The Structural Trends, Whoever Wins

May 26, 2024

5 minute read

by Erik L. Knutzen, CFA, CAIA, Chief Investment Officer—Multi-Asset, Neuberger Berman

Positioning for geopolitical shocks or election results is difficult, but we think the resulting structural trends are easier to identify and prepare for.

Investors were relieved last week, as marginally softer U.S. inflation broke a three-month run of hotter-than-expected data. U.S. and European equity indices regained their all-time highs, bond yields tumbled, and rates markets went back to pricing two full cuts by the U.S. Federal Reserve this year.

The day before, President Biden announced a fresh round of tariffs on steel, aluminum, semiconductors, electric vehicles and other goods made in China. Tariffs on electric vehicles will rise from 25% to 100%. Donald Trump had already told his supporters he would “put a 200% tax on every car that comes in from those plants.”

We take two lessons from this.

First, on key economic and trade policies, as we approach what is expected to be a very tight election, there may be less difference between the two U.S. Presidential candidates than meets the eye. And second, investors focusing on the immediate path of inflation may be missing the longer-term inflation dynamics of economic populism and heightened geopolitical risk.

We agree that last week’s data evidenced a declining path for U.S. inflation over the coming months, but we also believe that broader structural forces could cause upside surprises on the way down and could ultimately keep inflation higher and more volatile than it has been over the past 20 years.

So, how do we think investors should respond to these dynamics?

The Tangle of the Domestic and the Geopolitical

The U.S. election will cap a historic year for voters. Electorates representing about half of the world’s GDP and half its adult population are going to the polls, from India, Pakistan and South Africa to South Korea, the U.K. and the European Union.

Populism, polarization and volatility increasingly characterize the politics in many of these places. If this were not complex enough, domestic contention is often tangled up with ongoing geopolitical flashpoints and realignments. What happens in Gaza can affect the election in the U.S., which in turn has major implications for Ukraine and its European neighbors.

We believe it has always been difficult to position portfolios for an election result or hedge against political and geopolitical risk. It requires one to identify the risks correctly in the first place and then select effective positions.

For example, what does history tell us about how to position for U.S. election outcomes? Equity markets generally prefer a Republican “clean sweep” of the Presidency and Congress, but have tended to react worst to a Republican President facing a divided legislature. Returns tend to be positive albeit a little weaker than average during election years, but can rally strongly once the uncertainty of the poll is over.

At the geopolitical level, let’s say you identified the risk of a massive terrorist attack by Hamas on Israeli territory in October last year: How might you have positioned a portfolio? Long gold, U.S. Treasuries and the dollar, perhaps? Short equities? Gold was indeed up by 13% by the end of the year, and yields were down 100 basis points. But this was mainly due to rapidly falling interest rate expectations, not geopolitical risk, which is why equities went up 10% and the dollar fell by 5%.

So, positioning for either political or geopolitical risk is challenging, and by reordering traditional alignments, the tangle of the domestic and the geopolitical can make it even more challenging, in our view. For example: Republicans may not like the interventionism and constraints of net-zero policies, but a 200% tariff on Chinese electric vehicles is likely to provide a major boost to the domestic climate change-mitigation industry and a major blow to global free trade; and Democrats are pushing money toward an area that perhaps many traditionally wanted to cut: the military industrial complex, in support of Ukraine.

High Deficits, High Inflation

In our view, the most prudent way for investors to approach political and geopolitical risk is to focus on underlying, structural economic and political trends rather than trying to untangle the political specifics of individual events, parties or personalities.

Take a step back, and we think it’s a fair assumption that U.S. deficits will remain high and that inflation will continue to be volatile with the potential for upside surprises. Under Democratic leadership, the driving forces might lean toward net-zero policies and, under Republicans, they might lean toward tariffs—but investors should not miss the forest for the trees.

Similarly, one could focus on the potential for disagreement between Europe and the U.S., or on tensions between the European Union and the continent’s growing nationalist/populist voices, and miss that these tensions make all sides push in the same protectionist direction. It is not some populist firebrand leading the charge against global competition with prescriptions of more focused industrial policy and strategic intervention for the Single Market, but two grandees of the European center, Mario Draghi and Enrico Letta.

Diversified Exposure, but Leaning Into Structural Trends

We therefore think the question for investors is how to allocate in a world of unpredictable geopolitical and political shocks, free-spending, protectionist government, and the resulting structural inflation pressures.

In our view, the most prudent response to unpredictability is not simplistic “shock hedges,” but diversification. Genuinely uncorrelated markets and strategies can help here, but bonds have also regained some of their ability to offset the performance of risky assets now that yields have risen.

Bonds are vulnerable to free-spending governments and inflation, however. Even if inflation continues to decline this year, to us the fact that the 10-year yield has recently been falling faster than the two-year yield is a sign that markets may be complacent about longer-term inflation uncertainty and debt sustainability. Unless and until that adjusts, we prefer the short to intermediate part of fixed income curves.

And finally, as we have mentioned a few times over recent months, we think exposure to real assets and commodities is important in the new environment.

Gold is up 16% so far this year, and oil is up 10%. Copper, at a two-year high, is up 24%. One is a traditional “risk-off” hedge; the other two are traditionally associated with booming economic cycles, and one of those offers a traditional, geopolitical risk hedge in the bargain. In microcosm, they underline our argument: Remain diversified in exposure to short-term economic, political and geopolitical possibilities, and be prepared for the inflation implications of structural political and geopolitical trends.

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What to Watch For

- Wednesday, May 22:
  - U.S. Existing Home Sales
  - FOMC Minutes
  - Japan Manufacturing Purchasing Managers’ Index (Preliminary)
- Thursday, May 23:
  - Eurozone Manufacturing Purchasing Managers’ Index (Preliminary)
  - U.S. New Homes Sales
  - Japan Consumer Price Index
- Friday, May 24:
  - U.S. Durable Goods Orders