In a world defined by geopolitical disruption, technological change and market volatility, investors cannot afford to focus solely on downside risk. We explore why today’s uncertainties may also create powerful long-term opportunities from AI and energy resilience to innovation in an increasingly multipolar world.
Institutional investors and wealth managers ultimately invest on behalf of a wide range of beneficiaries across our communities. As such, we have a profound fiduciary and regulatory responsibility to ensure that we are acting in clients’ best interests and upholding high and ever improving standards of governance and risk management.
We completely agree with this, you’ll find no argument here! The plethora of macroeconomic, political, geopolitical and climate-related shocks that have rocked the global economy and financial markets since 2008 are clear examples of the drawdowns, tail risks and left tail events that modern portfolio construction and risk management systems are designed to monitor and mitigate.
However, one could argue that in the race to manage and minimize downside volatility if things go wrong, investors may run the risk of underexposing themselves to the upside if things go right. Indeed, the long term history of market returns shows that the opportunity cost of forgetting that volatility swings both ways may be the greatest ‘hidden’ risk of all. In that spirit, this article seeks to highlight some of the potential upsides in the most prevalent risks facing investors today.
It is clear that we are now living in a multi-polar world: a geopolitical paradigm where no single state holds a preponderance of power and none is able to fully impose its preferences globally. Conflicts in Europe and the Middle East, belligerent trade practices from the U.S. and increasing assertiveness from other great powers – including the EU and China – are clear hallmarks of this changing global regime.
We do expect more volatility, more divergence and more regional conflicts or geopolitical shocks going forward. However, just as greater competition compels innovation in the corporate world, greater geopolitical competition can also foster greater innovation and productivity growth, as nations invest to compete. A quick scan of the various transformative inventions from 1870 to 1914 - a historical period we would argue was also multi-polar- tells the tale: the telephone, wireless, the automobile, the aeroplane, light bulbs, air conditioning and plastics. These great inventions not only advanced our collective productivity and living standards but many birthed entirely new industries, too. The analogues of today? Artificial intelligence, bio-engineering, quantum computing and nuclear fusion, just to name a few. While there are clearly downside risks and threats to peaceful society from each of these, we should not deny the potential benefits to humanity (and to investors) if patriotic competition allows us to ‘get them right’.
We would be remiss not to acknowledge the tragic human suffering brought about by the conflicts in Ukraine and the Middle East. Sadly, from a financial market perspective, the cruel truth is that these shocks (including the U.S.-Iran conflict) ultimately present buying opportunities for long term investors.
We see three key reasons why:
We need to be mindful and wary of pockets of concentration and overvaluation in certain areas of equity, fixed income and currency markets, but stay engaged in the overall constructive dynamics and opportunities that still abound. We are doing this by right sizing our exposures to concentrated tech and market cap weighted indices and pivoting towards broader opportunity sets including value, small
and mid cap equities and market neutral active management strategies. We are also pursuing bottleneck thematics in real assets including energy resilience, defence, and infrastructure, to build portfolio resilience and leverage the growth we see there.
We appreciate the potential for an energy supply shock, a central bank policy ‘mistake’ or even a bursting of the AI bubble that could plunge the U.S. (and potentially global) economy into a recession. If that were to happen, a sharp drawdown in equity markets and a sharp rise in volatility is expected. How long and how deep? That would depend on the fragility of the U.S. economy.
On that front, data paint a relatively comforting picture. Consumer balance sheets in aggregate are in a sound position. Data from the U.S. Bureau of Economic Analysis and the Federal Reserve tell us that household debt levels are at their lowest since 2002. Meanwhile, the net difference between the value of the family home and the mortgage owed on the family home (a measure of household net worth) is at its highest level on record, giving U.S. households in aggregate around USD21 trillion of positive equity that they could draw on should they need to.
On the corporate ledger, aggregate net corporate debt as a percentage of U.S. gross domestic product sits at around 32%, its lowest level since 1985 and well below the post 2008 average of 37%. Though this clearly does not prevent individual companies or sectors that may have taken on too much leverage from getting into trouble.
Significant uncertainty remains around the economic, financial and societal impacts of the ongoing AI rollout. Meanwhile, investor euphoria has driven market concentration to extreme levels and reignited fears of 2001’s tech wreck. How do we map the pathway forward for this novel, potentially revolutionary technology?
We have actually been here many times before. From the dot-com boom in the 1990s to the railroad era of the 1800s and the canal mania of the 1700s, scientific breakthroughs mostly follow a similar pattern: (1) an exciting new technology emerges and first movers generate supernormal profits, (2) a massive infrastructure build out occurs as the technology percolates through the economy, (3) at some stage, we over build and the technology becomes commoditized, leading to a sharp reversion in supernormal profits, (4) which may or may not burst an asset price bubble, hurting late speculators, (5) leaving a painful lesson for investors but ultimately a successful technology from which new winners emerge.
What does this mean for AI? While it is important to monitor hyperscaler capital expenditure and watch for signs of excessive market concentration, we should also not lose sight of the broader productivity benefits of this new technology that are already permeating through the broader economy and incubating the future winners of tomorrow. After all, the 2001 tech wreck was a devastating experience
for investors, but many of today’s largest companies survived or were founded in its aftermath!
It is self evident that as a species, humanity has overcome every single existential challenge we have
ever faced and in doing so accomplished incredible deeds including:
There are countless other tales of humanity’s great achievements and we have no doubt that there will be countless more as we face off against the existential challenges of today: climate change and the energy transition, populism and societal inequity and the societal and employment implications of AI.
The choice we face as investors is to see these problems as insurmountable or to see them as challenges that will catalyze the next generation of human innovators, and get out there, find them, and invest in them. Based on the evidence of our human story so far, we know where we sit!
We are by no means espousing a naïve “she’ll be right” attitude to investing! One merely needs to open the newspaper on any given day to be reminded of the many risks and vulnerabilities facing our global economy and society. It is absolutely necessary for investors to take these matters seriously. We are no longer in the 1990s world of the “Great Moderation”, and failing to account for these tectonic shifts in our global political, geopolitical and macroeconomic environment is a clear recipe for failure.
We are merely providing some counterballast to the behavioral bias noted by Morgan Housel: “Pessimism just sounds smarter and more plausible than optimism”. That may be true, but humanity did not get to where we are today by shying away from downside risks and focusing too much on the left tail of the volatility distribution. After all, as the American author John A Shedd said, “A ship in harbor is safe, but that is not what ships are built for”.
Receive ongoing access to LGT Wealth Management’s insights and observations - a curated stream of thought leadership, market perspectives, and strategic updates designed to inform sophisticated investors.
