While politics plays a role in most investment decisions, it tends to arise on a fairly localized basis, says Michael Craig, head of the asset allocation and derivatives teams at TD Asset Management Inc. In addition, its prominence as a factor usually rises and falls on a cycle, slipping easily off investors’ radar in times of relative calm around the globe.
However, the opposite is also true, adds Craig, noting Russia’s recent invasion of Ukraine may have flipped the switch. “There’s no question that, with the recent turbulence, it’s coming more to the forefront. We’re on the path to a much more polarized world, where no country has the option of operating with everyone. That’s the situation in force now and there’s no turning back from it.”
Angelo Katsoras, a geopolitical analyst at the National Bank of Canada, says we were already on a path toward a world divided into geopolitical zones of influence before the Russian invasion. “If the war ended tomorrow, it would still have accelerated the development of economic blocs with parallel supply systems which are based no longer on efficiency, but security — who is an ally and who isn’t.”
Every year, the Global Risk Institute’s risk outlook survey gauges the feeling of its members — including asset managers, Crown corporations and pension funds — about the most prominent threats to the Canadian financial services sector and the global economy.
The last time geopolitics made the top five was in the 2020 edition of the survey, which was published a couple of months before the pandemic announced itself to the world. But Sonia Baxendale, the GRI’s president and chief executive officer, expects it to return soon.
“It’s always a factor in terms of countries that are more volatile and have political challenges, from a pure performance point of view, but also in terms of reputation. The reputational perspective has grown over time with the increased focus on [environmental, social and governance factors], particularly on the social and governance side, and I would suggest that it will be even more elevated coming out of the current situation in Ukraine.”
Pandemic-related concerns dominated the survey results for 2021 and 2022, says Baxendale, but in March, investors were content to place the coronavirus on the backburner after the peak of the Omicron wave passed in late January.
Still, she adds there’s no guarantee any pandemic reprieve will be permanent or that Canada has seen the back of the anti-lockdown protests that brought Ottawa to a standstill. Copycat convoys in other Western nation capitals lost momentum as the world turned its attention to the unfolding crisis in Ukraine, but the potential for further unrest remains.
“We’re always at the whim of a new variant that is more infectious or that can’t be protected with our current vaccines,” says Baxendale. “I’m not a medical practitioner, so I’m not sure where COVID goes from here, but I think it is pretty clear that there is no appetite pretty much anywhere in the Western world for any restrictions to continue in the near term.”
Inflationary pressures continue
Looking beyond the desperate humanitarian situation in Ukraine, Kristina Hooper, chief global market strategist at Invesco Ltd., says the Canadian dollar is likely to strengthen in the short term as the country is spared the worst economic effects of the Russian invasion thanks to a shared interest in commodity markets.
The severe sanctions imposed by Western nations on Russia have wrought havoc on the prices for goods such as aluminium, lumber, natural gas, oil and potash, all of which are high on Canada’s list of major exports.
“Canadian stocks are heavily commodity- and resource-oriented and typically, in the past, we have seen that what is good for raw materials is good for the Canadian economy.”
Canadian institutional investors should be more worried about the additional inflationary pressure those elevated prices will exert and the extent to which a lingering conflict will interfere with central bank efforts to combat an inflation issue that already demanded action, she adds.
According to Statistics Canada, the consumer price index rose 5.7 per cent in February compared with the previous year, marking the country’s highest inflation rate in three decades. “Central banks are unable to control for much of the inflationary pressure present right now,” said Hooper in March before the Bank of Canada raised its target for the overnight rate to one per cent. “It now seems less likely that there will be as many interest rate hikes in 2022 as we expected, not just at the [U.S. Federal Reserve], but at a number of central banks that are looking more dovish than we anticipated before the invasion.”
For some investors, the international community’s swift and sudden shunning of Russia had an even more immediate impact, as several Canadian institutional investors — including the Alberta Investment Management Corp., the B.C. Investment Management Corp., the Investment Management Corp. of Ontario and the Ontario Pension Board — scrambled to divest their remaining assets in the country. However, they’ve all run into difficulties thanks to newly enacted Russian legislation that bars foreign entities from trading their local assets.
Those not directly exposed to Russia have been digging into their existing portfolio to identify potential spillover risks, including the danger that countries in which they’re invested could find themselves labeled as international pariahs in the future.
Eyes on China
Many eyes settled on China, where the prospect of a Taiwanese invasion has hung in the air for decades. However remote the possibility, Russia’s attack on Ukraine has focused the minds of institutional investors on events that once seemed inconceivable.
“I think there will be caution about China and there may be some slowing of growth there, but it will partly depend on how strongly they line up with the Russians,” says Baxendale. “As time unfolds, China will probably be one of the bigger factors that will impact what the environment looks like going forward.”
If investors hoped for a boost to Canada-China relations following the recent release of Canadians Michael Kovrig and Michael Spavor, they were disappointed, according to Craig. The two Michaels were repatriated after three years in Chinese detention following a deal to end the U.S. extradition request for Huawei Technology Co. Ltd. executive Meng Wanzhou, who had been confined to her Vancouver home since her arrest in late 2018. “Relations are still quite frosty and probably going in the wrong direction,” he says.
In February, Canada participated in a diplomatic boycott of the Beijing 2022 Winter Olympics to protest human rights abuses, while pension funds have faced calls to divest from businesses allegedly tied to the manufacture of infrastructure and equipment used in the government’s persecution of its minority Muslim Uyghur community.
“China is an interesting dilemma” for investors, says Christine Tan, a portfolio manager at SLGI Asset Management Inc, noting it will remain one as the country closes the gap and eventually surpasses the U.S. as the largest economy in the world.
“The relationship is both a collaborative and competitive one. There are some areas where two largest economies in the world do need to work together — specifically, climate change. Then there are areas of natural competition — technology being one that has really come to the forefront in the last couple of years. So it’s really trying to figure out the new rules of engagement that we need to think about when we’re assessing political risk and the appropriate allocation to different geographies.”
A change in leadership
Geopolitical concerns are nothing new for institutional investors in emerging markets, says Laurence Bensafi, portfolio manager and deputy head of emerging market equities at RBC Global Asset Management Inc.
“Overall, they are less stable political environments and less stable mature economies. In general, the institutions are more fragile and the public sector tends to be very big. A change of leadership can be a big deal. Not in all cases, but most of the time because they can have a large influence on the economy.”
The 2022 presidential elections in two of the largest emerging market economies highlight this point. In South Korea, Yoon Suk-yeol defeated Lee Jae-myung, a member of the same party as the departing incumbent Moon Jae-in.
Although president-elect Yoon struck a more hawkish tone on China and North Korea on the campaign trail ahead of the March vote, Bensafi says the transition of power is unlikely to make big waves. “Korea is a very developed market and really it’s more of a technicality why it’s still classed as emerging. None of the candidates was very extreme: one was more to the left and one was more to the right, but neither would dramatically change the country.”
By contrast, the Brazilian election slated for October 2022 could result in a big political swing if the populist incumbent President Jair Bolsonaro loses out as expected to his expected main challenger, the left-wing returning former President Luiz Inácio Lula da Silva. “Clearly, the impact of whoever wins will be more important for the markets,” says Bensafi. “It’s a country that is boom and bust all the time and dealing with high inflation.”
Tan is also following developments closely and says the commodity price surge prompted by the Russian war in Ukraine may yet work to Bolsonaro’s advantage, since his country is one of the largest exporters of minerals and raw materials in the world.
“In emerging market countries, just like developed countries, voters tend to vote with their pocketbooks. How you feel about your economic prospects does, to some extent, influence whether or not you feel the incumbent is someone you might want to support further, even if you don’t agree with everything they are doing.”
She says institutional investors are missing a big opportunity to diversify their portfolios and deliver significant returns in the long term if they decide to steer clear of emerging markets altogether because of political issues. “There are ways you can manage the risk,” she says, encouraging investors to come up with a risk premium for particular nations based on their central bank policies and the governments’ overall level of fiscal responsibility.
“Then you can decide on what parts of the country and what industries you want to be in and which companies are most favourable to benefit from what’s happening in the country,” says Tan. “The key is to combine a more top-down analysis of the country with the bottom-up factors.”
High volatility ahead
Wherever in the world institutional investors are putting their money to work, Craig says they should be prepared for a period of high volatility in terms of both inflation and growth — conditions which he says set the stage for a higher rate of corporate failure in the coming years. “When you’re running a business and all of a sudden growth drops, the poorly run ones don’t survive.”
That, in turn, could have implications for the approach taken by asset managers, he adds. “If you’re taking a passive approach, you’re basically on the hook for every corporate failure. A lot of value will be in avoiding companies that go through missteps.”
Michael McKiernan is a freelance writer.