The outlook for sovereign bond investing in 2024 from Jupiter’s Aggarwal

by | Dec 18, 2023

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In 2024, Jupiter Asset Management’s Vikram Aggarwal expects geopolitics to have a major influence. Fortunately, sovereign bond markets offer opportunities to hedge against such risks.

During the US Presidential campaign of 1992, Bill Clinton’s election strategist famously coined the term “It’s the economy, stupid” to drive home to their campaigners the key message to focus on. A similar sentiment is probably true about what has been the ultimate driver of investor sentiment and market behaviour for most of the years since, particularly in fixed income where so much attention is paid to monetary policy and central banking. I would argue, however, that incorporating geopolitical factors into investment decisions will become increasingly important not only in 2024 but over the next decade. 

(Not) The end of history

 
 

Back in 1992, the world was still relatively fresh from the end of the Cold War, with an emerging consensus in the West that capitalist liberal democracies had established themselves as the culmination of political and economic progress (1992 was also the year that Francis Fukuyama published his book, The End of History and the Last Man). From our current context, such a view looks naïve.

The unipolar world of US global hegemony has clearly, since 1992, given way to a multi-polar world as China and other emerging nations grow in influence. The economic impact of this was seen in globalised supply chains and an exporting of deflation across the world. After the COVID pandemic exposed weaknesses in the global economic model, competing geopolitical agendas and a trend towards nations using military force (rather than purely economic pressure) are continuing to drive a wedge between the G7 nations and what one might loosely describe as the ‘BRICS’ grouping of major emerging markets. One medium-term outcome of this could be a reversal of the supply chain and deflationary trends, to see a more fragmented web of regional supply chains and upward pressure on inflation.

The universe of global sovereign fixed income is at an interesting intersection of markets and geopolitics, as it offers some directly correlated investment instruments to position for geopolitical risks, in a way that just isn’t possible in equities or corporate credit for example.

 

Geopolitical flashpoints in 2024

So what are the potential geopolitical flashpoints that global sovereign bond investors should have their eyes on in 2024? It’s a huge topic, but a couple of factors that spring to mind are tensions in the Middle East, and relations between China and the US especially regarding Taiwan.

At the time of writing, there are talks about a humanitarian pause in fighting between Israel and Hamas, which is an important step on the road to a full ceasefire. Nevertheless, the situation on the ground remains tense and highly fluid, with the potential for escalation still very much present. Any spillover in fighting beyond Gaza, or a deterioration in diplomatic relations between local Arab regimes and the West, could lead to a disruption in the oil supply to the global economy. Staying in the Middle East, the actions of Saudi Arabia in selling oil to China in Chinese Yuan seem to run counter to its historical position of being closely aligned to the US.

 

The challenge to the US Dollar’s position as the global reserve currency is just one manifestation of tensions between the US and China. The sovereignty of Taiwan is a focus for that tension, and Taiwanese elections in January 2024 will play a major role in shaping the narrative for the rest of the year. A victory for the pro-Beijing party would decrease the near-term likelihood of any military action on the part of China, and vice versa. Meanwhile, the lack of any military strike against Russian territory after its invasion of Ukraine, and the continuing sale of its oil and gas across large parts of the world, might have demonstrated to China that the backlash against escalation might not be so catastrophic. From a US perspective, the Presidential election in November will mean, in my view, that we are unlikely to see any softening of US policy towards China. The Republicans will position themselves as fiercely anti-China and so the last thing the Democrats will want is to appear soft on China, thereby risking the loss of swing votes in what is likely to be another close election result. 

Investing for the New World Order 

Investors need to manage geopolitical risks, as well as their outcomes, like any other risks. As mentioned earlier, the universe of global sovereign fixed income offers the opportunity to hedge some of these risks directly. Credit default swaps (CDS) are often an appealing way of doing so, as they are effectively like buying a put option on a bond, and in many cases the cost of hedging against these risks is relatively low. It therefore can make sense for global sovereign bond investors to overlay these hedges as a way of building resilience and asymmetry of returns into their portfolios.  

In the case of the China/Taiwan risks I highlighted, China sovereign CDS are trading at around 60bps at the moment, which in our view makes it a very inexpensive way to hedge against any potential financial sanctions in the case of military escalation – the balance of probability may be that no such sanctions will prove necessary, but if they are then these CDS would deliver outsized returns. Saudi Arabia and Abu Dhabi sovereign CDS are likewise lowly valued, and provide cost-effective hedges against further escalation in the Middle East region. We also believe that, medium-term, in a multi-polar world, US Dollar-pegged currencies could come under pressure and that there are some efficient ways for investors to take short positions against the Hong Kong Dollar and the Saudi Arabian Riyal.  

These are just some of the potential levers that global sovereign fixed income investors can pull to help insulate their portfolios from geopolitical risks. I think the time is long gone for major geopolitical events to be treated as ‘black swan risks’ that an investor cannot anticipate nor position for. To the contrary, I see that in 2024 and beyond such events will only become more frequent; investors can use all the tools at their disposal to help cushion their clients from the worst effects of such volatility.

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