Geopolitical risks from the Middle East



[0.17] In case anyone thought that we'd left off geopolitical unrest behind in 2019, it's been quite the start of the year. Can we kick off this episode by talking about some of the problems we've seen in the Middle East?

2020 started out with a bit of volatility coming from the Middle East. We had the US assassinate major general Qasem Soleimani, he was the leader of the Iranian Revolutionary Guard Baghdad Airport. The Iranians they responded with some missile strikes at the US but this was really calibrated to appease some of their anti-us sentiment at home. The end result was that there was no US casualties of sorts, so at least there was no knee-jerk reaction by the Iranians on some sort of oil fields or
energy facilities. If that had happened then we would see a spike in the ore Price, but that did not happen. So although the we had this strike it didn't have any sort of lasting impact.

[1.21] Just as market sort of got over that and put that behind them, we've had the coronavirus and all the volatility that has created. Presumably it has the power to have an impact on economic growth. How serious do you think it could Be, how long could it continue to create volatility?

Well it could potentially be quite serious and particularly for China, where they've locked down Wuhan and surrounding cities. This is basically 56 million people, or the population of Italy. That could have significant impacts on Wuhan and surrounding areas. Also in supply chains within China. Given that a lot of the countries around the world are not accepting some Chinese nationals from flying to their countries, that could also have a serious impact on the overall tourism industry globally. So yes, there will be some negative impact to growth around the world and particularly in China. As to how much, it's guesswork right now ecause you don't know; number one whether the coronavirus cases of Peak, we don't know when that's going to be, and two; we just don't know to what extent this lockdown if it's going be Extended - obviously it will have a significant impact. What I would say, the first quarter GDP in China will likely be revised down.

[2.44] The monetary policy backdrop has been quite benign, has this cushion the blow from these kind of geopolitical tensions so far, and will it continue to do so? Or have the kind of marginal gains from that lose monetary policy largely been realized?

No, I think the monetary easing will continue for a long period of time. We had $10.4 trillion of central bank expansion of their balance sheets, this is the Fed ECB Bank of England and Japan over the last decade, that's likely to continue.
I think if we looked in the last three or four months, the Fed, they've expanded their balance sheet by something like four hundred billion Dollars, because of the concerns about the short-term repo market. We would like to see that its likely to continue over the coming months.
In fact, if you look at the Fed futures markets, it's showing that the Fed is likely to cut rates at least once this year. So I think the monetary policy coming from the major central banks, lets put in China and the PBOC (The People's Bank of China), they're also likely to keep in policy quite loose in order to give you an insurance policy to support overall economic growth.

[3.59] What are your views on economic growth?

Luckily because of the trade protectionism concerns last year between the US and China, we've already had this accommodative policy put in place.
We've already started to see some of the key surveys like the manufacturing Purchasing Managers Index turn up in the last couple of months. So luckily, we've had a recovery coming through in the global economy. We've already had accommodative monetary policy, there is more talk on fiscal spending for example; fiscal spending in the March 11th budget in the UK. The fact that we have all these policies in place, should ease or mitigate some of the risks that we would get from the coronavirus.

[4.41] Turning to the fixed income Market, that looks like a bad backdrop for fixed income. Can there be any upside in government bonds with yields at these levels and with that kind of growth Environment?

Yields have come down quite significantly in the last couple of weeks, because of the concerns of coronavirus and its impact on the global Economy. Of course, that's still unknown at the moment. But what would say is the IMF before the coronavirus really got serious in the last couple of weeks, they released* their real GDP figures for 2020 of 3.3%, so that's up from 2.9% for 2019 and expect 3.4% in 2021.

So the overall outlook for real GDP growth still remains fairly constructive. We believe in the fixed income market that stronger growth will gradually lead to higher yields over the coming months, once we get over this coronavirus hump.

[5.41] You've talked about the sort of Three D factors that kind of deflationary or at least prevent any big upsurge in inflation over time. Can you talk about those kind of structural factors?

We talked about these the secular forces that will limit any upside in bond yields and inflation. The Three D’s, the first one is disruption in Tech, we looked at this about a couple of years ago. Essentially what we're talking about here is, we have technological innovations like big data, this enables companies such as Amazon, to lower consumer prices, they can use their sizable logistics network for Example; to become far more competitive than your typical bricks and mortar retailers. We also have other industries such as Uber, they're able to bring in existing assets and by doing so, they can also lower transport fees, for example that's the example of disruption by tech.

The second D is talking about Demographics. We see that the global population growth is starting to slow. In some countries such as the US, they reported population growth of just 0.5% in 2019**. That was the lowest growth rate we've seen since 1918, when we had the Spanish flu epidemic and also the end of World War One. We see other countries such as Japan, they're seeing that their population is contracted by about half a million a year, the government expects its fall by another 16 million over the next 25 years. The key here is that if you have a lower growth of population and you have less consumer demand, that puts downward pressure on inflation.

Then the final D was really talking about debt, which in itself can be quite Disinflationary. We've seen that over the last decade that global debt rose by $70 trillion that's public and private debt to $255 trillion. Essentially that means that a lot of this debt has been driven by the government raising lots of finance and of course that crowds out the private sector and encourages them to save more money and spend less money in the shops.

If you bring all three D factors together, we think they think that this is quite a powerful force to stop inflation accelerating and for bond yields to accelerate quite sharply from here.

* IMF, January 20th 2020
**US Census Bureau, 31 December 2019

[7.59] So what does this look like in portfolios, presumably lower fixed income, higher equities?

Yes admittedly it does look a bit difficult at the moment with the coronavirus and a lot of the panic that you see in the media. But remember, the media is newspapers trying to sell headlines. We have to look at the underlying fundamentals which could change if the negativity from the headlines gets really worse. But what we would say is, that the underlying fundamentals remain fairly intact, earnings growth continues to accelerate, we see that the economy is likely to accelerate, surveys recovered quite well and we have crucially accommodative policy already in place. So in our bet, we still can still continue to favour equities over bonds at this juncture.


This episode was recorded on  3/02/2020

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Podcast information:

The Pulse from Smith & Williamson

Investment Show: Geopolitical risks from the Middle East

Episode 6

Broadcast on Smith & Williamson at 09:00, 3rd of FEBRUARY 2020

Available online from 10:00 on the same day .

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