Timely & Topical

Geopolitical issues are currently having a heavy influence on economic and market outcomes. Global tectonic shifts are occurring in the areas of trade, defence, energy, technology and a desire for national resilience. Consequently, the key pillars that drove synchronised global economic growth are under threat with economic growth drivers such as the peace dividend we've enjoyed over the last 80 years and free trade agreements we've appreciated for decades, no longer intact.

Whilst we in the investment community would like to think markets are central to government actions, the harsh reality is that they are not. The market feedback mechanism is important in governments achieving their economic and geopolitical objectives. However, higher order priorities for governments are increasingly apparent.

For much of the past four or five decades, investors have been able to rely on some simple principles for investing within free market based capitalist economies. The allocation of scarce resources was driven almost solely by the highest return on capital available, feedback from market pricing and free competition anchored by comparative advantage. The role of government mostly centred around delivery of public goods and services, provision of safety nets as well as keeping checks and balances in place through regulation. An environment where private sector decisions ultimately drove markets whilst governments played a supportive role. Markets were at the forefront of these private sector (and some public sector) decisions.

Looking ahead, we see the potential for the roles of government and the private sector to be reversed. Where governments have strategic priorities driving critical decisions around the use of capital, labour, technology and other scarce resources dictating the growth or fall in certain sectors, the higher order priority now is to achieve nationalistic objectives. While the private sector will absolutely be necessary for governments to achieve their more strategic goals, the bigger picture decisions are not likely to be driven by free market pricing signals per se.

Going forward, the role of the private sector, whilst different and not in the driving seat, remains critical to governments achieving their objectives. The main reason being that the intellectual property, investor capital, skilled labour and track record of delivery sits within the private sector. Governments also absolutely need the private sector to execute their objectives. Therefore, key success factors for private sector participation will be:

• Certainty of execution (not necessarily price)
• Track record of delivery
• Alignment with longer term plans of governments, and
• National interests at the forefront of all decisions.

Thinking differently

The geopolitical environment over the coming decades will be significantly different to the past.

The historical norm of shooting for comparative advantage in trade is one case in point. Countries specialising in producing and exporting goods and services for which they have a lower production cost compared to others, enables greater total production and consumption than otherwise achieved in isolation. This is at the heart of globalisation and global commerce.

In a controlled environment, a constrained optimum, a framework that delivers the benefits of comparative advantage can still hold but the level of complexity increases. Regulation, resource availability, technological factors and social and political objectives have always been in the frame as constraints. Increased nationalist and protectionist policies can add further distortion and friction to otherwise economically rational decisions which have sharpened the focus of governments and their policy makers.

For investors, the implications are that the economy and markets are no longer front and centre in policymakers thought processes. Rather, markets are a tool through which economies and their respective governments to achieve their strategic priorities. Protectionist policies, for example, may mean that there's no certainty a trading partner can be relied upon to maintain willingness/capacity to deliver goods and services as required. Instead of an optimally efficient economic outcome being pursued, higher order government policies may take precedent. That is, governments may no longer pursue the cheapest option, but that with the greatest certainty of execution.

The outcome is that winners and losers will emerge and the gulf between each is likely to expand. Governments will be much more influential in who those winners and losers are at the country, industry and company level.

Investment implications - There will be winners and losers

For investors, the playbook for success has changed. Identifying the strategic priorities for governments and the number one, two and three operators with a track record of successful execution in these areas is a good start. Determining which industries could receive subsidies and tax breaks could also prove advantageous. As a guide, investors would be well served to assess investments with a focus on:

• Following the government strategic priorities
• Following the regulations, and
• Following the money.

This shift in approach from starting with the private sector to now commencing with governments' strategic priorities, whilst it may change the way industries and companies will succeed or fail, does not preclude successful investing and strong returns on invested capital across a range of asset classes.

There will be winners and losers!

Companies poised to benefit from strategic priorities such as the following are worth exploring:

• A renewed focus on defence including cybersecurity, ship building, defence supply.
• Energy transition incorporating renewables, transmission and distribution.
• AI and technology which promotes fundamental shifts in productivity including data centres and AI enabled technology platforms.
• Capital allocation towards an ageing demographic embedding social housing (senior living), Real Estate Investment Trusts (REITs), pharmaceuticals, healthcare.
• Population growth with core infrastructure (air, sea, rail).
• Supply chain resilience including transport, logistics.

A way forward

Clearly, investors need to think and allocate differently to how they have in the past and will need to work portfolios harder and more diligently to achieve their objectives. Pursuing similar return targets to those achieved previously but in a safer way may be the better way to go, rather than leaning into risk which has been so well rewarded.

For example, to maintain purchasing power and grow a corpus in real terms, pension funds, endowments, foundations and insurance companies often target CPI + 3%. Currently, investors are better able to avoid leaning as heavily into growth assets to achieve these objectives, with a greater allocation to defensive assets possible.

The past year has proven this to be the case with fixed income reestablishing itself as a compelling opportunity to drive attractive returns. The full gamut of options have delivered attractive return outcomes. Investment grade credit, the sweet spot between traditional equities and more pedestrian cash where risk of default, especially in Australia, is remote and has delivered 7.8% returns for FY25^*, close to long term assumptions for equity market returns in asset allocation models.

Investing differently for successful outcomes

The world is changing rapidly and for policymakers, markets are not the primary focus. Investors can still succeed but need to change the way they invest. When assessing policy and geopolitics, it is more relevant to back solve for what is firstly in the best interests of a nation and its public objectives, then the economy and markets - it's simply a different playbook. Just because markets have taken a back seat to geopolitics doesn't mean investors have to do the same. Many of the higher order government objectives will need to be delivered by the private sector. And with potentially government supported policy, regulation, subsidies, discounted funding and equity backing. Successful investment outcomes are very likely but achievable investing through a different lens.