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Traders work on the floor of the New York Stock Exchange (NYSE) on Aug. 2 in New York City. The Dow fell over 300 points in trading following news Fitch downgraded the United States economy to AA+ from AAA late on Tuesday spooking investors and markets.Spencer Platt/Getty Images

Mark Wiseman is chair of Alberta Investment Management Corp.’s board of directors.

The world is undergoing a paradigm shift, both politically and economically. This is the first in a four-part series that examines a series of changes, including the energy transition opportunity, evolving dynamics with emerging markets, and how North America can leverage its comparative advantages to strengthen its position in global market.

There are two fundamentals at the heart of investing: risk and return. The past two years have witnessed a tectonic shift in these factors and their interplay, reshaping the bedrock upon which investment strategies are built as the world has become a more uncertain and unpredictable place, both economically and geopolitically.

First, persistent higher inflation has made it harder to achieve inflation-adjusted returns, a reality that higher interest-rates are unable to rectify quickly, fundamentally changing the outlook for the foreseeable future.

Second, international relations have had an impact on investment calculus. Tensions between the United States and China, as well as the war in Ukraine, have ricocheted throughout markets, altering the structure of the global economy.

There’s also climate change, which is redefining government policy, and generative-AI technology, which is developing so rapidly that it is changing how we should view companies and how investment decisions are made.

To begin looking at the changing risk-return dynamic, one must start with an analysis of the impact of higher interest rates and the financial institutions that have borne the brunt of these challenges. Losses for lenders insured by the U.S. Federal Deposit Insurance Corporation ballooned from $8-billion in 2021 to more than $620-billion at the end of 2022, illustrating the scale of the problem.

The highest-profile examples can all be traced to the rate environment. Forty-four per cent of the venture-backed technology and health-care IPOs were clients of Silicon Valley Bank last year. Signature Bank was a leader in real-estate lending. And many of First Republic’s investments were in real-estate loans and municipal securities.

The failures of those banks, if not predictable, were structural. Similar valuation adjustments are likely to rip through the asset landscape. It’s a simple financial math problem: Discounted cash flows determine an asset’s present value based on projections of how much money that asset will likely generate in the future. The higher the interest rate climbs, the lower the present value of those future cash flows. This is true for every asset, including equities, bonds, real estate and infrastructure.

High-growth technology stocks, where predicted cash flows are far out in the future, are highly impacted by increasing discount rates. And, of course, borrowing (including mortgages) is more expensive, with many future cash-flow assumptions insufficiently accounting for higher interest rates.

These cases illustrate just how much risk has changed. Through much of our lifetimes, liquidity tests would look at a 25-basis-point or 50-basis-point move, but the fate of U.S. regional banks and persistence of inflation dictate that banks and investors should have been examining what happens if rates go up by 100 or 200 basis points quickly, to adequately manage their risk exposure.

Moreover, recent turmoil in equity and bond markets has, for now, done away with the notion of a “traditional” portfolio composition of 60-per-cent equities and 40-per-cent fixed income. With more reliable income potential on bonds than equities, given the rapid change in interest rates, investors might wonder why they would buy equities at all and not just invest in U.S. treasury bills.

But inflation and subsequent rate rises are only one factor contributing to the uncertain investment environment. It has been driven equally by the overwhelming and concerning rise of geopolitical instability. With the war in Ukraine and rising U.S.-China tensions, the broader context and impact of global politics has become crucial for global investors to comprehend. This knowledge, once confined to a small group of experts, is becoming table stakes, evidenced by the number of investment firms and consultancies establishing dedicated geopolitical risk-evaluation units.

The consequences of these issues are broader and farther reaching than a surface-level analysis would have predicted. For instance, Russia’s attack on Ukraine halted half the world’s neon output – an essential ingredient for chip manufacturing. It is little wonder that in the week of the attack in February, 2022, the S&P 500 dropped to a nine-month low, losing more than 500 points and erasing billions in shareholder value.

Moreover, de-coupling from China has changed many global cost dynamics, demonstrating that politics matter more and more. The highly consequential politics of this relationship may continue to shake markets as Washington considers expanded oversight on outbound American investments in China.

Investors will always be required to respond to unpredictable global events, but pro-actively identifying the trend lines can produce enormous value. While investors fancy themselves as masters of both the microeconomic and macroeconomic, recent worldwide shock waves have underscored the multitude of things out of their control.

Anyone doing that work must acknowledge the friction in international relations over the past years. I’m a globalist by default and always look to diversify internationally, but in the tense geopolitical climate we presently face – defined by near-shoring and supply-chain diversification – many investors have increased emphasis on the opportunities at home.

The new strained nature of risk and return is even more complex than it was in the 2007-2009 financial crisis. It demands a fresh perspective, the courage to adapt, and the wisdom to navigate through uncertainty. Rapid financial, geopolitical and technological change is the new normal.

By cultivating resilience and adaptability, investors can respond effectively and safeguard their assets in a landscape where disruptions are not only more frequent but also carry greater impact. There are spoils that lie ahead for those who can anticipate them and turn them into opportunities.

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