Geopolitical risks lift energy and reshape global investing

Text transcript

Welcome to Advisor to Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject-matter experts themselves. 

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Eric Morin, global head of research, CIBC Asset Management 

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The biggest macro risk to our current and long-term outlook is the inflation risks. In the near term, as of now, at the end of March, the biggest macro risk is, of course, Iran and the war. The link with inflation is that escalation could trigger a destruction of supply capacity for energy producers in the Middle East. 

For example, Qatar’s LNG infrastructure has been knocked out by about one-fifth. Basically, the country lost about one-fifth of its production capacity for three to five years. So, there’s really an inflation risk that’s emanating from the current war in Iran. 

And looking at the long run, a key risk that we see is inflation, meaning that inflation could remain sticky, somewhat, above target. And so the target may not be a target anymore. It may become a floor. That is the risk over the long term. 

And how are we positioned for it? Well, in the near term, I’ve mentioned the Iran risk. We’re positioned by having a lower active risk because the balance of risk is askew to the downside, meaning that there is high probability of an adverse scenario that could take place. In the near term, we’re positioned with lower active risk, and we’re trying to be positioned with having more weights on the winners than the losers. 

In the current environment, the winners are the energy producers, and the losers are the net energy importers. In terms of the winners, Canada is one of them, at least on a relative basis, given that we’re net energy producers. So that’s how we are positioned. 

And in the near term, the Iran risk increases the attractiveness of the U.S. dollar as a hedge. However, over the long term, we still have the conviction that the U.S. dollar will continue to depreciate as a trend, and this is something that we will be positioned for once we have more clarity about the situation in the Middle East. 

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Why are we confident that AI and infrastructure investment can counteract demographic drag on growth? This is a question for which we did research, and our conclusion is that AI and strong inelastic demand for infrastructure, such as military infrastructure, supply chain resiliency, from tech to strategic mineral and rare earth elements, we do think that there is strong, inelastic demand for those investments over the long term. And this is something that we believe will continue to support global growth, and this is likely to be more than enough, we believe, to offset the demographic shock. 

If we look over the long term, what we have is a demographic dividend that is becoming a demographic headwind, with population growth stagnating or declining. For example, we saw the latest data from Statistics Canada shows that the Canadian population is now contracting. That’s probably a blip in the data or a temporary feature, but the key point is the trend. And the trend for demographic is toward a much smaller population growth, and that is a lingering impediment for economic growth, but also return at some extent. 

But the key point there is that we do believe the investment tailwinds are strong enough to offset that economic drag. I’ve mentioned infrastructure investment, but there’s also the AI investment with data centres. We think that this thematic of AI investment in the U.S. and China has legs to continue, and that thematic of AI investment will also spread outside both countries. We do believe that this will become a more global thematic. 

For the military spending thematic, this is something that is going to become more global. We have more conviction about that growth driver, given the conflict in Iran. The world order is changing. Geopolitical tectonic plates are changing, and as a result, countries have strong, inelastic demand to build their military capabilities. 

That’s the case for Canada — that’s already in the policy pipeline. That’s the case in the U.S. That’s the case in Japan. That’s always been the case in China. It’s been the case in Europe, with Germany in particular, and also increasingly, in Asia and the Middle East. 

Net-net, those tailwinds are not only economic headwinds, but they should also support earnings growth globally, and provide a cushion to elevated valuations. Those tailwinds do really matter for investors, and for the construction of strategic asset allocation. 

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Given stretched U.S. valuations, where do we see the strongest equity opportunities across regions? There’s two answers. There is the short-term answer. As of the end of March, there is a war or conflict in the Middle East. We believe that the balance of risk is skewed to the downside, meaning that there is a risk of an escalation, or a risk that oil prices may remain higher for longer due to supply destruction. As a result, in the near term, we see the strongest equity opportunities in energy producers. Canada is one of them. And at the opposite of the spectrum, we see the most important headwinds for energy importers. 

In the near term, the U.S. remains a good destination to hedge against the risk of an escalation of the conflict in the Middle East, at least on a relative basis, versus other stock markets. Canada is also a destination that is attractive during a military conflict in the Middle East. That’s the short-term answer. 

But looking beyond the near term, what we see is that, over the medium term and the long term, U.S. valuations are quite elevated. And this increases the necessity for investors to consider diversification, or to reduce the North America bias. 

We are constructive on U.S. stocks over the long term. This is a market where we see a really constructive outcome for earnings growth, for sales, for margins. However, valuation is considerably more problematic than in other markets. 

Looking at the long term, and given that we expect global investment tailwinds from military spending and AI outside the U.S. and China, we do consider that several markets offer attractive expected return over the long term, with smaller valuation headwinds. We have, for example, Asia. We have emerging markets. We have Korea. We have Taiwan. And those markets are exposed to the thematic of tech, and a ramp-up of military spending. 

We do see a lot of opportunities in Asia and in emerging markets. But also in Latin America. Latin America is also indirectly exposed to the AI thematic because they produce, for example, key minerals. But also the region is likely to benefit from a world of higher energy prices for longer, which is a risk. So Latin America is also an attractive region. 

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How should investors adapt a portfolio to a weaker USD environment? In the near term, because of the military conflict in the Middle East, that macro or geopolitical uncertainty is positive for the U.S. dollar. We should see more upside on the U.S. dollar over the next few weeks. That would likely give a better entry point to short the U.S. dollar. 

Our long-term view on the U.S. dollar is negative, simply because, like U.S. stocks, the U.S. dollar is way overvalued. And historically, the U.S. dollar valuation cycle has been a mega-cycle where the U.S. dollar is cheap for an extended period of time, and then expensive for an extended period of time. What we believe is that, yes, the U.S. dollar is overvalued according to our model. 

Looking ahead, we do believe that the Fed will have room to cut a little bit their policy rate, although that may change depending on the military conflict. We have also a growth outlook that, over the long term and the medium term, we’ll see a reduction of the spread of growth between the U.S. and other markets. 

We have a growth differential over the long term that will become less favourable for the U.S. dollar, so that should weigh also on the U.S. dollar, and facilitate the reversion to a spot level that is closer to fair value. 

A natural way to get exposure to a weaker U.S. dollar is to invest in non-U.S. markets. Reducing the North American bias is the first approach to adapt a portfolio to a weaker U.S. dollar. But it’s important to keep in mind that, yes, U.S. stocks are overvalued, but the earnings prospects are quite attractive. As a result, investors may want to reduce their exposure on U.S. stocks, but maybe not materially, given the underlying attractiveness of U.S. companies. 

One way to reduce the currency risk without reducing too much equity exposure is via hedging. Historically, investors didn’t hedge their equity exposure in the U.S., simply because the currency was a natural hedge. But we may be in a situation where, over the long term, the U.S. dollar becomes slightly more cyclical due to the depreciation that we expect. As a result, that would increase the attractiveness for investors to consider having some of their U.S. equity exposure hedged.

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