A New Era of Navigating Geopolitical Shocks and Risks

Introduction

Investors have long paid attention to global geopolitical events, previously enjoying the luxury of thinking about them in the background. Today, however, with geopolitical tensions increasing at an alarming rate, all eyes are closely watching several hotspots that pose risks to global economies and financial market stability. This article looks closely at critical geopolitical flashpoints that should be on every investor’s radar. We also explore why constructing a diversified, well-balanced portfolio is more important now than ever — to simultaneously capture growth opportunities and manage increased volatility in 2024.

Geopolitical Flashpoints

Geopolitics has transformed from a simmering concern to a significant risk for investors and companies alike. With multiple conflicts and political escalations unfolding in tandem, we highlight three main hotspots with the potential to create spillover effects and introduce significant risks to international relations, economic stability and national security.

The first is the two-year-old Russia-Ukraine War. As time goes by, it is becoming increasingly likely that the war will become a stalemate that could continue for many years. However, there’s also the distinct possibility that the conflict could escalate at any time, a risk that is particularly susceptible to shifting U.S. and Western European government sentiment and military assistance around the 2024-25 election cycles.

Second is the Middle East. The ongoing Hamas-Israel conflict in Gaza has triggered a cascade of regional tensions on multiple fronts, including attacks on Red Sea shipping lanes (and possibly even digital connectivity) by Yemen-based Houthi rebels. These developments threaten to further strain relations on many levels, leading to greater instability in the Middle East and risk dragging the U.S. and other countries into expanding confrontations.

Lastly, the heightened strategic rivalry between the U.S. and China is always a primary focus of global markets. Tensions between Washington and Beijing have intensified on multiple fronts, including struggles over trade, technological dominance, cybersecurity, political ideology and relations with Taiwan. If other conflicts leave Western countries spreading their military resources thin, it could create opportunities for China and other countries to push their agendas more aggressively.

Against this backdrop, the upcoming dramatic evolution of the political landscape — which key upcoming election outcomes could reshape — will be pivotal for investors to understand. 2024 brings an unusually large number of national elections, including votes in the U.S., Mexico, India, Turkey and many others. These elections involve a meaningful percentage of the world’s population, so the political and economic implications will be profound. We’d specifically highlight the U.S. elections, which will be an essential driver of both risk and opportunity, with the results reverberating domestically and worldwide.

As a result, we anticipate a notable shift in market during the course of this year, away from the previous obsession with the Federal Reserve’s interest rate decisions and toward a new preoccupation with election sentiment and outcomes. This will likely introduce additional volatility for investors as market participants continuously recalibrate their assessment of risks and rewards — and adjust their positions based on their predictions of outcomes. This task is likely to keep everyone busy guessing.

Diversification: Painful but Necessary

With all this uncertainty, we believe the best way to navigate the minefield of geopolitical risk is to remain nimble and focus on diversification. One rarely wants to put all their eggs into one basket, but it is particularly ill-advised when that basket is wobbling precariously.

The tough truth about diversification is that you don’t really need it when things are going well.

But diversification is there for when things suddenly and unexpectedly go wrong. And when more things could potentially go wrong, as we think is the case now, diversification is more critical than ever. While there are no guarantees of what will happen, we suggest that the previous description of risks in the world points to this being one of those times to exercise more caution.

Opportunities Along the Shifting Investor Sentiment Spectrum

To build diversity in a portfolio, one needs to look where others are not. A fundamental aspect of our research process is looking for divergences on a company, sector or country level to find companies performing differently than the rest of the market. This strategy is integral to uncovering overlooked, underappreciated and undervalued opportunities and helps us maintain a well-balanced portfolio with a diverse array of idiosyncratic risks and rewards.

This dovetails nicely into two of the biggest topics in international markets today: China and Japan. First on China, where in an act of magician-like handwaving, most investors have managed to behave as if the world’s second largest economy no longer exists from an investment perspective.

In the pre-pandemic era, China enjoyed robust economic expansion, which was a key driver of global growth. However, the country has since faced numerous global and domestic challenges in the post-pandemic environment, and its economy has downshifted considerably. The Chinese government’s often heavy-handed approach to troubleshooting its economic issues has made the country challenging to navigate, leading many investors to reduce or even eliminate exposure to China entirely. Unlike such investors, we firmly believe that entirely dismissing China is a mistake.

China Has Underperformed Global Equities by 79% since the January 2021 Peak

Source: BCA Research, MSCI, S&P, Bloomberg

We’ll be the first to admit that China may not be as strong as it once was, but despite its challenges, we find it hard to agree that there isn’t still some intrinsic value to be found. In fact, we continue to find great companies at downright attractive valuations that we believe will reward investors with a little patience.

What’s more, despite the doom-and-gloom that has descended on the market’s sentiment around the Chinese economy, there are actually some rather encouraging signs if one pays attention from a global (rather than just a Western-centric) perspective. While it wouldn’t seem like it from what one frequently reads in the Western press, we believe, much like Mark Twain, that the reports of globalization’s death have been greatly exaggerated. Rather than dying, global trade relationships are evolving – as they have throughout history.

Although China’s exports to the U.S. have declined, it has simultaneously increased its trade with many emerging markets, dramatically elevating its partnerships there. These strategic maneuvers could potentially unlock meaningful opportunities down the line. We believe that as this becomes more evident to investors, they could reap substantial benefits from China’s growing influence in these emerging market regions. Moreover, China’s valuations are trading at historically low levels, offering an enticing entry point for investors seeking to capture this growth opportunity.

Japan’s Improved Governance Has Led to Improved Performance

Net Profit Margin and ROE Are Improving

Source: Tokyo Stock Exchange, Bloomberg, Japan Financial Services Agency

Sitting at the other end of the investor sentiment spectrum is Japan, which had long been out of favor with investors due to its sluggish economic performance over more than a generation. However, meaningful policy changes in Japan — such as a sharper focus on corporate governance and business profitability — have sparked a shift in the corporate and economic landscape, and suddenly investors can’t get enough.

While other investors have largely neglected Japan over many years, our team has remained committed to researching and uncovering hidden opportunities in Japan. This approach has enabled us to invest early in the best opportunities at discounted prices, positioning us for meaningful gains — unlike others, who are now scrambling to invest in Japan at less favorable entry points.

Ready to Act

While we’ve spent a lot of time here talking about big geopolitical and macroeconomic topics, we’d be remiss if we didn’t finish by highlighting that for us, at the end of the day, it is always about the companies we own. Sometimes these high-level factors impact our positions (though it is all the better when they don’t), so we certainly keep an eye on them. But more than anything, we see these topics as signals to go looking for opportunities – and to be extra vigilant in avoiding risk.

Geopolitical flashpoints will likely remain a significant threat to the global economy and markets for the foreseeable future. At Thornburg, we focus on adapting to the ever-changing landscape; we keep our eyes on the ball, even when that particular ball isn’t very popular, so that we are ready to act when opportunities arise. We believe managers who have consistently done the groundwork will be well-positioned to seize the most compelling opportunities — that’s why we continue to monitor and carefully build up positions in high-quality companies, even in countries facing economic or political challenges. We believe the best way to navigate geopolitical tensions and volatility is to maintain a diversified portfolio of companies with idiosyncratic drivers of success (preferably within their own control) — companies that march to the beat of their own drum.