Deterrence, Correlation


Things have changed since the late 2021 US pullout from Afghanistan. The world is now a more uncertain place, as deterrence no longer seems to hold the same guiding influence on state behavior. What affects human behavior, also effects where asset prices clear. By implication, a sea change in the geopolitical environment should mean some shift in how asset prices may correlate or not. It now behooves the global investor to kick the tires on his or her stress testing techniques, concepts on hedging and working tolerance for leverage. The world is a different place, assumptions may need adjusting.

It was a rule of thumb – what re-rates equity prices, bolsters bonds. The market commentator Robert Armstrong opined on this, or rather, on what used to work, but no longer does. That is, he commented on what had become a tenured effect in a long-term low inflation environment, but with inflation’s comeback, no longer is. Armstrong writes:

“When inflation is tamed, downturns are all anyone thinks about, so stock and bond returns tend to hedge one another (ie, negative correlations). But when inflation is volatile and scary, such as in 2022-2023, stocks and bonds fall and rally together, jerked around by changes in the inflation outlook…”

(Robert F. Armstrong, “The Questions that Matter to Investors in ‘24”, Financial Times, 1/2/24)

Per Armstrong, the wheels came off, when investors could no longer take a low inflation rate for granted. Arguably, US fiscal excesses posted in 2021, flawed energy policy choices, and geopolitical dislocation all stoked US inflation which peaked at an annual rate of 9.2% during the summer of 2022, a forty plus year high. In reaction, the US Federal Reserve pushed benchmark interest rate levels to their highest in over forty years as well.

What Robert Armstrong is saying and what other market participants and commentators are noting is that a fundamental change in the environment signals a different market reality, hence the flipping of the stock-bond correlation.

Which begs the question: With geopolitical deterrence on the wane, could something else flip?

Over the last couple of years, MMD has undertaken a qualitative analysis of the geopolitical environment. The work is expressed in working papers, which update our Geopolitical Risk Framework (GRF), the latest published on 10/31/23. Please do not hesitate to contact us if you would like to receive a complimentary copy of this working paper.

In brief, MMD posits that a geopolitical environment functions best when it is “positive sum” – everyone effectively benefits from the geopolitical arrangement or “world order”, and when it’s roughly knowable and largely predictable. Sovereign states, for the most part the participants, remain incented to observe the status quo order and are confident in its resilience.

Implementing the GRF, we grade the four cardinal characteristics underlying geopolitical stability – confidence, deterrence, transparency and reciprocity. An “optimal” score for the GRF would be a 4, while a minimal or “poor” score would be a 1.

The current GRF, as of this past month-end October, stands at a little better than “fair” at a score of just 2.25.

The current geopolitical arrangement still functions in many ways, but it has become more threadbare, largely because of the erosion of one salient characteristic, deterrence, and the negative knock-on effects upon another key characteristic, confidence.

Since August 2021, deterrence – and the role the US has had as the world’s “benign hegemon” – has been buffeted. The US unilateral pullout from Afghanistan, without first consulting NATO allies, demonstrated feckless behavior and a US lack of resolve and probity in a sensitive geopolitical matter. This new absence of dependable force posture encouraged adventurism, perhaps catalyzing the Russian invasion of Ukraine in February 2022, saber rattling from China over Taiwan, stepped up Iran aggressive action, possibly the October 7th brutal Hamas assault on Israel.

If geopolitical stability is more uncertain, because different actors now stridently question the existing geopolitical order – through both word and deed (and are confident in doing so), it follows that the general interaction of states (and markets) may be called into question, or rather subject to what could be sharp changes in perceptions and stakes.

This more dynamic ongoing reappraisal that sovereign states are making, and that global savers and investors are making as well, might mean that value ascribed to different assets – that is, prospective profitability, robustness, likely pricing behavior – could be construed differently.

The critical thing is that we won’t know until or when/if these changes in asset price dynamics materialize. It’s below the surface in a sense in that correlations and pricing behaviors that recast assets may have not yet materialized, but they could, very suddenly. Like sovereign states, global savers and investors are trying to parse and make sense of what has become the more dynamic geopolitical order. Old ties, heuristics and rules of thumb may no longer work, but you won’t be told when that will happen. It’s best to think about what could indeed happen, how excessive leverage or confidence could be resting on stale assumptions, and what it might take to remain nimble in a new world.

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