Background
Over the last year and three months, it’s been difficult to break attention from the global centerpiece of foreign affairs that is Russia’s invasion of Ukraine. Against this backdrop, we’ve seen a number of other “black swan” like events playing out on the periphery of the geopolitical stage competing, for societal bandwidth (China brokered Saudi-Iran peace deal, de-dollarization paranoia, the banking crisis in the West, Chinese spying balloon saga, Russian downing of a U.S. drone in international airspace, etc.). For the uninitiated, a black swan is a term coined by mathematical statistician, former options trader, and risk analyst Nassim Taleb and is defined as “an event that comes as a surprise, has a major effect, and is often inappropriately rationalized after the fact with the benefit of hindsight”, think a nuclear bomb exploding in New York or a sudden and complete loss of all satellites globally (Taleb himself has ruled out the COVID 19 pandemic as a black swan). Now, considering the list above, clearly, not all of these events are what we would consider true black swans, but rather what we coin as “black cygnets,” or to us non-biologists, young/small swans.
We think of these black cygnet events as having many of the same characteristics as their adult counterparts; however, they are not entirely surprising or unpredictable and have smaller yet meaningfully impactful effects – such as the Chinese spy balloon saga, Norfolk Southern Ohio train derailment, destruction of the Nordstream pipelines, or Pakistani flood of 2022. To solidify the concept, let’s draw out an example – the Chinese spy balloon saga earlier this year. We can reasonably assume that other countries (particularly China) spy on the U.S. The act of clandestine spying is not a surprise or unpredictable; what was a surprise was 1. the brazen use of a blunt tool like a 200 ft balloon to do the spying, and 2. Seeming reliance on uncontrollable wind patterns. And the effect of the event? We all know what . Needless to say, it had a meaningful effect, still impacting relations today. So, setting the context for black cygnets – not an entirely surprising or unpredictable events (clandestine spying happens, just not typically how it happened via a huge low altitude spy balloon) that have meaningful effects (Secretary of State calls off Beijing visit, U.S./Canada go on a flurry shooting down ‘UFO’s across North America, and U.S.-China relations crater to new lows on the tail of the relationship high from the Biden-Xi meeting on the sidelines of the G20 meeting in Indonesia).
Importantly, Taleb’s black swans and our own black cygnets are not meant to provide “”, but rather are “negative events capable of creating a rolling, widening collapse —a true black swan—in the same way that the failure of a single transformer can collapse an electricity grid.” In the case of black cygnets, however, instead of a transformer leading to the collapse of the grid, think a broken capacitor bank – failure of a capacitor bank might affect power quality locally but would not collapse the entire grid. Consequently, we put forward that the devolution of the geopolitical landscape to a multipolar environment is conducive to a more globally volatile world where fat-tail risks (ie. black cygnets/swans) are increasingly likely. Better said, “the unpredictable is increasingly probable”. As a result, we believe the increasing pace of both geopolitical volatility and volumes of black cygnets demands a re-thinking of investment risk in modern equity portfolio construction.
Analysis
Multipolarity & Multilateralism
One of the best and quickest overviews of how we’ve arrived at our current state of geopolitical multipolarity is summed by Andreas Kluth from the Washington Post,
“The dissolution of the Soviet Union in 1991 appeared to end bipolarity and introduce a new unipolar era — or “moment,” depending on your view at the time of its durability. The US, as the sole remaining superpower, would in effect act as global cop. Another fancy term for that role is “hegemon.” Depending on where in the world you sat, that was great news, or the worst.
It was ephemeral, in any case. For at least the past decade, diplomats and scholars have felt sure that we’ve moved on into a new era. Josep Borrell, the EU’s foreign-policy supremo, calls it “complex multipolarity.” That system’s main actors, he thinks, are the US, China and the EU — well, he does work in Brussels — with other middling powers making cameos, including Russia, Turkey and India. Far from happy about this arrangement, Borrell worries that such multipolarity actually makes rules-based multilateralism harder”
The core of what we’re examining is essentially wrapped up in the last bit – multipolarity actually makes rules-based multilateralism harder. What this means in plain English is that when the big kids all hold the relatively same size stick and have different visions of how to run the playground (multipolarity), it’s harder to get the little kids all on the same page (multilateralism). What you have as a result is the general tumult we feel and see in headlines on a regular basis, what Foreign Affairs coins “The West, the Rest, and the New Global Disorder.”
A key example of this dynamic was played out at the G-7 summit in Hiroshima. Non-members Brazil, India, and Indonesia were invited to the summit as a way for Zelenksyy and the group to appeal to leaders from emerging economies that have taken a neutral — and at times ambivalent — stance on the war. Brazil, India, and Indonesia are all United Nations member state; a military invasion should be table stakes for, at the very least, verbal support for Ukraine. Instead, what we got a Brazilian official saying the (There are also other dynamics, motivators, and histories at play for both and as to why they’ve taken such a lackluster stance on the war, but multipolarity is the largest influence). This is only one example of many that multipolarity makes difficult to resolve via multilateralism but paints the picture as clear as day.
The flip side of the coin is the U.S. brokered Israel-Jordan peace deal in 1994, at the height of the U.S.’s unipolar ‘moment’. President Clinton brought together Israel and Jordan, who at the time had been in a state of war for 46 years, to sign the Wadi Araba Treaty ending hostilities, establishing diplomatic relations, settling territorial disputes, and addressing issues such as water rights, security cooperation, and mutual recognition.
A monumental moment punctuated in stark comparison to today’s Russian war against Ukraine and other historic moments catalyzed by authoritarian poles of power (below).
Bringing us back to the start – multipolarity actually makes rules-based multilateralism harder. Underline rules-based, the varying poles that comprise today’s multipolar environment are between democracies and authoritarians. The former favors order and multilateralism through global legal institutions to resolve disputes and respect basic human rights, while the latter favors order and multilateralism through dictates, acting above the law, and doesn’t recognize basic human rights.
So, multipolarity is the ‘state of the state’ in today’s geopolitical environment, what does that mean? In essence, it means the U.S. no longer holds asymmetric relationships with key players ( China), or using our previous analogy, we no longer have the biggest stick – in this case the stick represents diplomatic, economic, or military status. Without getting too into the weeds, there are a vast many reasons why we no longer hold asymmetry in key relationships (almost every Chinese weapons system has been created from stolen American technology, which former US Keith Alexander branded bitterly as “the greatest transfer of wealth in history”) – but the fact is our positions across diplomatic, economic, and military fields have been degraded.
Highlighting what an asymmetric relationship looks like, Max Hastings lays out a question: “I am also bothered…by the dilemmas posed by drone assassinations in far-flung places. Sure, most of those whom the CIA-directed drone crews kill are enemies of freedom, murderous fanatics. But what happens when our enemies start playing this game with our people, perhaps our prime ministers and presidents?” Hastings’ heavily implied scenario is in reference to the U.S. drone strike that killed Iran’s Major General Qasem Soleimani near Baghdad International Airport in 2020. Soleimani was Iran’s head of the Quds Force, a division of the Islamic Revolutionary Guard Corps primarily responsible for extraterritorial military and clandestine operations, and would essentially be equivalent to the director of the CIA. If the roles were reversed, this would draw a declaration of war from the U.S., but instead the Iranian reaction was . This is important, why did the Iranians act this way, as Hasting’s questions, “why don’t they start playing this game with our presidents?” They don’t because the U.S.-Iranian relationship is one of asymmetry. Feelings about public extraterritorial assassinations aside, the fact is Iran cannot react in a tit for tat fashion or reciprocally because it would mean taking too much pain in one of the three buckets from which the U.S. dominates the relationship: economically, militarily, and diplomatically, the U.S. holds a royal flush (or pretty close to it).
Tying our concepts together, loss of asymmetry begets multipolarity, which in turn makes rules based multilateralism harder, greatly increasing geopolitical volatility and, in tandem, expands the proverbial surface area in which the probability of black cygnets can occur.
Black Cygnets & Re-Thinking Investment Risk
Many calories burned later, we now understand the current state of our changed geopolitical landscape. Fantastic. So if the surface area in which black cygnets can occur is increasing and , how do we invest into these events, and also, why invest into these events rather than constructing a portfolio to attempt to mitigate their impacts?
Starting with the why. To level set, as a proponent of investing into black cygnets/geopolitical events, what we’re essentially describing is thematic and to a lesser extent, value investing. Without delving too deep, these are investing strategies that sit alongside names readers are undoubtedly familiar with – Growth, Index, Income, Momentum investing, etc. Here’s a quick sheet. Thematic investing is a strategy that focuses on identifying and investing in specific trends or themes predicted to shape the future. These trends typically span across industries and sectors and could include technological advancements, demographic shifts, environmental changes, emerging markets, political shifts, and changes in consumer behavior. We believe that geopolitical volatility/black cygnets not only trump all other trends but also heavily impact them, like the ones mentioned above (technological advancements, demographic shifts, environmental changes, emerging markets, political shifts etc. & many more)
Because geopolitical volatility and black cygnets play such a large role in macro trends shaping the future, they also outweigh all other risk factors both in importance and cross-sector impact, putting the greatest amount of alpha from investments at risk/generating the greatest amount of opportunity (with the obvious exception of financial risk, you need to be able to generate cash to run a business). As such, this inherently calls for a re-thinking of the risk environment facing all businesses in all sectors (below).
Next, the how. For both retail and institutional investors, portfolio construction that effectively and pragmatically parses through the noise and captures geopolitically driven opportunity requires that investors understand two concepts – systematic and idiosyncratic risk. There is also a separate conversation to be had around regime switching asset allocation models, however, this is largely an institutional consideration that retail can get by on without, so for our purposes, we’ll leave it out – but the basics are attached here.
Systematic vs idiosyncratic are fancy ways of saying undiversifiable/diversifiable risk. Systematic risk cannot be eliminated by holding a diverse range of assets and affects all securities in the market, driven by macroeconomic factors or systematic financial factors. Sound familiar? Systematic risk is what we describe in the why – geopolitical volatility. Idiosyncratic risk is unique to a particular company or industry and can be reduced through diversification.
Understanding the difference here is important, as in our reasoning, systematic risk needs to be weighted more heavily than idiosyncratic. Multipolar driven geopolitical volatility/black cygnets heavily affect the largest trends impacting investable companies today. Choosing the correct trend/theme under which listed equities will be negatively or positively impacted needs to be of higher importance in portfolio construction and investment decision making than idiosyncratic or company level risk. Due diligence at the company level will always play a role. However, research here will provide only marginal alpha. We posit that as long investors correctly position themselves in the favored or disfavored trend to be impacted by geopolitical risk, then you only need a handful of quality companies without the need for overdiversification in each sector.
Sources:
[1] https://www.nytimes.com/article/ufo-spy-balloons-china.html
[2] https://www.reuters.com/world/china-expresses-regret-that-civilian-airship-strays-over-us-2023-02-03/
[3] https://www.newyorker.com/news/daily-comment/the-pandemic-isnt-a-black-swan-but-a-portent-of-a-more-fragile-global-system
[4] https://www.washingtonpost.com/business/the-geopolitical-multiverse-is-backto-two-superpowers/2023/02/22/ad55a9a0-b270-11ed-94a0-512954d75716_story.html
[5] https://www.foreignaffairs.com/issues/2023/102/3
[6] https://www.bloomberg.com/news/articles/2023-05-21/g-7-struggles-to-win-over-swing-nations-courted-by-china-russia
[7] https://acrosstatlantic.com/brazilian-election-impact-on-foreign-affairs/
[8] https://acrosstatlantic.com/india-geo-strategic-partner-or-indifferent-beneficiary/
[9] https://www.foreignaffairs.com/china/what-it-will-take-deter-china-taiwan-strait
[10] https://www.reuters.com/article/cyber-summit-alexander/reuters-summit-top-general-says-u-s-under-constant-cyber-attack-threat-idUKL2N0DV3XG20130515
[11] https://www.bloomberg.com/opinion/articles/2023-04-30/cia-and-nsa-spies-are-losing-their-edge-to-china-and-russia
[12] https://www.npr.org/2021/01/01/952716680/a-look-back-at-what-happened-after-the-killing-of-iranian-gen-qassem-soleimani
[13] https://www.wallstreetmojo.com/investment-strategies/
[14] https://www.google.com/search?q=How+does+a+regime+switching+model+work&rlz=1C1RXQR_enUS987US987&sxsrf=APwXEdenwjic3zU1bDNYQL0c1mD2X1leMw%3A1687124354402&ei=gnmPZLiQGP66qtsPp727wA0&ved=0ahUKEwi42df-483_AhV-nWoFHafeDtgQ4dUDCBE&uact=5&oq=How+does+a+regime+switching+model+work&gs_lcp=Cgxnd3Mtd2l6LXNlcnAQAzIFCCEQoAEyBQghEKABMgUIIRCrAjIFCCEQqwIyBQghEKsCOgoIABBHENYEELADOgoIABCKBRCwAxBDOgcIIxCwAhAnOgcIABANEIAEOgYIABAHEB46CAgAEAgQBxAeOgoIIRCgARDDBBAKOggIIRCgARDDBDoGCAAQFhAeOggIABCKBRCGA0oECEEYAFC2CliVI2C-JWgBcAF4AIABfogB5gqSAQQxNC4ymAEAoAEBwAEByAEK&sclient=gws-wiz-serp#fpstate=ive&vld=cid:b8a07a63,vid:K9rBFb4xC54
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