China, Russia and the New Cold War

At the recent Sanlam Investments Institutional Insights conference, Dr Pippa Malmgren said that geopolitics is about the extension of politics across borders where nations begin to compete with one another over national interests. This ‘new cold war’ is very much underway. She explained how this affects the investing environment for better and for worse.

The inflation disconnect

At the heart of the matter is the intriguing stand-off taking place between the US Federal Reserve and emerging markets, with China and Russia accusing the world’s largest economy of attempting to inflate its way out of debt.  Although the Federal Reserve doesn’t count asset prices such as property and the stock market in its official inflation data, China’s view is that record high prices indicate that inflation has already begun.  Even now we’re seeing much higher wage demands in emerging markets as workers try to keep up with rising prices for food and rent. People in the industrialized world feel it too in the form of a generally higher cost of living. Overall, there seems to be a big disconnect between the real cost of living and official inflation statistics released by national governments, and more and more people are becoming suspicious of official inflation data, as it no longer reflects their real world experiences. Malmgren observed that this low-grade global inflation was not only contributing to market uncertainty but could also be fuelling geopolitical risk.

This has profound implications for emerging market economies and asset allocation, and impacts the investment portfolio strategies of pension fund administrators.

How monetary policy decisions affect emerging markets

China and Russia believe that the US is trying to ‘inflate’ its way out of its debt problem. They believe that the US is literally ‘exporting inflation’ to emerging markets which is causing considerable angst for low-income workers who spend most of their money on food, energy and rent. This is a function of “Quantitative Easing”, the US Fed’s policy that involved flooding the markets with liquidity.

China and Russia believe the Fed and other central banks are deliberately manufacturing inflation because it is the only means they have of managing their historic (and sizeable) debt problem. This is making emerging market countries like China and Russia nervous, because their ability to sustain these rapidly escalating prices is limited. In China for instance, the critical staple food is pork, the price of which has gone up 50% since March.

“You can tell an emerging market worker that the United Nations aggregate food data says his food price costs are down but he cares more about the specific items that matter to him”, says Malmgren.

How are China and Russia retaliating?

China has retaliated against the US’s inflationary tactics by engaging in a massive sell-off of treasuries, gilts and sovereign debt in the industrialized world.  This selling could see billions wiped off the value of global bond markets and cause a potential fallout for investors, and retirees who routinely hold government bonds – known as gilts in the UK or Bunds in Germany – in their pension pots.

Some also argue that China’s recent 2 percent devaluation which knocked the yuan to a near three-year low against the dollar was a deliberate attempt to rattle Wall Street.

In addition to their retaliation, the Chinese are looking to take control of those resources whose prices are rising, and these efforts have intensified to a scale never seen before. China’s “One belt, One road strategy” is a perfect example of this and will define what happens to asset prices over the next decade.

This refers to an ambitious plan to develop two economic corridors spanning the entire width of Asia to the gates of Istanbul and Cairo. One follows the old Silk Road through Central Asia. The other follows the Maritime Trading Routes that lead from China to the Middle East and beyond. The policy also involves unprecedented expenditure on infrastructure, including roads, ports and power, will ultimately put China deep into Europe Africa, Latin America, Asia and the Middle East.

Russia

Russia’s response to the inflation impetus is to claim greater control over the supply chain of inflating assets. As a result they are looking to secure the Baltic, the Arctic and Ukraine by opening their old Soviet bases across the Arctic.  And, no small wonder. Energy fields in the Arctic for example have to date produced some 40 billion barrels of oil and 1,100 trillion cubic feet of natural gas. The US Geological Survey estimates the region also holds 13% of the world’s undiscovered conventional oil, a third of the world’s undiscovered conventional gas and a fifth of the world’s undiscovered natural-gas liquids.  The Arctic is one of the last great unprotected wildernesses, a safe haven for endangered species and home to native people whose subsistence lifestyle has survived for thousands of years. No wonder some now fear a new cold war since Russia has cast its attention to the Arctic, and begun militarizing the world’s most remote region.

Russia has two objectives in the Arctic:  to secure the Northern Sea Route and exploit the natural energy resources potential. They are also improving their surveillance in that part of the world, with the objective of moving their airborne troops from central Russia to the north. China too has expressed an interest in the mineral assets of the far North.

The impact on asset allocation

Faced with these facts about “hidden” cost pressures, Malmgren said the least attractive global asset class currently was bonds, the value of which was being eroded by underlying inflation and the massive sell-off of treasuries and gilts globally. Instead, she suggested the next wave of “growth, innovation and entrepreneurship” would be driven by people who could put capital to work by being risk-takers. Such investment opportunities could only be found in equity and alternative markets. Low yields in bonds are here to stay.

In fact, the risk is that governments compel pension funds to hold more “safe” assets and then define “safe” as their own sovereign debt. In other words, the losses get pushed from the government balance sheets onto the shoulders of ageing savers. Retirement funds have to accept the harsh reality of what is required to compensate their funding shortfalls, and they will need to change their investment strategy accordingly. This could mean considering alternative strategies such as hedge funds and private equity.  In times of market dislocation, nimble investors willing to implement such risk-based strategies should generate excess returns. Luckily the returns from innovation in the economy are looking good.

“Low yields, negative interest rates and rising inflation are tilted against traditional saving methods. The geopolitical environment at the moment compels you to be a speculator in equities and participants in alternative asset classes,” said Malmgren. “Embrace the change by learning more about what is happening in the world beyond your own country…”