The geopolitical ripple effect

The following is an extract from our latest CIO outlook.

Geopolitics has always shaped the course of human history. As Sonja explains, today’s geopolitical landscape looks increasingly fractured, with ideological rifts giving rise to a multipolar world.

As investors concerned with themes that have the potential to change the world in previously unimaginable ways, we are cognisant of the impact of geopolitics on the three broad areas we see driving transformative change: technology, demographics, and energy and resources.

An example we’ve covered previously on these pages is the increased focus on cybersecurity in the wake of Russia’s invasion of Ukraine. As well as the looming threat of full-blown cyberwar, state-sponsored cyberattacks may increase the danger posed by nonstate actors by creating an environment in which identifying cyber-attackers is harder than ever.

The river in the desert

Elsewhere, geopolitics is lending fresh urgency to challenges that have been created by long-term changes in the climate and demographics.

Although water covers approximately 70% of planet Earth, only around 3% of that is fresh water that can be processed into potable water.[1] Climate change is exacerbating water scarcity by causing droughts in some areas and floods in others.[2] Global population growth is further stretching supplies, with the UN forecasting a rise from 7.9 billion people today to 9.7 billion by 2050.[3]

This challenge is particularly pronounced in dry countries that have experienced rapid population growth, such as Sudan and Egypt, both of which rely heavily on the Nile River for irrigation and drinking water.

The strategic importance of the Nile means geopolitics further complicates the situation. In 2011, Ethiopia began construction of the Grand Ethiopian Renaissance Dam (GERD), which when completed will have a capacity of around 5,000 megawatts, more than doubling the country’s total capacity.[4] In a country where half of the population is currently without access to mains power,[5] the dam has transformative economic potential – but its development has stoked tensions with downstream countries.

Just as energy security became a priority for Europe as Russian gas lines were shut down last year, water security is rising up the agenda. Egypt, for instance, has an US$8 billion long-term plan to reverse its annual water deficit of about seven billion cubic meters.[6]

Across the Middle East, Africa and parts of Asia, desalination holds the promise to address water scarcity, with the market forecast to see compound annual growth of 8.8% between 2011 and 2027.[7]

The chart shows how the cost of desalination has fallen over the long term. This has been driven by technological advances, larger plants translating into greater economies of scale, and project development choices such as colocation of desalination plants with power plants.[8]

Opportunities closer to home

Another way in which geopolitics is leaving its mark in financial markets is via the phenomenon of 'friendshoring', as mentioned by Tim, meaning the re-allocation of trade towards countries that are perceived to be friendly to the US.

The friend-shoring effect is already somewhat evident in global goods trade, and to a greater extent in flows of foreign direct investment (FDI) between countries, according to research from LGIM’s economics team. They note an IMF study found the top 20% of geopolitically aligned countries accounted for 37% of global FDI flows in 2010 – but more than 50% in 2021.

In the US, the Inflation Reduction Act and the CHIPS and Science Act have potential to galvanise investment in strategically important industries. In Europe, the Net Zero Industry Act aims to achieve the same thing.

The impact of policy support is already evident in FDI into the semiconductor sector, where FDI flows towards the US and Europe doubled between 2020 and 2022.[9] Our approach The linkages between geopolitics and technology, demographics, and energy and resources are dynamic and idiosyncratic. In the context of a multipolar world, we will continue to focus on potentially overlooked areas of risk, as well as those areas where geopolitical pressures reinforce existing long-term structural shifts.

The above is an extract from our latest CIO outlook.

[1] Source: https://education.nationalgeographic.org/resource/resource-library-hydrosphere

[2] Source: https://www.worldwildlife.org/threats/water-scarcity

[3] Source: UN, 2019

[4] Source: https://www.africanews.com/2022/08/11/ethiopia-starts-power-generation-from-second-turbine-at-mega-dam/

[5] Source: https://iea.blob.core.windows.net/assets/220b2862-33a6-47bd-81e9-00e586f4d384/AfricaEnergyOutlook2022.pdf

[6] Source: https://smartwatermagazine.com/news/smart-water-magazine/egypt-plans-build-21-desalination-plants-worth-3-billion-boost-water

[7] Source: https://www.globenewswire.com/en/news-release/2022/05/10/2439389/28124/en/Global-Desalination-Market-2022-to-2027-IndustryTrends Growth-Insight-Impact-of-COVID-19-and-Opportunity-Company-Analysis.html

[8] Source: https://documents1.worldbank.org/curated/en/476041552622967264/pdf/135312-WP-PUBLIC-14-3-2019-12-3-35-W.pdf

[9] Source: https://www.imf.org/en/Publications/WEO/Issues/2023/04/11/world-economic-outlook-april-2023 (see page 95, figure 4.4)