The House of Medici, which ruled over Florence for much of the Renaissance period, established a political dynasty with influence built on successful ventures in commerce and banking. The Medicis predated the concept of geoeconomic power, or governments’ ability to wield economic might to achieve geopolitical and economic goals. Today, soft power might be giving way to intensifying competition between great powers. Government leaders are increasingly focused on solidifying economic security through trade leverage, tariffs, sanctions and other measures. As a result, potential new investment risks and opportunities are emerging.
This episode of The Outthinking Investor discusses how investors can measure their portfolio’s exposure to geoeconomic shifts, which economies and sectors could benefit amid a realignment in supply chains, whether the US dollar can maintain its global dominance, and investment strategies that could potentially mitigate risk and capitalize on new opportunities.
Our guests are:
- Matteo Maggiori, finance professor at the Stanford Graduate School of Business
- Joseph Nye, political scientist and former Dean of Harvard University’s Kennedy School of Government
- Mehill Marku, Lead Geopolitical Analyst at PGIM
Do you have any comments, suggestions, or topics you would like us to cover? Email us at thought.leadership@pgim.com, or fill out our survey at PGIM.com/podcast/outthinking-investor.
Episode Transcript
>> The House of Medici ruled over Florence for much of the Renaissance period. Like a plot from a Shakespearean play, the family used its power to acquire more power, marrying into royalty and successful businesses across Europe and even providing four popes for the Catholic Church. They were epic patrons of the arts and sciences and, of course, the church. But they had no military presence. They maintained power through public influence and their financial leverage, innovating financial techniques that promoted trade. The Medicis predated the concept of geoeconomics by hundreds of years, but they skillfully used their economic leverage to achieve political goals. They may not have been the first geoeconomic experts, but they were among the most successful.
How does geoeconomics play out today in the global economy? How can we use the insights from geoeconomics to better understand current trade tensions? And what tools are available for investors to measure their portfolios exposure to geoeconomic risk? To understand today's investment landscape, it's important to know how we got here. This is the Outthinking Investor, a podcast from PGIM that examines the past, the present-day opportunities, and the future possibilities across global capital markets. Three experts will discuss the impact of geoeconomics on investing. Matteo Maggiori is a professor of finance at Stanford Business School. Mehill Marku is lead geopolitical analyst at PGIM. We were also privileged to speak with Joseph Nye, who passed away shortly after our recording with him. He was Harvard University's Distinguished Service Professor Emeritus and former dean of the Kennedy School of Government. He served in key US national security roles for two administrations and conceptualized the theory of soft power. The core concepts of geoeconomics are ancient and universal. A couple of centuries after the Medicis ruled Florence, the British Empire famously competed with Russia for influence over East and Central Asia. Matteo Maggiori looks at how countries today are applying pressure through trade and finance to achieve economic and political goals.
>> Many governments, whether it's the UK, Western Europe, Australia, Japan, are pursuing what are called economic security policies. What they really are is they're attempts to reshape their domestic economies and the relationships they have with either China or the US to insulate their domestic economies from potential coercion afterwards. Now, what you're really doing is you're trading off the gains from trade, the gains that we all have from globalization and from trading with each other and specializing with security. If you think of Europe, you could say, look. I want to do all of my manufacturing within the confines, within the borders of Europe because I don't want to rely on China. Or you can think of other countries trying to develop alternative payment systems to not rely on a system that is very centric on the US. But, ultimately, if all of us try to do everything within our borders, we're very inefficient. We give up a lot of the gains from trade. And part of the problem with this mechanism is that we call it the fragmentation doom loop. It's a bit like social media. A lot of the global economies, you want to be on it because other people are on it. Again, payment system are a typical example. You want to be on that system because everybody else is on it; and it's easy to transact. So, as more and more countries withdraw from these global efficient technologies, they also become less attractive for everybody else. They will want to withdraw. And all we're going to do is build up this kick sort of globalization in reverse, and some of the same mechanisms that made it very successful can bite in reverse. And so there's good reasons to be worried. At the moment, we've only seen tiny signs at this. We're at the beginning. But, if you kick in this feedback loop, it can quickly snowball against you.
>> The shift in US-China relations is at the center of trade tensions. Joseph Nye watched this complicated relationship between the two countries unfold over many decades, including his time advising the Clinton and Carter administrations.
>> The US has a -- or had, until recently, a fair degree of soft power in the Global South. Soft power is the ability to get what you want through attraction rather than coercion or payment. And it's interesting that China in 2007 declared that it wanted to grow its soft power and spent tens of billions of dollars to do this. Nonetheless, if you looked at the results of public opinion polls taken by reputable organizations like Pew or Gallup, they show that the United States was more attractive to more countries than China. In that sense, we had an advantage in soft power. What we're seeing, however, is that the second Trump administration is discarding many of the instruments of soft power, for example, cutting back or destroying the US Agency for International Development, which makes us look more attractive into humanitarian goals in the Global South or stopping the broadcasts of The Voice of America, which were ways in which we reached out with our message. China is trying to fill that vacuum. For example, it has its Belt and Road Initiative, which is an aid program that China provides primarily for infrastructure assistance across the world. And it certainly is doing or hasn't cut back on its broadcasting by China radio or TV. So, in that sense, I think what the administration is doing is undercutting our soft power; and China is happy to try to fill the vacuum.
>> Competition has been heating up between the US and China for some time and especially over the last couple of decades. That's made trade relations and geopolitical risk difficult to navigate.
>> The idea of having a engagement, which was the phrase that was used in the beginning of the century, is long past. I think what people think of now is what Ambassador Kevin Rudd has called managed competition. The competition will be intense. The question is, can we manage it so that it doesn't get out of hand? I think the policymakers have changed their view from, let's say, half dozen years ago or so when there was a hope that you're going to be able to have a policy of engagement with China to now having a focus on a high degree of competition. The question of can you do deals in that atmosphere varies a bit with administration. The United States has over 60 countries that are either an alliance or close relationship. China has just a handful. So the big asset that we have is this structure of alliances. Seems to me the Trump administration doesn't appreciate that. If you use the metaphor of a poker game and a entity from Mars came down and peeked into the hands of the two players, they would say that the Americans have an ace. Chinese have a deuce or a two, three in this area of alliances.
>> A crucial factor here is how other countries are responding to US-China tensions. In North America, trade negotiations between the US and its closest trade partners, Canada and Mexico, have been nuanced, including issues like immigration and fentanyl. It's a different picture in Asia. Countries like India, Vietnam, and Thailand have strong links to both the US and China, mostly trade surpluses with the US and trade deficits with China. As Mehill Marku explains, these relationships are complicated.
>> The biggest fear for these countries is really being forced into choosing between China and the United States. And should they be forced to make this choice, then I think it's going to provide more disruption to production, investment, and growth for these countries. And this also explains why some of these countries, particularly Vietnam, India really have been very quick in responding to the US' concerns about trade imbalances. And they have committed to lower tariffs. They have committed to lower non-tariff barriers, purchase more US goods precisely because they want to avoid this choice between the United States and China.
>> It's a similar picture in Europe, where most countries still hold trade surpluses with the US and trade deficits with China. There is one important difference.
>> Unlike these other countries, European Union views China as a systemic rival; and, therefore, really they are likely to be less inclined to get in a more cooperative relationship with China. I think that Europe would be also willing to get into a deal with the United States to jointly confront China in selective areas, particularly, for example, in car sector or even green energy. But I also think that Europe will try to stay away from formalizing an agreement with the United States, suggesting that they want to create an alliance with China, mainly because China continues to be a very important trading partner for Europe. Many European countries actually favor strengthening trade ties with China. India obviously has a significant importance for US strategic outlook from the Indo Pacific. It's a country with extraordinary economic potential and trade potential, but it is also a country that has had significant trade barriers. Reports suggest that negotiations are ongoing in a very constructive way, that they have agreed to lower tariffs while keeping some high barriers, also to some critical sectors, particularly in pharmaceuticals. It is very critical for United States to have India on its side as tension potentially between United States and China over Taiwan and overall Indo Pacific is likely to intensify in the years ahead.
>> US-China trade tensions are reshaping the geoeconomic map. If the world becomes increasingly fragmented, one extreme possibility is that it spreads to the financial markets and China begins to diversify away from US treasuries and other assets.
>> If this were to happen, if these portfolio shifts were to occur, that would probably have large impacts on things like exchange rates and interest rates, particularly because it is not easy to find, for example, a market the size of the US treasuries in terms of liquidity, safety, and just the sheer size of the market. And so if you try to, for example, reallocate towards German government bonds to bonds, there is quite a small market. And you might move the prices a long way as you try to do that reallocation. I would also say that, in reverse, the US investors particularly have had large holdings of Chinese companies that are listed on the New York Stock Exchange. They're listed with very particular capital structures called variable interest entities. In the Cayman Islands, these structures have attracted a lot of attention in recent years because they're unusual; and it's not clear what the exact property rights would be. And I am surprised to this day that there hasn't been more of a regulatory intervention on these structures. I've always thought that a shaky structure in the middle of these kind of political tensions seems a disaster waiting to happen. And so I certainly would encourage more clarity on that side, particularly since they're listed and the public can hold them. They're not just professional investors in private equity. These are really held quite widely in asset management and directly in retail or in pension funds.
>> The biggest risks are typically the unknown unknowns, when we don't know what we don't know. Large global institutions like the International Monetary Fund and the World Trade Organization have historically been effective at promoting stability to thwart a crisis. Is this still the case?
>> Whether the WTO can persist in such an environment is an open question. The idea that it will be able to negotiate large trade rounds, as it did in the past, I think is very unlikely. Can it help on certain sectoral approaches? Maybe. And, there, I think there's more promise. But the WTO is not going to have the universal applicability which was expected of it when it was created in the 1990s. The IMF, on the other hand, still plays a significant role in terms of international financial stability and particularly important with providing loans to countries that are in difficulty with their balance of payments positions. Recently, the IMF has given such a loan to Argentina, for example. I expect that will continue. In general, the degree of cooperation which we're seeing through international institutions has declined from what it was, let's say, in the 1990s. And whether this will be reversed or not is an open question.
>> The shifting geoeconomic map and level of uncertainty around the world has fed into increasing speculation around whether the US dollar could lose its status as the reserve currency. While still extreme and unlikely, it is a possibility.
>> Once you've been a reserve currency for so long, investors tend to become overconfident. They tend to think that this is going to last forever. When you look at history, there is no reason to have that confidence. You look at every previous reserve currency in history; it did came down with a crash. And, in fact, when you look at how they came down, they look like bank runs. Nobody thinks that it's happening until the last minute, and then everybody runs on the currency together. So, when I had to model them in my previous work, I decided to model them almost as bank runs, like as multiple equilibria. In fact, I will mention one that affected England; and the US was part of it. So in 1957 England, together with France, invaded the Suez Canal. They tried to regain control of the canal from Egypt. The US administration at the time was displeased with this military action, and Britain was suffering through a balance of payments crisis. It was suffering essentially a run on the pound and asked the US for liquidity help, either the US or the IMF, which ultimately relied very heavily on the US contribution. And the US administration threatened to withdraw the liquidity support and therefore make Britain go through a financial crisis, had they not withdrawn from Suez. And, of course, this threat was sufficiently credible and expensive. Britain indeed decided to withdraw the troops from the canal. So you can see it as a situation where the borrower was in trouble. It was having a very hard time figuring out another lender; and, therefore, the US had a choke point on Britain at that particular point in time. Now, that would not have been possible had Britain had its balance of payments in order, ample reserves because everybody else would have been willing to lend them on good terms, since you didn't think that there was going to be any risk that they wouldn't pay you back, or they would try to lower the repayments by depreciating. So it's not a statement that one can make in general. It's about the particular situation and what is the fiscal situation of the borrower, and can he find somebody else to replace the government or whoever it is that wants to withdraw the liquidity. So, for the US, for many years I dismissed this as an uninteresting conjecture. I think it probably still is. I would strongly suggest to all policymakers that we don't want to discover the world where that is an actual possibility and you are dependent on that all over because that will surely cause a lot of political tension.
>> Matteo and his research partner provide access to their framework to help investors gauge their economic risk. For example, investors can estimate the magnitude of a potential loss related to a certain risk.
>> So think of it as estimating what is the loss of using access to financial services of the US if you're Brazil or if you're Australia or if you're Russia. And you can do this sector by sector, and there are techniques to do that. And we do it in our research, and we make it available. The other thing that you can use in this framework is the typical problem with threats is they're very difficult to observe. Some of the most powerful, for example, never occur; or the companies might be reacting in anticipation of the possibility of being subject to this. So a lot of our work is taking a different approach, which is using large language models, AI, to read machinery, very large amounts of text, and figure out what are companies or analyst reports saying about this. Is the company reporting that they are getting out of Russia because they're worried about the sanctions? Is the company reporting that they think that they're not going to be able to sell in China because they might be subject to export controls from either Europe or the US? We release the very first draft, and one of the things that we're trying to do is to make the output available to investors so that you can see in almost real time who is complaining about what, when are they getting out, how are they reacting? For example, if you think of the announcement of April 2 of the Trump administration of potentially extraordinarily high tariffs on US imports, we wanted to know are US companies reporting in response to this they plan to increase their prices? Are they planning to decrease the quantities that they import? Are they planning to find alternative suppliers?
>> There are a number of geopolitical risks around the world that could impact geoeconomics And the financial markets. The Middle East has been a heightened risk since October 2023. Two other regions are also worrisome for investors, one in Europe and one in Asia.
>> One is a potential escalation of the war between Russia and Ukraine. And then this obviously would present risk also for Europe, that Russia might choose to respond to Europe using hybrid war methods, including, let's say, sabotage or euro cyberattacks and things like that, which very clearly would be a risk for European economy. And then the second geopolitical risk is China's potential military bench against Taiwan. This is a risk that I think is going to increase. So that is a big risk now because the threat of tariffs that Trump thought would prevent Xi Jinping for undertaking an adventure, I don't think that threat is any longer there. And this is significant risk. In terms of market implications, even though they are not like base cases but, if they do happen, then I think there are only two traits, in my view, that investors should be thinking. So being long gold to really hedge against both geopolitical risk as well as trade risk. Gold has been really performing well since April 2 announcement. And then being long companies in the defense sector, particularly defense companies that are involved in high tech warfare. These are the two trades that I'd say I have very high confidence.
>> Trade tensions and rising tariffs are pointing to structural shifts in both trade policy and supply chains, but there's also a lot of noise in the headlines. How should investors think about these issues from a longer term asset allocation perspective?
>> Both these shifts actually imply investment risk as well as opportunities. In the short-term, it is almost a given that we are going to see disruption in production and maybe also reduce volumes in global trade. But, over the long terms, actually, we could see deeper economic reliance because of these policies. For example, the tariffs might benefit certain industrial sectors in the United States, let's say steel; or they could benefit semiconductors. On a broader scale, you could see also some countries benefiting from it. And I would include here major emerging market countries. Countries that come to mind, for example, are the gulf countries, Turkey or certain countries in Latin America. And then obviously you could have also other industries or sectors being affected negatively by it. For example, export-oriented industries most likely will suffer from the tariff war, as well as, for example, companies that depend on global inputs. These are likely going to suffer from what is happening currently on the trade front.
>> Investors should be cautious here and not fall into what Mehill Marku refers to as the rationality trap. Just because something seems rational or probable, it doesn't mean it will happen or that markets will react in a rational way. Take the April 2 tariff announcement as case in point.
>> We saw market completely tanked, erasing trillions of dollars of Americans wealth within a week or so. Right now, we are almost in the opposite position where markets now think, because Trump has been continuously climbing down, that he might continue to do so. And this has been exemplified by the so-called TACO trade, which is Trump always chickens out. But I think markets could be also wrong here because what if he doesn't? I mean, as I said before, this 25 percent sudden increase on tariffs on steel and aluminum actually should be a warning sign for market participants. And this is always the case that sometimes market normalize certain event and start thinking rationally about it, rationalize it. And then, you know, a reversal becomes really a surprise. And this has been the case since Trump's win, followed by, obviously, the announcements on tariffs.
>> One thing is certain. The global order that we've known for decades is changing. That presents risks for countries and investors, but it also presents opportunities.
>> I hope that one very positive outcome is that, out of this, we end up rethinking the global order. Sometimes you can get stuck in history dependent outcomes, and this might give us a chance to rethink some of these institutions, make them work better, update them, and ultimately get to a better place.
>> Thanks to Matteo Maggiori and Mehill Marku for their insights on how geoeconomics influences investing. And, to Joseph Nye, this episode is dedicated to his lifetime of service and leadership. The Outthinking Investor is a podcast from PGIM. Follow. Subscribe. And, if you like what you hear, go ahead and give us a review. If you enjoyed this episode and want to hear more from PGIM, tune in to our Speaking of Alternatives podcast. See the link in the show notes for more information.
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