Navigating Geopolitical Risks: A Conversation With Marko Papic (January 21, 2024)

“The risk is in the politicization of monetary policy. Nobody wants to talk about it, and nobody is really positioned for a really aggressive Fed in 2024.”

By Lisa Beilfuss

Surveys across Wall Street suggest investors see geopolitics as the biggest risk in 2024. But if risk is about unexpected outcomes, how should investors think about geopolitics if that is where so much attention is already focused?

In the latest week, Praxis spoke at length with Marko Papic, chief strategist at alternative investment management firm Clocktower Group. Papic leads Clocktower’s strategy team, covering geopolitics, macroeconomics and markets. Previously, he founded BCA Research’s geopolitical strategy practice, the financial industry’s first dedicated political analysis investment strategy. He is also the author of the book Geopolitical Alpha: An Investment Framework for Predicting the Future.

An edited version of the conversation follows.

Praxis
There is a lot going on geopolitically. Where are the biggest risks for investors this year?

Marko Papic
Let’s start with how to think about risk. For investors, it’s about something unexpected happening. Geopolitical risk lies where investors aren’t looking. 

With that said, too many investors and geopolitical analysts have overstated the probability of a regional war in the Middle East. There is some chance that the Israel-Hamas war spirals, but there’s a reason it hasn’t already. It may still expand into Lebanon, but the main players–Saudi Arabia and Iran–don’t want war.  A lot of the violence is occurring in non-macro relevant parts of the Middle East, like Houthis lobbing missiles at commercial ships in the Red Sea, and that's not going to have any real investment implications other than for shipping companies.

The Ukraine-Russia conflict is in stasis and it's increasingly becoming a frozen conflict. If anything, it offers only upside surprises in terms of performance of some European assets. The Taiwanese election that just ended was very positive in terms of the outcome, and also in terms of how China has reacted to that outcome. 

So where is the risk? Right now, investors aren’t yet taking the U.S. presidential election seriously. More specifically, the risk is in the politicization of monetary policy. Nobody wants to talk about it, and nobody is really positioned for a really aggressive Fed in 2024.

You’re saying the biggest geopolitical risk for investors is the 2024 presidential election here at home?
By far. My bias has always been to downplay the outcome of an election. But this time around, assuming Donald Trump is the Republican nominee, I don't think that investors understand how much the American establishment sees Trump as a threat. This bit is misunderstood and it matters because I think investors underestimate just how much the Fed's reaction function could be influenced by politics in this election. 

What I'm telling you is a story that's almost fantastical. It's like Lord of the Rings as far as most investors are concerned. It's like I'm describing Turkey, not America. That's where I think the risk is, that disconnect between the expectation of what is the relationship between politicians and the central bank in the U.S. and the reality that I think we're actually in.

Why do you think the Fed might be influenced by politics this cycle?
First, think back to December. There is no data that warranted the pivot in December, other than the core PCE was coming down. But that was the case for months. So why did they choose December to pivot? You cannot explain that to me unless there's an unobserved variable that's motivating them to be lenient, which I think is politics. It's the threat of a Donald Trump presidency.

Second, it is just reality. Most investors, particularly in the U.S., find it uncouth to suggest that the Fed is political. It's not something you speak of in polite society because most investors in the U.S. have been raised on this mythology of an independent Fed.

I don't subscribe to that mythology. I think the Fed is a political institution. And when you have an anti-establishment candidate running for president with a clear intention of attacking that establishment–he plans to fire tens of thousands of federal employees–of course the Fed is not going to ignore that.

What about the economy? Can politics really eclipse economics when it comes to monetary policy, or are you saying it is all related?
If you think about what the Fed really cares about, it's anchoring long-term inflation expectations. I can tell you that the price of gasoline or the price of food and rent don’t matter. The policy decisions–politics–are what matter for long-term inflation expectations.

In that way, a Fed concerned about inflation expectations should lean against Trump. I don't use the word “should” normatively because I don't care who wins. I'm a nihilist. But I am saying the Fed is going to get involved and I think that that's just something that ideologically and normatively most American investors just don't want to contemplate.

So regardless of the economic data, the Fed is cutting soon and aggressively?
For the last year and a half, the median investor has convinced themselves that Powell wants to be Paul Volcker, not Arthur Burns, and is serious about 2% inflation. 

If we get a growth slowdown and sticky inflation, the median investor is like, ‘well, they're going to focus on inflation. They cannot cut in that scenario.’ And I am saying, no, they're going to cut like crazy. They don't care. 

Inflation could go back up to 5%, and they wouldn't care. Oil prices could quadruple because of war in the Middle East and they'll say, "Look, it's geopolitics, it's transitory, it's not something that the Fed really focuses on." The narrative will shift dramatically.

How much easing do you see?
Think about different scenarios. If there is a recession, how many cuts would the market expect? If there is no recession, how many cuts would the market expect? I want to bet more cuts than the market expects in any scenario. 

What if growth accelerates further? I don’t think that will happen this year, and so I am no longer maniacally bullish as I was for the past 18 months. But let's imagine a scenario where growth does reaccelerate. What would the Fed do then? I would say that they will not hike for sure. There's almost no scenario in which the Fed will hike. 

Can all of this be true at once? Can’t economic conditions alone merit easing?
The Fed will target employment much more aggressively than inflation for at least the next 12 months. If we do actually get a recession, I think it's highly unlikely that we get one that is severe. 

But I think the Fed’s reaction to even a shallow recession will be quite dramatic. There's this emerging consensus that in the next recession, the Fed will not cut rates as much and they won’t do QE. That's absolutely bonkers. If we have a recession, they'll cut by more than 300 basis points. They'll do QE, they'll do whatever they have to stabilize growth because a recession ahead of the election will definitely produce a populist outcome that they want to avoid.

When was the last time US politics were the top geopolitical risk for markets?                   
I can't think of a case where U.S. politics was a risk to investors. Most U.S. elections have not mattered. As an investor, did you care if Bob Dole or Bill Clinton won in the mid-'90s? In 2016, Trump was a faux populist. He said all sorts of stuff that made people lose their minds, but in terms of his policies, he was actually a pretty centrist run-of-the-mill establishment Republican. He cut taxes–how anti-establishment!

This time I think Trump is a European-style anti-establishment figure. Last time, Trump put a bunch of Goldman Sachs executives in the White House. But many people who came from the establishment and worked for him have since either testified against him, written a book, or gone on cable TV to say mean things about him. It is not clear to anyone that Trump would pick the same kind of a cabinet and advisers this time around. 

Are there other election-related risks for investors apart from Fed policy?
Let's say three, four months from now, Biden continues to poll as poorly as he is polling now. Democratic presidents facing re-election and difficult polling have a history of being aggressive on foreign policy. 

Biden doesn't really have domestic legislative initiative anymore because the Republicans are controlling the House. But in terms of foreign policy, a U.S. President doesn't have many constraints. We already saw that with the Houthis and the attack in Yemen. Maybe that isn’t enough. Maybe there needs to be a fight picked with China. I don't mean a major one, but maybe more export rules, maybe more rules on investing in China–the kind of foreign policy that can impact markets.

How do the interplays you describe–politics, economics, Fed and fiscal policy–net out for investors?
I think it's very difficult to be very bearish on equities throughout 2024 because I think the Fed will have an itchy trigger finger due to politics. The Fed has 525 basis points to cut. That’s a lot of ammunition. That is the first reason why I think U.S. stocks should at worst be flat on the year, but quite possibly could actually go up quite a bit.

The dollar should suffer in a world where the Fed is lenient and behind the inflation curve. In that case, global equities should outperform the U.S. 

As for bonds, I think they could rally as investors get surprised yet again by being wrong on growth. In 2023, bonds had one of the worst sell-offs in history because everyone was wrong about a recession. And now you could have everyone wrong that we’ve landed softly. Bonds might do a round trip if I'm right about the Fed cutting rates, because that would reignite consumers. The economy could actually be on fire by the end of the year.