has lost some relative economic and military strength to the rest of the world, the US remains the largest, highest quality, and most dynamic economy in the developed world. Militarily, where it chooses to engage, the US remains superior to all contenders. Coupled with its continued status as the global reserve currency and dominance of the global financial and trade systems, the US will likely remain the biggest fish in the global pond for the foreseeable future.
This incumbency gives the US tremendous advantages, and while we expect more challenges to US hegemony going forward, any potentially irreversible decline is likely to lie beyond the next 10 years. In the meantime, we expect the world will still take the US’ lead on the ‘big issues’ (including the energy transition) and we expect US economic dynamism will continue to create opportunities for investors. We also cannot discount the pendulum of fate swinging back in favour of a return to US hegemony.
Investors should expect higher growth and inflation, and look for higher productivity growth as nations compete to get ahead.
A key feature of a multi-polar environment is that nation-states prioritise national resilience and security over economic efficiency, due to the lack of a predominant global hegemon to enforce the ‘rules of the game’ for all players. Inevitably, this results in increased capital expenditure (capex) as nations look to repatriate (or ‘friend-shore’) strategic national capabilities that were previously outsourced.
We expect this secular capex cycle to include increased defence spending, as well as increased spending on infrastructure, manufacturing, and other strategic industries. We already see this happening through the various state-directed industrial policies of the past five years, including the Inflation Reduction Act and CHIPS Act in the US, the Future Made in Australia Act domestically, and other industrial policies enacted throughout Europe and East Asia.
This capex wave is one of the key thematics behind our broader secular view that inflation will settle at a higher resting rate over the next decade, especially compared to the post-GFC zero interest rate regime. As with most state-directed spending, some portion of this money might be wasted on pet projects or ‘white elephants’. However, some of the expenditure will prove productive, and we think astute investors who are able to identify these opportunities can expect to be well rewarded for their effort.
A corollary of our expectation for higher capex is a hoped-for boost in productivity growth, particularly as nations invest more in research and development (R&D). While it comes with a (sometimes multi-year) lag, the economic theory is clear that higher capex tends to lead to higher productivity growth. Anecdotally, we believe the imperative for nations to compete in a multi-polar world may also spur increased innovation.
A scan of the various transformative inventions of the 1870-1914 period tells the tale: the telephone, the radio, the automobile, the aircraft, the light bulb, air conditioning, and plastics. All of these greatly advanced our collective productivity and living standards, and many birthed entirely new industries.
Another important outcome of our research is that like most things in life, geo-political risk is relative. As an example, the severe sanctions placed on Russia following its invasion of Ukraine have made many US-domiciled investors cautious about committing capital to other perceived geo-political rivals that may be subject to similar risks in the future.
However, investors in other jurisdictions, particularly non-aligned countries, may be less exposed or less concerned with such risks. Our prior example of India turbocharging its economy by purchasing sanctioned Russian oil at below-market rates is a pertinent one. Because of its non-aligned nature and its importance to the US as a strategic counterweight to China, India has escaped censure for doing so.
It may be harder for individual investors to receive the same privileges as a sovereign state, but those who have the flexibility and risk appetite may benefit from considering what their domicile means for their investment universe. Other investors may also consider opportunities in non-aligned countries that stand to benefit from prudently ‘playing all sides’ to gain benefits from the various multi-polar powers.
Staying informed, nimble, diversified, and active are important ways to navigate a multi-polar world.
We have spent the effort to begin educating ourselves on the theories and frameworks of geo-politics and international relations so that we can both assess current conditions and identify signposts to monitor where we may be going as circumstances change. History tells us that sometimes, the world can and does change overnight!
By embedding our best assessments on the geo-political environment into our investment process, we aim to be able to respond promptly and appropriately if the global tides appear to be shifting.
“There are decades where nothing happens; and there are weeks where decades happen”.
Apocryphal quote commonly attributed to Vladimir Lenin
A multi-polar world tends to lead itself to increased levels of conflict as various regional powers attempt to pursue their strategic objectives without a clearly superior hegemon to check them. While we can identify potential regional flash points to monitor, these conflicts are almost impossible to predict or position for in advance. Rather, prudent diversification across asset classes, investment styles, geographies, and managers is likely to be an investor’s best friend. The goal is to ensure that portfolios can deliver attractive risk-adjusted returns without being overly dependent on a particular outcome or overly exposed to a particular bet.
One of our core beliefs going forward is that a more complicated, volatile world should present a richer opportunity set for high quality active managers to add value to portfolios. In this instance, we expect that, where relevant, our highly recommended managers have developed (or are developing) a prudent framework for incorporating geo-politics into their investment processes, to ensure they can adequately manage risk and identify the significant opportunities that we expect to emerge.
Constraints-based analysis can help investors prudently evaluate political and geo-political developments.
Developing a grand strategic view as we have can provide investors with a roadmap to design and build robust long-term portfolios. But how should we respond to emerging crises or risks in real-time?
To tackle this challenge, our investment process utilises a constraints-based framework to evaluate political and geo-political developments. This framework was first popularised amongst sophisticated institutions by Marko Papic of BCA Research and is detailed in his book Geopolitical Alpha.
In a nutshell, the constraints-based approach advocates developing a deep understanding of the material constraints facing policymakers to determine the most likely or plausible courses of action, rather than relying on their stated preferences or fearful newspaper headlines.
This framework provides a powerful tool to help investors evaluate geo-political risk. We illustrate the concept with two recent case studies below, relating to (1) the fears of escalating conflict between Israel and Iran in late 2024 and (2) our outlook for the second Trump administration.
On 1 October 2024, Iran launched about 200 ballistic missiles into Israel, its second direct attack on Israel as part of the ongoing conflict between the two regional powers in the Middle East. The initial market reaction was risk-off, with some commentators fearing a significant escalation in the conflict that could embroil the US and potentially disrupt global oil supplies if Israel retaliated against Iran’s oil production facilities.
This framework helped us navigate 2024’s geo-political tensions in the Middle East and informs our outlook for Trump 2.0.
Our analysis of the constraints facing the key protagonists led us to take the view that the conflict was less likely to escalate to the stage where it would impact the global economy or financial markets.
• Iran’s failing economy limited its appetite for further escalation. Iran’s economy has been hard-hit by international sanctions and its military was in no shape to endure sustained conflict.
• Israel’s capacity to project power into Iran was reliant on US support. In addition to its military being committed at the time to two intense conflicts in Gaza and Lebanon, Israel has no strategic bomber force and limited inflight refuelling capabilities. As such, any attempt to project power to Iran (over 1000 km away) would be dependent on US consent and support.
• The looming US elections constrained President Biden. With the US elections barely a month away, we also knew that President Biden could not tolerate an oil price spike caused by escalating conflict. As such, he was heavily incentivised to limit the scope of Israel’s response.
Based on this, and our broader constructive macro outlook, we increased our overweight to equities into this short-lived dip. Later in October, Israel retaliated with limited airstrikes on military targets in Iran, allowing markets to turn their attention elsewhere, rallying on Trump’s eventual election victory.
We laid out our analysis and outlook for Trump’s second term in detail in our November 2024 Special Report Four More Years… an investor’s guide to Trump 2.0. In short, we believe the following constraints should restrain President Trump’s more extreme policy preferences, pointing to more moderate risks with regards to fiscal profligacy, trade wars, and geo-political disruption:
• The bond market has already punished one Western ruler (the UK’s Liz Truss) for fiscal profligacy in recent years and has also bared its teeth at the Trump administration, with US 10 year Treasury yields some 50 bps higher since the US election.
• An incredibly narrow Republican majority in the House of Representatives presents a key legislative constraint to President Trump. It also showed its strength by resoundingly rejecting an attempt by Trump and Elon Musk to shut down the US government in late December 2024.
• Inflation and immigration are the key issues that US voters want President Trump to address, with both areas topping a Reuters/Ipsos poll conducted post-election.
A shifting geo-political environment is creating a more complicated, volatile world for investors to navigate. In this Observations piece, we have laid out a robust framework to help investors with this challenging task. In closing, we encourage all investors to consider the following key takeaways:
• The world is getting more complicated whether we like it or not, and investors need to do their homework to better understand and incorporate this into their investment processes.
• Investors should not fear a multi-polar world. Rather, look for opportunities from increased growth, practice prudent diversification, and lean on high quality active managers to add value.
• An objective framework (like our constraints-based approach) can help investors avoid emotional overreactions and objectively evaluate political and geo-political developments.
This document has been prepared by LGT Crestone Wealth Management Limited (ABN 50 005 311 937, AFS Licence No. 231127) (LGT Crestone Wealth Management). The information contained in this document is of a general nature and is provided for information purposes only. It is not intended to constitute advice, nor to influence a person in making a decision in relation to any financial product. To the extent that advice is provided in this document, it is general advice only and has been prepared without taking into account your objectives, financial situation or needs (your Personal Circumstances). Before acting on any such general advice, we recommend that you obtain professional advice and consider the appropriateness of the advice having regard to your Personal Circumstances. If the advice relates to the acquisition, or possible acquisition of a financial product, you should obtain and consider a Product Disclosure Statement (PDS) or other disclosure document relating to the financial product before making any decision about whether to acquire it.
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