Macro Trumps Geopolitics - Now And Forever More

by: Valtteri Ahti


In terms of asset allocation geopolitical shocks are transitory and trumped by macro.

It's time to be overweight in equities and utilize shocks emanating from Russia, Middle East and Ebola, to which the market overreacted.

The key is to follow the global business cycle, which in turn follows that of the US.

The last few weeks have seen markets spooked by a biblical set of shocks. European stocks - particularly Finland and Russia - were hit hard. US stocks were relatively immune, government bonds rose and high yield credit took a tumble. War in the holy land, epidemics in the tropics and Russian embargoes… Hollywood would find this type of scenario farfetched.

Fortunately in terms of asset allocation, the direction or duration of Russian obstinacy is of marginal importance except in the obvious tail risk extreme. The success of the allocation decision is contingent on the global business cycle and not the behaviour of countries that have smaller populations than Bangladesh and generate only 4 times the GDP of Sweden.

By now it should be amply clear to Western investors that Russian economic policy is completely subordinated to foreign policy goals. Half of the government budget is funded via oil and gas revenues and roughly 70 % of Russian stock market capitalization consists of oil and gas producers and banks. These companies should not be analysed using traditional Western equity analysis as their objective is not to maximise shareholder wealth, but to serve and fund foreign policy goals. The Russian market is set to remain cheap until the country undergoes a structural shift in terms of policy.

Russian policy is distinctly myopic. Production is quickly dropping from its conventional oil fields in western Siberia. Western capital and technology are necessary to tap into the hydrocarbon sources in the Arctic seas, Bazhenov shale, Yamal peninsula and Sakhalin islands.

The fact is markets needed to let off steam, as every secular bull run necessitates regular corrections as part of its inherent dynamic. This smörgåsbord of war, embargo and disease has provided a satisfactory excuse to set off this particular fright. However, in the medium to long run stock markets track the business cycle. The Fed funds rate is a good proxy of the business cycle in the US as its level is dictated by economic growth and inflation. The US business cycle in turn tends to lead the global business cycle. Economic growth spurs revenue growth in companies, which translates into earnings, which drives share price appreciation. To a first approximation everything else is noise.

The latest US macro figures have been good, and the earnings season surprised on the upside. Europe continues to be sluggish, but this is what one would expect. Europe continues to suffer from demand deficiency and lags the US. It is not at all unlikely that the ECB will commence aggressive easing as the lack of demand continues exert deflationary pull on prices. Importantly, in Mario Draghi we finally have a proficient central banker in the vein of Bernanke and Yellen, who will combat deflation.

As transitory geopolitical shocks dissipate, major markets including European stock indices will recommence their climb upwards as the business cycle dictates. Markets will renew speculation as to when the Fed will initiate interest rate hikes. In global macro parlance geopolitics has generated market dislocation, which will correct. Macro trumps geopolitics.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.