3 Crucial Risks and Opportunities the Market is Missing in a Changing World Order

March 2022

The Ukraine conflict is the first of a rolling series of crises we will face in the coming years, with tremendous implications for many investors.  Volatile market conditions with most asset classes providing little to no return (and certainly none – if not negative returns in real terms) should now be a baseline expectation for all investors.  This means investor portfolios need to and will eventually, drastically change to avoid further pain, as relying upon large weightings to risk assets and a failing dollop of bonds will no longer provide sufficient risk-adjusted returns – and will certainly not emulate the real returns of the past great and dying bull market. 

Such a drastic change to the status quo for investors will not happen quickly or by itself, as the structurally entrenched business models of the media, allocators and intermediaries will fight the change.  Their business interests will move reluctantly from their low cost and profitable asset gathering business models – with low value-added (to clients) but most importantly low career risk (for them) – to more skill dependent and less market-dependent portfolios.  The change will, however, eventually be likely if not inevitable as investors demand more and better, and that their portfolios be adapted to the times.  In the interim, trusting the entrenched business models and wrong people could be deadly to your financial well-being.

What are the 3 Crucial Risks the Market is Missing?

1. The Most Drastic and Immediate Risk of All – World War III

The West has mismanaged Russia all along, and continues to misunderstand the risk of the conflict.  This has been a significant contributor to a changing world for the worst.  For example, by nonchalantly ignoring the grievances and threats of Russia before the Ukraine war, as well as repeated Russian requests for dialogue and negotiation, the opportunity for peaceful resolution was erased.  Furthermore, by not being prepared for a Russian invasion of Ukraine and not making it clear the economic sanctions of invading Ukraine would be horrific before the event, the US lost another opportunity to avoid conflict.  In yet another example, Europe made itself even more dependent on Russian gas and oil by mismanaging its energy policy and climate transition in recent years. 

Even more cynical analyses can be made.  Since the late 1990s, numerous US State Department officials have warned that a Ukraine in NATO would be suicide, yet the push towards this has progressed regardless and haphazardly.  A cynical conclusion can be made that the military complex found new ways to express itself in a new and predictable conflict without being directly blamed?

But what is being missed now?  The Russian military is reported to be bogged down and surprised by staunch Ukrainian resistance and experiencing meaningful military losses, including thousands of troops and a significant number of Russian planes and tanks.  This means that without a negotiated resolution of the crisis – which we still consider the most likely outcome in the short term – this war and its attendant near term risks of escalation are very real.  Weapons and support from the West are pouring into Ukraine, posing further risks to the Russian military.  A determined Russian leader that is unlikely to give up on his goals may hence need to resort to not only a threat but the use of the nuclear option in a shock and awe campaign aimed at stopping the West’s resistance to their goals.  This risk may be misunderstood by the West, but Russia may gambit that in response to a nuclear escalation the West will have no choice but to stop their support for Ukraine – or face mutual destruction.  Hugely powerful nuclear powers being at war with each other is a major risk that is being misunderstood, no matter which way you look at it, because of the rule of “unintended consequences”.  We can only hope and pray for a more peaceful resolution being made shortly.

Commenting on geopolitical risk is fraught with difficulty and inaccuracy.  We and I know almost nothing other than the propaganda we read and watch, as in wartime, the first casualty is the truth. I consider nuclear escalation nothing more than a realistic scenario (albeit a horrifying one) rather than an accurate forecast, simply because I can understand how it can result from the current situation on the ground – even if no one wants it.  Such is what happens in war. Nonetheless, realistic scenarios should be considered when building risk-managed portfolios – and I won’t ignore horrific risks like this for my investors simply because they’re uncomfortable, nor will I foolishly over-estimate our political capability to meet such crises.

2. Further Damaging Crises will Ensue

Investors should realise that the poor political leadership we are experiencing is not a one-off and is likely to be a persistent challenge for all of us (as Western democracies have been diminished by time, poor education, complacency and ongoing and increasing corruption, among other issues).  For example, is the West currently capable of dealing with or even managing a changing relationship with China?  Or the Middle East?  Further crises and conflicts are hence almost inevitable as the world shifts to a more multi-polar world.  Russia and Ukraine itself will prove a huge challenge for the world given the quantity of critical resources and food previously supplied by them, and the supply side shortages with ongoing sanctions (which appear likely to be ongoing for now regardless of what happens from here).

A belief in such a changed geopolitical situation means that the peaceful prosperity and complacency enjoyed by the West and its people is likely to change. Most portfolios have been built based on this belief in peaceful prosperity and ongoing economic growth, hence the dramatic rise in investment into a market tracking ETFs over the previous two decades.  Instead, we appear likely to have a world in which deglobalisation escalates, and economic resources and efforts are committed towards (more inefficient) self-sufficiency and survival, and conflict and conflict avoidance, rather than economic prosperity.  The geopolitical situation comes at a huge cost to real economic growth and hence market earnings growth over time.  Drastic shocks to markets become more the norm than the exception as investors come to realise that they are poorly positioned for this world and how fraught and risky the world actually is.  Sometimes risks really matter, and today and into the foreseeable future is one of those times.

Investment portfolios focussed on positive outcomes need to be built differently, with much lower dependency on asset class performance, i.e. you can’t rely on houses and stocks going up persistently, as they may actually fall.  Portfolios need to rely more on dynamic and skilled value-adding judgements and have more significant allocations to more crises-resistant asset classes such as gold.  This is truly a time for exceptional professional active management to shine and show its true value add compared with the hold and hope approach of old.  Indeed, finding this aligned and professional management (which is the exception rather than the rule) may be essential for most investors and a realisation that portfolios need to be built to be much more resilient to crises and negative or flat market returns.

3. Beyond Ukraine

Geopolitical risk isn’t the only major risk and is not even necessarily the most certainly problematic for investors.  Beyond Ukraine, the West is now facing a huge problem with inflation which won’t be easily resolved, even if the war stops tomorrow.  Central banks are caught between a rock and a hard place today.  For instance, the FED appears to have only bad choices today and to be running out of tightrope to walk an unrealistically fine line between stimulating growth and taming inflation.  They can either:

    1. Raise interest rates until inflation gets under control, as Jerome Powell has recently alluded to.  Unfortunately, this is likely to only work by crushing interest rates and the economy and markets first.  Stagflation morphing into recession or a market crash could easily result. 
    2. Talk tough but make token rate rises to avoid crushing growth, and hence tolerate higher inflation.  This is what most market participants seem to think will happen.  However, such an approach may prove highly problematic to enact in practice for long because there is political pressure to address inflation. Real buying power is diminishing, which is hugely damaging to the vast majority of the (poor and middle class) population.  Not addressing inflation properly will result in inflationary expectations becoming entrenched and more permanent economic hurt.

What does All This Mean for Your Money?

Inflationary or stagflationary outcomes will both likely see poor outcomes for the typical equity and bond portfolio.  Most equities can both derate and see margin compression, resulting in large falls being not only possible but a fairly likely outcome.  Furthermore, a recession (which is usually very bad for markets) is probably already set in train – and sooner than most think and history suggests – with real economic growth greatly diminished regardless.  Rising interest rates and the other political imperatives to adjust to a changing and more adverse world order will result in a recession in real terms occurring far earlier in this cycle than in prior rate rising cycles, hence either in 2022 or 2023.  Furthermore, the recession could be prolonged (and certainly will be in real terms).

Avoiding this hurt from the likely highly adverse political and macroeconomic environment is now an imperative and should be actively considered – if not immediately acted upon – by anyone who cares about their money.  A prudent and easy switch for many is to greatly reduce equities and bonds in favour of alternatives and gold.  This enables investors to permanently lock in the majority of gains from the great bull market of recent decades, and benefit from better future buying opportunities in risk assets.  Your portfolio need not see the fake wealth created by massive economic mismanagement and excessive monetary stimulation of recent years being unravelled by the adversely changing world order and economic circumstances.  Instead, your paper gains can be made real wealth and crystallised into a permanent gain through selling, and then transformed into a portfolio better suited to the very different challenges of the coming months and years.  As always, making a change sooner rather than later is usually the best approach, as it brings you ahead of the likely market deratings.  The choice and responsibility is yours – choose wisely.

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