Back to school: the market and geopolitical outlook ahead of the US midterms and beyond

Good afternoon, and welcome to this Quintet Private Bank webcast about the outlook for the market and geopolitics ahead of the US midterm elections and beyond.

My name is Nick Nesson. I'm head of corporate communications at Quintet.
It's my pleasure to introduce my colleague, Daniele Antonucci, who is our head of investment and chief strategist.

I'm likewise delighted to introduce our special guest, John Emerson. John is vice chair of Capital Group and a former US ambassador to Germany.

Over the next 30 minutes, Daniele and John will share their perspective on the key themes shaping markets today, including the geopolitical developments worth monitoring and the macroeconomic trends likely to influence portfolios in the weeks and months ahead. As a reminder, you can share your questions anytime during this webinar by submitting them in the chat box you see on your screen. We'll address as many as we can when we come to Q&A.

Daniele, let's start. To set the scene, what are the most important economic and market themes shaping your outlook today? If you had to distill it down to three, what would those key drivers be?

Okay, sure. Thank you, Nick. Good afternoon, everyone. Delighted to have John Emerson with us today.

So just to set the scene, if I had to think about three key drivers, I think as the first one, I'll pick inflation and interest rates. You might recall at the start of the year, things were very, very different. Oil prices were maybe $70 per barrel or so. Inflation from above central banks targets was coming down not as fast as central banks wanted. Slowly but surely, though, it was starting to moderate, and a lot of investors expected the next central bank move, the next interest rate change, to be a rate cut.

Things couldn't be any different now. Inflation is on an upward trend. Oil prices, they've touched peaks of $120 per barrel over the past few months. There's some concerns around the level of government debts in the United States, in several developed market economies. So inflation and interest rates are a key driver of the outlook this week. Market participants assign quite a big probability to the Federal Reserve to raise interest rates and to the Bank of Japan as well. The European Central Bank has already raised rates a couple of times, and we think the Bank of England, maybe after the budget, also will increase interest rates.

So that's the first driver. Inflation dynamics. Inflation is trending higher. Interest rates are trending higher as well.

The second one is more structural, and it's that we now live in a much more multipolar world. So the world used to be a lot more globalized, a lot more US-centric. As an economist, my main day was a Wednesday night every month to figure out what the Fed was up to. So you don't have to, but now we have many more cross-currents. Geopolitics really is a driver. We'll hear it from John. And you have seen it in many different ways, from the US tariffs to pretty much the rest of the world, the conflict in the Middle East with Iran. Now Canada is in the spotlight. The European Union or the UK have been before that. So that's a much more enduring, long-lasting driver, and I think it's all coming down to a quest for strategic autonomy. When it comes to defense, also when it comes to energy resources, infrastructure. That's the second driver.

And then number three, we could not not talk about AI, and that plays out in very different ways. In the near term, we have seen analyst expectations for earnings beat week in, week out during the reporting season. Each year recorded reporting has seen actually earnings coming on top of expectations, exceeding these expectations, and so that is an important theme there. We'll discontinue our valuation, really reflecting quite a bit of that. But also longer term, we think a lot about how the benefits of AI and also the risks will spread across industries. We think about the enablers, the tech companies that enable all that to the beneficiaries, and we can find them across very many different industries.

So I would say to sum it up, inflation interest rates is a driver, geopolitics, a much more multipolar world is a driver as well, and AI.

John, thank you again for being with us. Can we pick up maybe the second point, the second driver that Daniele highlighted, which is a more multipolar world, a new world order. Where do you see the global order heading, and what does that suggest for investors? I know it's a big question, but-
Well, first of all, thanks so much, Nick, for having, and Daniele as well, for having me here today. Daniele is absolutely right. We are no longer in a superpower-dominated world, as odd as that may feel. We are in a much more fragmented, multipolar world where power is more diffused and risks are harder to predict. And I think we've seen-- And by the way, the Iran war has demonstrated a number of aspects of this. So we've seen, I think, three basic trends in terms of where things are heading that have investment implications.
The first trend is we are now in an era of economic competition rather than an era of economic cooperation. We're no longer trying to negotiate big free trade deals. We no longer see just an expansive distribution of supply chains globally as countries and companies are starting to pull them more inward. We're in a competitive era where tariffs and sanctions and export controls seem to be dominating.

Second aspect of this is the importance of energy independence and diversification and sort of a national security independence. One piece of this is that I mentioned is demonstrated by the Iran war, is if you are a factory owner in Asia and you had to close down your factory because you didn't get the oil you needed because the Strait of Hormuz was closed, or if you are a government leader in Europe and all of a sudden the liquified natural gas that you were depending upon Qatar to deliver to you cannot come out because of what's happening in the Strait of Hormuz, that has massive implications. And the idea that smaller states or even rogue states like the Houthis can have this sort of inordinate control over economic choke points that could throttle the global economy is something new that we're seeing literally play out on the front pages of the papers every day these days because of the war in Iran.
So this second dynamic of quest for energy independence and diversification allows for that, and for sort of national security independence, because you can't necessarily trust that the United States, for instance, will be there to protect you in the future. It has two consequences. One is a massive infrastructure spend that we're beginning to see, particularly in the energy space, just in the Gulf States, construction of pipelines. So they're less dependent on either the Strait of Hormuz or Bab el-Mandeb in terms of exporting their products. But we're seeing construction and infrastructure in terms of energy grids, in terms of solar. I would predict in terms of nuclear as well.

And then on the defense side, we're seeing a massive defense spend. I think this is getting pretty close to being structural. It's not just what Europe is doing. We're seeing the Gulf States now spending more to protect themselves. We're seeing this in China. We're seeing this in South Korea. And in the United States, Trump is proposing a $1.5 trillion annual spend for our defense. So that I think also is a part and consequence of this more greater fragmentation.
And then the third trend that we're seeing is a restructuring of alliances, and either economic alliances or national security alliances. And Mark Carney talked about this in his speech at Davos, where he talked about the middle powers coming together and maybe building trade relationships ex the United States. And we're seeing this in terms of conversations. Just this week, you've got Canada joining with the EU in terms of some of its major discussions about economic growth and trade. We see it with Europe pursuing the Mercosur agreement. We see it with different countries pursuing perhaps deeper relations with China. And in particular, deeper and more extensive relationships with one another.

And then on the national security front, there's probably no better example of this than last week's announcement that the Saudis, the Pakistanis, and Turkey are joining together in what sounds a little bit like a NATO type of relationship. An attack on one of us is an attack on all of us, and we would be obligated to respond.

So in any event, I think that's the three dynamics that this fragmented world are leading to, are the economic competition rather than cooperation, the search for energy, and national security independence, and then a reshifting of alliances, which actually might be quite positive from the standpoint of economic growth and development. With countries maybe not being so dependent on what's happening with the United States, and a shifting in national security alliances.

Daniele, I want to ask you briefly about the bond market and the dollar, because I think a lot of the people on this call are interested in that. But first, can you, a very brief reply to John's point about, you made the same point, about the reordering of the world and the restructuring of alliances that were once global, that become more regional, the need for greater autonomy. From an investment perspective, from a portfolio construction perspective, how do you integrate that kind of stuff, those changes in the world?

Yes, that's a very important perspective, and when I look at this from the perspective of an investor, it's really, really different. So what we used to was a world where there was one driver, the US, the economic cycle, the market cycle, was pretty much aligned everywhere you looked. But now you have many more crosscurrents. You have the middle power, you have emerging markets as well. Asset classes move in a very different way.

So we think a lot more about diversification, spread your investments, perhaps is another way of saying that, rather than concentrating investment just in one place. So that's one. And also, at the other side of the spectrum, there's many more asset classes to think about beyond equities and bonds. So we now look at commodities, we now look at strategies that can mitigate downside risks in portfolios, and many other asset classes that make the toolbox a lot richer to look at.

Now, when it comes to your questions, currencies and interest rates are also part of the toolbox. And here I want to highlight another structural change. So when you look at this from a market perspective, the paradox is that for the decade prior to the pandemic, when inflation, with the reopening, started to rise and interest rates followed. For the decade prior to the pandemic, investors were perfectly happy to buy government bonds at near zero interest rates, actually incurring a loss in nominal terms, or certainly in real terms, adjusted for inflation.

And now that interest rates, the bond yields are higher. They look more normal from a longer term perspective. A lot of commentators are quite cautious. And I think things are changing. You can lock in with government bonds now quite a good rate of return for low risks. And government bonds with this level of yields now can have the role that they were always designed for in portfolios. When rates are zero, how much lower can you go? How much negative can you go with bond yields? And now bond yields are higher, and so in a downside scenario, there's a lot of room for bond prices to rise and bond yields to fall.
So actually, we're starting to act. We don't want to do that in one go. We still maintain a reduced allocation to US Treasuries compared to our strategic long-term weights. That reflects some caution on the debt dynamics, on the high level of government debt. In Europe, where government debt, you take Germany, government debt is half the size of the US, relative to their respective share of their economies. We have an overweight position in government bonds. But there too, we prefer short-dated government bonds, because this way you're less exposed to interest rate changes.

But when interest rates have risen quite a bit, and they already reflect a lot of the risks, and you're well compensated, that could be the case for UK yields. We also buy both medium term, longer term maturities in this case. So when I look at government bonds, I think things are normalizing now. There's probably somewhat more to go. Bond yields could rise a bit further. They reflect the new debt dynamics that might reflect inflation as well, but also the stronger growth that we see in the United States. And even though we are still underweight US Treasuries, and we see good income prospects from high quality government bonds that we have started to add.

With the dollar, it's trickier, I think, and we have seen two different dynamics. First of all, longer term, my sense is that this process of de-dollarization, meaning emerging market investors, private investors, or central banks, trying to disengage from dollar-denominated assets. Again, it's this more multipolar world and these investors have seen the sanctions, for example. So they disengage from that and trying to buy other assets such as gold. And gold is a useful diversifier in portfolios. So we have that.

But we're also seeing dynamics in the near term. We have seen that when we have spikes of market volatility, when investors are worried, the thing they want is cash, and the cash they want is dollars. So that too is a useful diversifier. There our strategy is not to trade the currency per se, but to strip out, to hedge some of the currency exposure because we are European investors, we are UK investors, and so should the dollar weaken at longer horizons, when you translate that into euro-denominated gains or sterling-denominated gains, you would tend to lose. So we insure our portfolios against some of these currency movements.

Thank you, Daniele. Thank you, everybody who is sharing questions in the chat. We have a lot of them. Let me turn to one for you, John. Somebody asked very simply, what do you expect from the US midterm elections? So maybe you can tell us what will happen, as I'm sure you know as well as anybody, and then Daniele can perhaps unpack that a little bit from an investment perspective.
That sounds good. Well, I can certainly tell you what I think will happen. May or may not be right, but first of all, as you all know, historically, when you have one party in the United States that controls both ends of Pennsylvania Avenue, the White House, and both houses of Congress, that party almost invariably gets whacked during the ensuing midterms.

And secondly, a midterm election tends to be not so much a choice election as a referendum on the party in power and, in particular, on the president in power. And given Donald Trump's approval rating somewhere in the mid-30s, and given frustrations that we're seeing both from the populist right and the populist left about the cost of living in the United States, and cost of gas prices and all that, which has been exacerbated by the war in Iran. Most of the commentators are saying, well, this is poised for a big Democratic sweep.

My view is the election will be a lot closer than that, maybe not in terms of total votes cast, but in the sense of whether the Democrats take over the House or take over the Senate. And by the way, the reason for that is a simple math problem. In the House of Representatives, there are 435 seats, and because historically there's been so much gerrymandering or redrawing of the districts to make particular district constituencies, whatever you want to call them, that are represented by members of Congress, safe Democratic seats or safe Republican seats. There's only about 10% of the total totality of congressional seats that are truly flippable in one election to another, particularly in this election.

And then, of those seats, a number of them are already held by Democrats, so that narrows the amount of flippable seats the Democrats can win to take over control of the House to an even smaller number. So at the end of the day, I would predict that because of these broader dynamics, the Democrats do take over the House, but it's really by a high single digit or a low single-digit number. They'll control it, but by eight votes or nine votes. It's not going to be a massive shift in power as we've seen in some past elections.

And on the Senate, the Democrats need to flip four seats. In order to do that, they would probably need to flip three or four in states that have historically been red states. They may get a couple, but my guess is the Democrats pick up net two in that Senate, but do not ultimately take over the Senate.

And the question is, what difference does any of this make? And the answer is not a lot. And the reason is, neither party is actually campaigning on the basis of a massive legislative agenda. Even if the Democrats were, we all know Trump's president, and he would veto anything that they put through, even if they did have control of both the House and the Senate.

Secondly, on the Republican side, while for sure Trump does not want to lose either seat of Congress, he's not campaigning on it with a legislative agenda anyway, and they're not campaigning with a legislative agenda. And so some of you may remember way back when Newt Gingrich ran in the '90s, he talked about this contract with America that was very specific in terms of what they wanted to accomplish. We don't have that at this point.

The Republican campaign against the Democrats is what it has traditionally been. It'll be heavy on the culture wars and basically trying to say the party is way too woke and way too left for mainstream America. It's not going to be a proactive, “Vote for us, and you will get this,” kind of campaign.

And typically, a president in the last two years of their term will basically govern by executive order, spend a lot of time on foreign policy, the kinds of things we've seen Trump move into this year in any event. So I would expect that to continue.

The main difference if the Democrats did take control of the House would be they would have oversight, authority, and responsibility as it relates to actions taken by the executive. So you'll have more hearings, you'll have more visibility, more transparency, perhaps, in terms of what the Trump administration is doing. Maybe that'll slow down some of what they're doing. So you'll see that.

And then secondly, on things that the president really does need to get through Congress, like next year, a big one is raising the debt ceiling so we can deal with this massively increasing deficit that we have. Another one, of course, is the annual budget. He's going to have to negotiate with the Democrats, and I think it was telling that a week or so ago, Jared Kushner, clearly representing the president, met with Hakeem Jeffries, who would be likely to be the Speaker of the House if the Democrats were to win.

Not clear what was discussed or what have you, but it was interesting. It certainly suggests a recognition that there would be some things that they could work on. And in terms of any bipartisan legislation, the only thing I could see possibility of something happening is in the area of regulatory reform one way or another of AI.

And that's because the whole question of data centers, the question of job loss, and more recently the question of sort of the existential questions that have been raised by Anthropic and others have really captured the public's imagination. If you're a politician running from the far left or the far right, I guarantee you're hearing this from your constituents. And so there may be an area there where you see some push for bipartisan legislation.

But other than that, I don't see a dramatic shift. But I think in general, it's important to understand Trump's political power in the United States will begin to diminish as he is a lame duck and as even Republicans who have been so eager to please him, even if maybe it was not in their political interest or even their ideological interest. Maybe we'll be thinking about that a little less as they're beginning to focus on what's the world going to look like in a post-Trump era.

Thank you, John. Daniele, if you want to react, and if you could, because there's some questions about it. John touched there upon the potential cooperation among Democrats and Republicans to regulate AI. We saw some wobbles in tech stocks today. There's some questions about what do you see happening with technology stocks generally amid such concerns, AI stocks in particular, AI firms in particular, and what does this suggest about the medium-term outlook for markets more broadly?

Yes. Okay. Sure. First of all, and to follow on from John, I invite the participants to this webcast, do a little bit of a thought experiment to try to imagine you're sitting at the start of the year and think about a memorable event of the past month. Lots of people will come up with most or any of these geopolitical events that we talk about. And if you try to think with the knowledge, did you believe that the markets behaved in the way it did, meaning rising? Most would say no, these are negative events, geopolitics, some of the risks that come from high debt, and also some of the AI risks.

So to me, the first lesson is that the market has been climbing really a wall of worries and has done that more successfully than many thought. So, but when it comes to the midterms, I think the main point is spread your investments. We talked about it before, and we like some of the technology themes. Yes, we think they will be transformative.

Actually, I don't think that valuations per se are necessarily so demanding because the larger capitalization companies in the US so far, and we think this will continue, have been able to show strong earnings unlike the rest of the market, if you like. But diversification means that our portfolio strategy looks at US large capitalization stocks, which means an exposure to AI, just like emerging markets, because they have different drivers, demographic growth.

The UK, for example, because it's more defensive in nature, longer term, also Europe, or where we have a more neutral exposure for now, but longer term, a higher share of European equity allocation compared to their importance in global markets. And we combine that with government bonds, inflation-adjusted bonds, or gold that can mitigate, hedge some of these geopolitical risks.

So that's how we approach AI. And in time, we talk less and less about AI per se, but more about this is feeding through, and you will find that across all sectors. We think this will be transformative, but also in the more traditional sectors, the firm that will advance are those that are able to lock in a competitive edge through this use of our technology.

Thank you, Daniele. Two minutes left. Maybe the two of you can discuss together very briefly. First, John, as a former ambassador to Germany, we saw the recent regional election result of the AfD winning, of course, in Germany. How do you see the future of Europe politically? Is this a one-off event? Is this a harbinger of what's to come? So in a minute, what is the future of Europe hold? And Daniele, from an investment perspective, what does that mean about investing in Europe? John first.

Well, I would just say that, obviously you had AfD win a very small state election. I'm always shocked to read how many people who follow Germany are shocked by this. I could've told you that was going to happen two years ago.

But look, what's happening is you've got, just as we've seen populist movements from the right and the left in the United States, we're beginning to see the same thing in Europe as people are getting frustrated as a consequence of lack of economic growth, concerns about job futures, job prospects, et cetera, and a sense that the establishment centrists in government haven't been delivering for them.

They're getting, to quote the movie “Network,” mad as hell and they're not going to take it anymore. And so you're beginning to see this. So I think on the other hand, people worry, does that lead to a sort of more authoritarian response in Europe? But look what happened with Orbán. After 12 years of that, they threw him out. So I'm still pretty bullish on Europe.

After Brexit, everybody thought there'd be a Nexit, a Grexit, a Frexit, an Italyve. None of that happened. I think the combination of Donald Trump and Vladimir Putin has really brought Europe together again, and that you will weather this just fine.

Well, that's very good to hear. Daniele, thank you, John. Daniele, last word. Within Europe, as a European looking at Europe, are you equally bullish?

I think Europe has a pretty big opportunity, and this opportunity, paradoxically, is coming from outside, US policy with Trump. The opportunity there, and I think Europe over time will be able to deliver on that, is to boost strategic capabilities and strategic autonomy. We talked about energy, resources, infrastructure, defense. This is the opportunity that Europe has, coming together. And from an investment opportunity point of view, these are the themes that we like when we think about European assets.