Explaining the disconnect between geopolitics and markets

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Joyce Chang: Welcome to J.P. Morgan's Making Sense. I'm Joyce Chang, Chair of Global Research at J.P. Morgan. Today, I'm joined by Derek Chollet, who is head of the J.P. Morgan Chase Center for Geopolitics. Well, we just wrapped up our flagship investor seminar around the International Monetary Fund, World Bank Spring Meetings. This year, the key themes on everyone's mind, and especially in the case of policymakers, was uncertainty, with geopolitics as the defining variable.  So Derek, geopolitical tensions and energy disruptions have set the macro backdrop for this year. On Iran specifically, what are you seeing as the plausible path forward and the implications for securit. What are the key things we should be keeping an eye on?

Derek Chollet: Well, Joyce, thanks for having me here, and congratulations again on such a terrific conference. These always seem to come at a very timely moment, and this one, it felt like was just every panel was full of interesting insights on the news of the day and what's happening in this very complicated world of ours. So, look, where I think we stand today on Iran is we are at a pause, but not peace. And we do foresee a path of deescalation with some perhaps blips of back and forth on the military side, but I don't foresee a return to the kind of major military operations that we saw over the last couple months. I think what we're seeing right now in the Strait of Hormuz, for example, is a bit of game of chicken between the two sides. And I think the US bet is that it can inflict enough pain on Iran in terms of cutting off the very few resources it has to keep its economy afloat by blockading the Strait. And Iran is, by keeping the strait effectively closed on its end, making the bet that it can absorb more pain than the US, and that ultimately the US administration will cry uncle and come to some sort of deal that, again, is not gonna resolve the core issues, but at least provide some sort of ceasefire. And I think in the near term, we're pretty confident that we're gonna see something that we call fortress Iran, which is the Iran we have today, a regime that's unquestionably weaker just in terms of its military power. Many of its senior leaders have been removed, it is a regime that is willing to use whatever leverage it can muster to try to continue to assert its influence. But it's also plausible that we could see an Iran that is more fragmented, that perhaps as a regime that's still intact, but is, is under a lot of pressure internally. We could also see Iran end up into something that I think would be quite concerning for US interests and for the region, something that we think of as a black hole Iran, an Iran that descends into the kind of chaos we've seen in places like Syria, like Libya 15 years ago, in which leadership of Iran is deeply contested, and we see it exporting a lot of instability. I think the most optimistic scenario, which unfortunately in my assessment for the next few years is the least likely is something that we think of as more of an accommodating at Iran that the US administration hoped to bring about. The bottom line is I think we're gonna see this play out in the coming years. I, I don't think we c... this is not gonna be over anytime soon. I think all of us understandably have a desire to sort of see this closed, but I think the uncertainty is going to persist. The question is just gonna be what comes next, and if these worst case scenarios begin to play out. But if I could, Joyce, to bring it back to you, because I think one of the interesting things that I took from the conference, was the sense that the, the poly crisis around the world seems to be surfacing everywhere, except the financial markets, it's not surfacing. (laughs) I mean, we don't see the, the kind of sustained impact in the financial markets. And the question to you is, how resilient is the global economy? You've highlighted the geo-economic fragmentation, AI, persistent inflation, high fiscal debt, I mean, are there any safe havens left?

Joyce Chang: Well, the global economy has been very resilient, and there's a couple of things to talk about, but the first thing is that the starting point of this conflict, you had the global economy entering this year on very strong footing. Growth was a lot more resilient than many people had thought it would be because there was deescalation on trade and on tariffs. You had very easy financial and monetary conditions, a lot of fiscal support through the one big beautiful bill, but most importantly, the AI boom. So going into this conflict, global growth was on track at a very healthy three, 3.5% this year, very similar to last year. And we have seen an impact from Iran, but this is really going from above trend growth to trend growth. Now, we think if oil stays at 100, higher than a lot of estimates through the middle of the year goes down to 90 in the third quarter, $ 80 by the end of the year, we think this takes about half a percentage point off of global growth, which is manageable because we were above trend. But it does raise inflation and consumer prices by, like, 0.8, almost close to one percentage point this year. But I think the big story and the reason we're seeing the markets at new highs is the emergence of Anthropic's ethos really helped to re-ignite a very bullish AI trade, which has been the story all year. The S&P 500 performance is increasingly tied to the AI theme, not just the breadth of the linkage, but also how this is expanding into other markets. So, you start with the data centers, we're looking at $5 trillion in financing needs to the end of this decade, but you also have the build out. It's not just tech hardware and semiconductors now. Now we're seeing this really expand into small cap, credit markets and even the private markets. So this has been taking the earnings projections up for the year. And our equity strategists just raised the target for year-end for the S&P 500 to 7600. So we've seen the shocks that are coming from higher oil prices, but we're also seeing just the higher earnings that are coming from AI. So we've taken the CapEx earnings forecast up, um, you know, to around 18 to 19%, and we've taken a lot of the earnings forecast up, and it's not just the US, it's around the world that we're seeing some of these trends. So we're at levels that are higher than before the Iran conflict started, but it's been harder to find safe havens. One thing that really has stood out is the disconnect between what we're seeing in the developed sovereign debt markets and in equity markets. So markets have become much more sensitive to shocks, and you're really seeing that looking at US treasury yields, uh, looking at JGBs, looking at gilts. Well, public debt continues to grow and the deficit continues to grow. And there's less fiscal space for increases at this stage in the game. So term premiums remain very elevated here, and we don't think you're gonna see the Fed cutting rates this year. I think one thing that has been more of a safe haven has actually been being in the investment grade, US high grade corporate bond markets. Those spreads have actually tightened since the conflict began. And that's supported by what's shaping up to be a very strong earning season across a whole broad range of US companies, not just in the technology space. So we're seeing markets that have now gone into a pattern. What we're seeing is this pattern of mini sell-offs and these very quick rebounds that are really on the narrative of the day. The draw-downs that we're looking at have been much smaller than what we saw at COVID, Russia, Ukraine, or even last year's Liberation Day. So, markets that have really held in there very well. Derek, how are you looking at the outlook for Europe and the transatlantic relationship, how that's developing? And here we're seeing a lot of variation, like Hungary's election results were actually ones that were seen as really endorsing the EU agenda. But how are you looking at the state of play in Europe right now and where countries have the biggest trade-offs and opportunities?

Derek Chollet: Yeah. Well, it's, it's been a, quite an eventful year thus far for Europe and US-European relations. You know, we started the year off with Greenland as a manifestation of the Iran crisis, we have another question of the future of, of NATO before us. And I think there's certain things that we know. I mean, defense spending in Europe at long last is rising meaningfully and, and there's going to be significant defense investment. We're already seeing it. It's only gonna continue. And I think this is a huge opportunity as well for investors. I mean, resilience is the word of the moment. Almost every corner of the planet you visit, you hear about the need for greater resilience. And certainly from a Europe perspective, and we heard it in the conference, there's a sense that the dangers of being too vulnerable is causing European countries to build greater resilience in terms of their relationships with China and the de-risking. You're also hearing, hearing more need for resilience when it comes to the United States in the sense of whether there's greater uncertainty about US staying power, whether the US is gonna leave NATO or not, is the US gonna keep troops in Europe? Now, there are real limits to that. And we talked about some of that over the course of the week at the conference about how real strategic autonomy, which is a nice slogan, but it's much harder for Europe to achieve strategic autonomy in practice. I mean, what's interesting, if you think about the recent events, I mean, you, you kind of see the paradox of, of the US-European relationship at work. You think of Ukraine and the lessons that Europe took from Ukraine, what is very clear is that they do rely on the United States for their own defense. And it was the US, carrying the lion's share of the burden for the first few years of the Ukraine war to keep Ukraine on footing to beat back the Russian offensives. Now, Europe has taken up most of that work in the last year or so as the US has backed away from providing support for Ukraine. But what Europeans understand is that they still need the US. At the same time, the US has seen with Iran, it still needs Europe. Now, we've, we've heard a lot of frustration by the administration about European allies' unwillingness to step up when it comes to issues like the Strait of Hormuz, but the US could not have conducted the air campaign against Iran in the way it did without the cooperation of European partners. I think this is certainly a theme that we heard throughout many of the panels in the conference, that the US-European relationship gets on stronger footing. You asked about countries that we really should be watching. I think one of my takeaways from last week was we really need to be keeping our eyes on Germany. It's not just the bellwether, it's sort of the driving country when it comes to Europe's ability to spend more on its own defense, to ensure that the European continent, that economy is strong. Germany's been moving in a very interesting direction under Chancellor Merz. Speaking of the transatlantic relationship, obviously trade and tariffs have been one of the dominant themes, over the last 15 months or so. And we've had a lot of news in recent weeks about the direction of US trade policy from the Supreme Court's decision overturning the President's IEEPA authorities to then the administration's quick pivot to the 301, 232 investigations that are currently underway. So I'm curious, taking all this in, how you're assessing the path of US trade policy and the reconfiguration of the US approach to trade, and the impact of tariffs overall? So I guess the question to you is who pays the cost of tariffs?

Joyce Chang: Yeah, no, it's a great question. And look, let me just start by saying that the tariffs led to trade reorientation, but not de-globalization. Really what we saw was a strengthening of China's external position in all of this. China now trades more with 130 countries in the world than the United States, but we did not see de-globalization here. So that's the starting point. But turning to the tariffs specifically, I mean, we've seen a huge round trip. So you saw tariffs that were 25% a year ago on Liberation Day. Then after the Supreme Court overturned the emergency powers, that went down, all the way down to 7.6%. Last year, the observed rate for the tariffs was just under 10%. And now, when you look at using the Section 122 and the 301s, I mean, we think you're gonna have tariffs that settle in a 10 to 12% range. And a lot of businesses have adapted to this, particularly the large businesses. It's mid-cap that's actually hurt the most by that. But who pays the cost of the tariffs? I mean, look, the tariffs are a form of tax. This is paid by US importers, not by the foreign countries, and there is a pass-through. We do think you're gonna see a pass-through to inflation, and that along with higher oil prices, this is why the Fed is going to, we think, remain on hold. Now, the cost of the tariffs is distributed across the supply chain, and so it really varies a lot by sectors. I just spoke at one of our retail conferences, but the companies there are basically saying that you had about a third, a third, a third. So a third of the costs were absorbed by retailers, a third was renegotiated with suppliers, and a third was passed on to the consumers. And what we see is that the larger companies with pricing power or domestic production are in much better shape to absorb the cost of the tariffs, but it's been mid-cap businesses that import a lot from the countries with the highest tariffs, who can't move their supply chains as easily, that have been the most adversely impacted by this. And I think one thing that's gonna come up is, particularly if you look at the USMCA, the US, Mexico, Canada negotiations, there's gonna be more focus on the auto sector. I would say that the auto sector, automakers have so far passed along much fewer of the tariff costs to consumers than had initially been anticipated, maybe only 25%. So the tariff story is not in the headlines the way it was last year. There's a sense that at these levels and with refunds underway, that we've probably seen the worst passed of some of those tariff threats. Derek, I wanna just, you know, turn to you and talk more about, you know, the next event that we're watching right now, which is the Trump Xi Summit, which I think is still on track to happen in the middle of May. And we have seen a real pivot in China's five-year plan towards more focus on security, security first in their economic models. What kind of agreement do you think we can come up with between the US and China at this juncture. Do you see this as more of a trade truce or maybe even the opening for a bigger deal? There’s been a lot of talk about whether China would be allowed to invest in more sectors in the US.

Derek Chollet: Yeah. Well, we expect the summit to be full of pageantry. Will probably be one of the most highly hyped US-China summits in recent memory. It's the first presidential visit to China since the last time President Trump visited there six or so years ago. That said, I think that expectations are pretty modest for what will actually get achieved at the summit. It is important to note that this will be the first of what could potentially be four meetings between the presidents over the course of the year, because one of the expectations out of the summit is an invitation by President Xi to come back to the United States for another bilateral summit. And then the Chinese are hosting APEC later this year and the, the US is hosting the G20. So if both leaders attend those meetings, you could be out of four sessions between the two presidents, which is quite significant. I think in terms of whether we see a trade truce or a bigger deal, I expect a trade truce and perhaps the beginnings of something that lead to a bigger deal, but nothing at this summit in May. I think of it as the five Ts, uh, tariffs, tech, trade and investment, travel and Taiwan. So I started with tariffs. I think we'll probably see an extension of the truce from the, the meeting between the presidents last October and Korea where the kind of retaliatory spiral that we were in after Liberation Day was, was arrested. I think that that will probably, there'll be an agreement to keep that going, keep that truce going. I think on technology, of course, the Chinese are gonna be very interested to see the US potentially loosening some export controls. I'm not sure if we'll see that. I think what I'm watching more carefully on technology, Joyce, you mentioned, mythos and, and the both the Anthropic and the OpenAI real step change we've seen in their models. I think that AI and, and AI governance and the guardrails around advances in AI will be something that will creep its way onto the agenda in the coming weeks as in the lead up to the summit. Third, trade investment, you mentioned, some speculation that, that coming out of the summit, there could be some major announcements of Chinese investment in the United States. Some of the expectations have been tempered a bit. I think that obviously politically could be quite sensitive here in the United States in terms of massive Chinese investment. It's a very delicate matter. On travel, as I said, I think we'll have an announcement of, of President Xi's commitment to traveling to the United States for a summit. And then lastly, and perhaps most importantly, Taiwan. There's a lot of speculation that the Chinese side will push very hard to get the US to shift its position on Taiwan. We just recently had the high profile visit of the KMT, the Taiwan opposition leader to China. And the US is has also put forth a major trade deal with Taiwan and also a major arms package that's making its way through the US Congress on Taiwan. I expect that will be a topic of conversation. So probably on the Chinese side, their number one issue will be Taiwan. On the US side, I expect it will probably be technology. And one of the important questions overall that I think a lot of commentators will focus when it comes to the US-China Summit is how it's playing out in what is increasingly a fragmented geopolitical landscape, in which financial globalization has been disproportionately shaped by US exceptionalism. So, Joyce, I'd be curious to get your take on this, and particularly, uh, how you see the implications of that for asset allocators and portfolio diversification.

Joyce Chang: So the trade story has been dominated by China, but the capital market story is still dominated by the United States. I mean, there just really is no alternative to the dollar right now. There may be questions about the US Treasuries as a safe haven, but it's the scale and the size of the US markets that stands out. Just taking a look at the S&P 500 right now and the size of US financial markets, uh, you can add all of the middle countries together and China, and you don't come up to the size of the US market. So what we have seen, and we've been writing about this all year, is that we're in a world now where the asset oriented world has actually replaced a lot of the labor income world. Just looking at wealth gains in the United States that came from AI linked equity gains, that created about $5 trillion in US household wealth over the last year. And that's actually accelerating right now. So the US exceptionalism in the financial markets still continues here. But I do think, that one of the big paradoxes of this size of market concentration, and also of the de-globalization, is that you need to be diversified now more than ever. So, we are seeing increased demand for international diversification here. For the first time in a number of years, we're finally seeing the inflows coming back into emerging markets, a sense that emerging markets equities and also the emerging markets FX looks more attractive right now. And I think while there was a thought that will there be a flight to quality trade with the dollar, we're back to really looking at much more of a medium term bearish outlook on the dollar here, just given the size of the fiscal debt in the US. So the demand for diversification off of the meetings and the conference we hosted was very strong. We saw that benefiting emerging markets, but even Europe, which outperformed the US equity markets last year, and also still demand for Japan as well. And turning to which sectors make sense, defense stood out as a big winner, but many of the commodity sectors as well. And one area I really wanted to just ask you more about related to that is how you're seeing the investment prospects for Venezuela. That was, you know, on everybody's radar at the beginning of the year, has kind of left the radar a bit, but in light of the current energy market constraints and all of the focus on resource security. How are you seeing the outlook for Venezuela? What should we be looking for next with respect to how they handle having fair and free elections? And how are you seeing just Trump's strategy more broadly in the Latin America region?

Derek Chollet: Yeah, it is remarkable. I mean, if you think of just this year so far, the first four months, it was all Venezuela for a while, that it was all Greenland for a while, then it quickly pivoted to Iran and it was all around for a while. I think China will be a big topic in the coming weeks. But look, for Venezuela, my headline would be where we are today, lots of hype, some hope. I think it's more or less we've landed in Venezuela where I expected we would be, where things have changed modestly for the better. We've had some sanctions lifted by the US side. We've seen some laws passed by the Venezuelans, which open up some opportunities for investment. We've seen some political prisoners released. The IMF World Bank last week announced their resuming ties to Venezuela, which is important because it will unlock special drawing rights. It will also allow the IMF to conduct its first comprehensive assessment of the Venezuelan economy in about 20 years. So that's all for the good. That said, we haven't seen big investments made yet. The investment environment remains pretty tricky. There's lots of questions about the sustainability of rule of law there, and how confident one could be and invest in, and you're gonna see a return or deals adhere to on the Venezuelan side, given the uncertainty about governance there. And so, that's kind of the underlying story I'm gonna be watching in the coming months is, first, does some of the loosening we've seen in the economy and some of the loosening in the political space, does it lead to some meaningful investment, particularly in the energy space, even though it's gonna take several hundred billion dollars at least, to try to do the infrastructure repairs necessary to get the energy flowing back to the way it was 25 years ago. And the political space, although it's opened a slight bit, it hasn't opened substantially and we have this lingering question of elections out there. And if there's a push by the opposition and we see people return to the streets, what does the regime do? And those underlying issues are still th- very much there with us. I do expect that the administration, because you asked more broadly, what does this mean for the region? Uh, I mean, obviously the Iran war has shown that the administration, the U.S, it's very hard for the U.S. to just pivot away from the rest of the world and focus on the Western hemisphere. I do, however, expect that while there'll be continued focus on Venezuela, obviously, we will be focusing on Mexico and Canada because of the USMCA negotiations over the summer, but also, a continued focus on Cuba and, and a likelihood that we will see some sort of change in Cuba.

Derek Chollet: So Joyce, uh, I mean, another theme of the, of the year will be it's a midterm election year here in the United States and every day we get closer to November. I think more and more of the debate in Washington will be dominated by what's happening in the midterms. Is the Congress gonna change hands, uh, from Republicans to Democrats? And I'm, I'm curious to get your take on, on how geopolitical and trade issues are gonna spill into the midterms, and particularly, how this affordability issue, which was kind of the watchword of a couple months ago. We haven't heard much about it recently, just given, uh, all the events going on in the world, but how do you think the affordability issue will play in the coming months and where you think the record setting government debt levels and global trade imbalances we're seeing, how those should stand on the watch list in terms of the midterms?

Joyce Chang: Thanks for that question, Derek, because yeah, affordability was all the talk, and I think it's gonna come back, and a lot of that does relate to how high gas prices will stay and for how long. So if you just take a look at the research we have done, uh, the calculations, like if you have gas at the pump at $5, you wipe away a lot of the benefits for personal income taxes from the One Big Beautiful Bill. So we're looking very closely at just the inflationary effects, but I would describe the U.S. consumer as stable at the top, but strained at the bottom. And the most important thing is, uh, really looking at the job market right now as well. And there's been a lot of concerns about labor displacement that's coming from AI, although I think some of that is premature. But what we're seeing is that lower income households are in a much weaker position relative to the top. I mean, about 20% of the population is two-thirds, of the spending right now because of all of the wealth effects. So I think we're seeing a lot of focus now on inflation, on essentials like food and rent, um, and fuel. Um, we're also seeing that the delinquency rates have been going up, um, in a number of areas as well. We look at student loans and we look at, uh, you know, credit cards and also auto loans. So I think that affordability is going to come back as an issue. So we're keeping a close eye on this and in particular, on what's happening with the fiscal debt. So we're not gonna collect as much from the tariffs. Uh, you have requests for reconciliation bills to increase, um, the defense spending. All of this means that we could be looking at a fiscal deficit that is, you know, considerably higher than what's in the baseline from the congressional budget office at just under 6% of GDP. And that means that these issues are going to weigh on some of the sentiment going into the elections. So there's a lot to watch here, um, you know, with respect to the global imbalances being back on the table as an issue, although I don't see either political party really doing much about this right now, because of affordability, I think there's gonna be just much more of a bias to spend here. So the midterm elections will give us a lot to watch and talk about. So with that, I really wanna thank Derek for joining us today and for sharing his insights. I encourage you all to follow the insights from the Center for Geopolitics. The Center for Geopolitics brings sharp focus insights on global developments that really matter the most for markets, strategy and risk. For our listeners, please stay tuned for more episodes as we continue to explore the trends that are shaping the global economy and financial markets. Thank you so much, Derek, for joining us, and we look forward to continuing the conversation.

Derek Chollet: Yeah, thank you, Joyce, for having me, and thanks to you and the team for all your support and partnership, and right back at you. I think everyone here, obviously, I know they're dedicated followers of you, but you do great work, you and the team.

Joyce Chang: Well, thank you so much, Derek. So much to talk about.

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