A couple of weeks from now, it will be exactly 12 months since NATO was kicked out of Afghanistan; it will be also exactly six months since Putin invaded Ukraine. It is an appropriate time to take stock of what has been a momentous period for all the wrong reasons. On 20th August 2021, we wrote in that week’s Jupiter Merlin Weekly update, under the sub-heading “NATO’s own goal”:

“Russia, China and Iran will all enjoy their moment of hubris about the US and NATO’s humiliation (not least President Putin seeing the tables turned after the Russians were defeated in the 1980s by the Afghan Mujahedeen who were funded and trained by the CIA). Further, the lack of NATO members willing fully to participate in ISAF (the multi-national International Security Assistance Force in Afghanistan), even after later terrorist atrocities in Europe, will not be lost on NATO’s potential foes. The cumulative effect of Biden’s various foreign policy failures may embolden these key players to push the boundaries even further than they already are. Afghanistan might sit squarely in central Asia, but the geopolitical ripples of apprehension are likely to be felt as far afield as the Baltic States, Ukraine and Taiwan”.

We saw spreading ripples of apprehension. However, lest we might be seen to be blowing our own trumpet, we had no crystal ball foresight; alongside just about every other market commentator, we certainly did not predict a major war in the centre of Europe beginning within six months!

Afghanistan: a model policy failure and a humanitarian and social disaster
Afghanistan remains highly unstable. It sits squarely, strategically and geopolitically, at the centre of the one of the most sensitive regions on the planet. NATO scored a decisive own-goal in the manner of its withdrawal last year having completely failed to ‘do’ nation-building in the wake of nearly two decades of conflict laying waste virtually all the country’s essential infrastructure, industry and services. It doubled down on the error when 45% of the country’s GDP was removed at the stroke of a pen when NATO governments suspended all overseas aid to Afghanistan and froze its international assets.

If the aim was to isolate the Taliban, to bring it to heel, it failed miserably: in fact, all it did was to impoverish and punish the entire population. Reduced under the yoke of the Taliban to almost medieval standards of living and facing acute famine but with the Taliban itself increasingly ideologically divided between the hard-line religious radicals and a more pragmatic, ‘moderate’ wing (it is all on a relative scale), the country is reportedly a social tinderbox potentially on the verge of exploding into civil war. That a year on, and in complete contravention of Trump’s Doha Agreement, the Taliban is still provenly harbouring international terrorist groups is merely the latest indictment of a misguided, inept and ultimately failed western policy towards Afghanistan. We have discussed before the competing interests and sensibilities of Afghanistan’s neighbours: Pakistan, Iran, Russia and its satellites to the north (Uzbekistan, Turkmenistan, Tajikistan), and China. A potential civil war which creates a vacuum which might then draw any of them in or creates political tensions for them at home would be deeply unhelpful.
The simultaneous preoccupations with Russia and China have not changed
In December (3rd) in another Jupiter Merlin Weekly article, we discussed the strategic preoccupations of our defence and security services. We described how Russia was the immediate concern of the military (as related by the retiring Chief of the Defence Staff, General Sir Nick Carter), while for MI6 and the intelligence community, the overriding strategic threat was posed by China. That was not contradictory, or the left hand not knowing what the right was doing. Intelligence had already pinpointed the likelihood and imminence of a full-scale invasion of Ukraine; there was little more they could do other than hand it on to the military and say, “it’s going hot. That’s your department”. But the China threat is still developing, very much in evidence this week with Beijing’s somewhat hysterical sabre-rattling reaction to US House Speaker Nancy Pelosi’s deliberately poking the hornets’ nest with her ‘solidarity’ visit to Taiwan.
The Russian fuse has already gone from flash to bang
Thus, it is notable that today, the same priorities still apply as nine months ago. Our military is at absolutely full stretch: the Army, committed with a bolstered armoured battle group garrison in Estonia, and heavily engaged in full-scale training of thousands of Ukrainian conscripts here in the UK; the RAF’s operational elastic is bow-string taut maintaining a handful of fighter aircraft guarding the Baltic Basin while also on the logistics front ferrying arms and ammunition up to NATO’s eastern frontier for onward transportation into Ukraine as fast as the factories can produce them; the Royal Navy, with what few warships it has left and serviceable, is keeping tabs on Russian naval movements needling away in the North Sea, the North Atlantic and elsewhere. But virtually the entire British military effort is currently devoted to the European Theatre of Operations with Russia as the focus.
Trying to ensure China does not follow suit. Taiwan the touchpaper?
However, among the security services, alongside the usual terrorist threats and the increased incidence and sophistication of cyber-attacks, here in the UK the head of MI6 is warning of the growing risk of an ‘accidental nuclear war with China’. In the US, his counterpart at the CIA has conceded that it is no longer a case of if China re-takes Taiwan, it is merely how (peacefully or by force) and when. Others disagree, believing that despite China’s nominal significant supremacy in manpower, tanks, guns, missiles, aircraft and ships over Taiwan’s, China is militarily too unsophisticated to mount a successful major amphibious assault on an island nearly 100 miles offshore.

One thing is for sure, weighing up the possibilities in his strategic and tactical calculations, General Secretary Xi will be taking copious notes on Putin’s own very obvious strategic errors and tactical mistakes from the invasion of Ukraine, and making sure he does not repeat them were he to use military force against Taiwan (bearing in mind also that an amphibious operation is a much more challenging prospect than Putin’s relatively straight forward land attack). He will also be weighing up the potential western response having seen the reaction of NATO towards Russia and noting the publicly hopelessly confused and contradictory messages emanating from the White House and the Pentagon about US obligations (or not, as the case may be) to Taiwan.

Taiwan is a potential military flashpoint but is only one element of the wider strategic threat posed by China through its neo-colonialist ambitions encompassed in the One Belt One Road project and the maritime ‘String of Pearls’ development, and its active and very current militarisation of the South China Sea through its creeping appropriation of the Spratley Islands.

Still stung by the hullabaloo of ‘sexed-up’ intelligence, dodgy dossiers, and the accusations of being partial with the facts ahead of the Second Gulf War and toppling Saddam, all levelled against the intelligence community, the security services are now highly sensitive to further charges of crying wolf or making unsubstantiated claims. As it was, they were spot on about Russia and Ukraine. So it is interesting that in only a handful of years, augmented by the political rhetoric from Beijing a year ago on the centenary of the CCP’s founding when Xi was unequivocal about his intention to restore Taiwan to mother China, the western narrative on Taiwan has shifted markedly from one of virtually dismissing the possibility of annexation, to speculating if China might take it back again, now to one of it WILL happen and it is just a question of how China does it and when it thinks it can get away with it. Oh, and we might have a nuclear war.
Does it matter to investors? It certainly should!
The world is demonstrably a less safe place than it was. Indeed, at the risk of pointing out the very obvious (but it seems it needs repeating), aside from the exogenous shock provided by the pandemic, the reason we are in our current mess is entirely thanks to the fault lines of the geopolitical tectonic plates shifting, the gaps widening and causing significant tremors. The resulting seismic reactions, whose epicentre currently is the Ukrainian conflict (and with it the western sanctions regimes and Putin’s countermeasures) are manifest in soaring global inflation rates, central bank policymakers capitulating, economies beginning to de-rail, and governments being destabilised and toppled.

Russia alone is causing enough grief. But a conflict with China would be of a different order of magnitude in its economic effect. Russia ranks as the 11th biggest economy globally but at $1.9 trillion of GDP it is only a tenth the size of China. Russia is obviously important in a global context thanks to its wealth of natural resources and its significant commodity exports. But beyond that, it is a trading minnow. China, on the other hand, at 18% of global GDP, is embedded in the very foundations of global manufacturing, woven into the fabric of the world’s supply chains. In the event of 100% mutual sanctions being imposed, for us in the UK for example, based on the Department for International Trade’s 2021 direct trade data, the impact to the UK economy would be £17.5bn attached to Russian trade (we export £4.6bn and import £12.5bn), but £82.4bn in respect of China (we export goods worth £18.8bn to China, importing £63.6bn from it). This ignores any collateral disruption and its associated significant frictional costs.
The yield ‘curve’ is missing in action. ‘TBD’
We have argued in these columns before that the natural place in which long-term investment risk should be reflected is in the yield curve of bonds; logically, the longer time period over which one is prepared to invest (by, for example, buying a 30-Year bond rather than a 5-Year bond) the less certain the outlook will be for that period and therefore the greater yield an investor might ordinarily demand to compensate for that risk.

But where is the heightened geopolitical risk being reflected in bond yield curves today, let alone any other long-term risks, including the next industrial revolution as the world migrates (probably far from seamlessly) towards a carbon net-zero society by 2050?

The answer is that the risk is apparently not reflected at all. Look at the yield curve for US government bonds: for a bond with one year until maturity the yield is around 3.10%, two years until maturity it is around 3.06%; five years 2.80%; ten years 2.70%; and thirty years 2.98%. You’ll note that those numbers don’t change much, and in fact even trend lower over time – this is known as an ‘inverted’ yield curve.

The near-term yield is entirely dominated by the markets’ perceptions of Federal Reserve interest rate policy, as it attempts to contain inflation, and the increasing likelihood of it wrecking the economy in the process. But if one travels further forward in time, looking at bonds with more time until their maturity date, the market is current ascribing virtually zero additional investment risk from the future’s inherent uncertainty. Indeed, the inversion of the yield curve implies that the market sees today’s economic risks as being far greater than tomorrow’s broader geopolitical ones, or next year’s, or any year’s all the way out to 2032. Even by 2052 the amount of perceived risk is negligibly different to 2027’s, let alone today’s.

This is important because the US 10-Year government bond yield is the world’s accepted proxy for a ‘risk-free’ rate of return for capital projects with a duration of a decade. Such is investors’ seeming confidence that all the market demands today for a ‘risk-free’ investment over a decade period is a paltry 2.7%. Yet 12 months ago, investors, treasury ministers and central bank policy makers were unable to predict that in less than a year, thanks to Covid and Putin, inflation would be running away at 4/5 times the central bank mandated targets and, far from enjoying the growth boost of the post-pandemic ‘re-opening trade’, the wheels would be falling off the economy.

Inevitably the situation is more complex than this. The trajectory of bond yields is capable of being heavily influenced by central banks, as we have clearly seen since the global financial crisis. We say ‘influenced’ rather than explicitly manipulated: while manipulating the curve to target a specific yield is the official policy of the Bank of Japan, such strategies are forbidden for the US Federal Reserve and the European Central Bank. The brutal volatility seen in recent months in US, eurozone and UK government bond yields demonstrates that most bond markets are beyond the direct control of their central banks. Of course, other agencies exert their own pressures too, for example in the UK the Pensions Regulator dictating what minimum percentage of pension funds’ assets must be held in bonds to match their liabilities.

But, technicalities aside, viewing it at the high level, there are only two logical conclusions: that in ascribing no discernible term risk premium, investors either see no greater risk in the future, or, more likely they have filed it away for another day, labelled TBD, ‘To Be Decided’. Or is it more prosaically and more accurately ‘Too Bleeding Difficult’?

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.

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