Competence Shock Drives "Avoid America" Trade Amid Inflation Fears

The market's seemingly muted reaction to the escalating Iran conflict belies a complex interplay of geopolitical uncertainty, economic sensitivities, and a growing distrust in American leadership. While immediate price swings might appear confusing, the underlying currents reveal a deeper anxiety about inflation and a potential recalibration of global investment flows away from the U.S. This conversation with Katie Martin and Justin Wolfers unpacks the non-obvious implications, highlighting how a "competence shock" and the president's specific market sensitivities are shaping investor behavior, even if the broader market hasn't fully priced in the long-term ramifications. Those who grasp these subtle dynamics--particularly the potential for sustained inflation and the shifting global investment landscape--will gain a significant advantage in navigating future market volatility.

The "Avoid America" Trade: A Subtle Shift, Not a Sell-Off

The initial market reaction to the Iran conflict was, as Katie Martin noted, "quite a weird market reaction." While oil prices predictably spiked, traditional safe-haven assets like gold and government bonds did not surge. Instead, we saw a weakening of currencies like the Swiss franc and the yen, and a dip in bond prices, signaling a potential rise in inflation. This counterintuitive behavior, Martin suggests, was less about a full-blown "end of the world" panic and more about investors "taking a little bit of risk off the table." However, the persistent sensitivity in government bond markets, worried about a "resurgence in inflation," is a critical signal. This isn't just a geopolitical shock; it's a new risk factor that central banks, who had just begun to get inflation "under control," were not anticipating.

Justin Wolfers frames this broader market behavior through the lens of a "competence shock"--a growing distrust in the U.S. administration's planning and decision-making. This uncertainty, he argues, can lead to a "sell America trade," or more accurately, an "avoid America trade." This isn't necessarily about divesting existing U.S. holdings, but rather a shift in how new capital is deployed. Investors are increasingly diversifying their portfolios, allocating less to the U.S. and more to Europe, Asia, and emerging markets. This trend, which Wolfers observes is standard practice for European and Asian asset managers but often missed by their U.S. counterparts, has significant downstream effects. Markets that have benefited from this "diversify away from America" trend, like South Korea, were hit hardest during the recent shakeout.

"What investors that I speak to around the world are doing, however, is that they are, you know, every incremental euro or pound or yen or Australian dollar that comes into their investment pot, they're not mechanically sending 60, 70% of that to the US anymore, which you would do if you're sticking to the big global indices. What they're doing is saying, 'Maybe I can spread this a little bit more evenly. Maybe I want to be more exposed to Europe, to Asia, to emerging Asia, to all sorts of different places.'"

-- Katie Martin

The U.S. market's relative insulation, Wolfers points out, is partly due to its geographical distance from Iran and its energy independence. This creates a divergence where Europe and Asia bear more of the immediate economic pain, a dynamic that could further fuel the "avoid America" sentiment. This isn't just about short-term market jitters; it's a fundamental recalibration of global capital flows driven by a perceived decline in American exceptionalism and a more complex geopolitical landscape.

The Inflationary Spiral: A Deeper Threat Than Geopolitics

While the immediate conflict in Iran grabs headlines, the more insidious consequence for global markets, as highlighted by Martin, is the renewed threat of inflation. The war has reintroduced a significant risk factor that central banks were only just beginning to manage. The bond market's sensitivity to this inflationary pressure is a crucial indicator. When bond prices fall and yields rise, it signals that investors are demanding higher returns to compensate for the eroding purchasing power of their money.

"The other thing that, you know, as Justin was saying, there is definitely a conversation in Europe about, can we rely on the American security umbrella? That, that definitely means much more defense spending across Europe. And we're starting to see some of that kicking in, you know, from Germany and the UK and elsewhere. But one of the interesting things that a number of investors have brought up with me over the course of this week is that if you ever needed a big advert for the reason why spending on green technology makes sense and green energy, it is this."

-- Katie Martin

This inflationary pressure is exacerbated by the potential for prolonged disruption in oil supply, particularly through the Strait of Hormuz. While the market may be betting on a quick resolution, Wolfers cautions against underestimating Iran's agency and its capacity to sustain supply disruptions. The nightmare scenario, where oil prices skyrocket to $150-$200 a barrel, would have profound implications for global monetary policy, potentially forcing central banks into a difficult choice between controlling inflation and stimulating growth, or even leading to stagflation. This prolonged period of economic uncertainty, driven by energy shocks, could have lasting consequences for public debt and defense spending, as Wolfers notes, potentially leading to a significant fiscal strain on industrialized nations. The push towards green technology, Martin suggests, is not just an environmental imperative but a "geo-strategic imperative" born out of this vulnerability.

The Competence Shock and the President's Market Sensitivity

Wolfers' concept of a "competence shock" adds another layer of analysis. The market's volatility isn't solely driven by the direct impact of the conflict but also by uncertainty surrounding the U.S. administration's intentions and capabilities. The "unannounced intentions, unannounced allies, and an unannounced exit plan" of the war create a vacuum of information, leading to overreactions to every piece of news. This lack of predictable leadership, Wolfers argues, erodes confidence in the U.S. as a safe haven, contributing to the "avoid America" trade.

The president's specific focus on oil and gasoline prices, as noted by Martin, becomes a critical feedback loop. While investors might be concerned about broader geopolitical risks, the president's immediate political calculus, tied to mid-term elections, can influence his actions. This creates a dangerous dynamic where market-driven political pressures could either de-escalate or, conversely, lead to miscalculations. Wolfers draws a stark lesson from the Iraq War, where initial forecasts were wildly inaccurate, and suggests that current market optimism might be underestimating the potential for prolonged conflict and its economic fallout by an "entire order of magnitude." The president's perceived willingness to engage in "war wars" and "trade wars" raises profound questions about his commitment to established institutions and norms, potentially leading to a future where the U.S. is increasingly isolated.

"And so the question is, is he a big personality but in the tradition of American presidents, or do we put him next to Orban? Do we put him next to, you know, Putin? Do we put him next to Turkey? Do we put him next to Argentina? Because if what we're learning about is how serious he is about the autocrat project, the autocrat project undoes the resilience of the economy."

-- Justin Wolfers

The market's resilience, Wolfers contends, might be a function of economies absorbing shocks rather than markets being inherently stable. The historical precedent of wars being longer and more costly than anticipated, coupled with a potential decline in faith in American leadership, suggests a future where the "autocrat project" could significantly undermine economic resilience. This is a sobering thought, implying that the current market calm might be a temporary lull before a more significant reckoning.

Key Action Items

• Immediate Action (Next 1-3 Months):

  • Re-evaluate Inflation Hedging: Review existing portfolio allocations for sufficient protection against sustained inflation, considering assets that historically perform well in such environments.
  • Diversify Beyond U.S. Markets: Actively explore and increase exposure to international markets (Europe, Asia, Emerging Markets) to mitigate risks associated with the "avoid America" trade.
  • Monitor Energy Supply Chains: Stay informed about geopolitical developments impacting oil and gas supply, particularly concerning the Strait of Hormuz, as this remains a critical inflation driver.

• Medium-Term Investment (3-12 Months):

  • Increase Green Technology Investments: Allocate capital towards companies and funds focused on renewable energy and green technologies, recognizing their growing geo-strategic importance and potential for long-term growth.
  • Stress-Test Portfolios for Prolonged Conflict: Model the impact of scenarios where oil prices remain elevated ($150-$200/barrel) or supply disruptions persist.

• Longer-Term Strategy (12-18+ Months):

  • Assess Geopolitical Risk Premiums: Develop a framework for assessing and pricing in geopolitical risk, particularly concerning the stability and predictability of global leadership.
  • Build Resilience Against "Competence Shocks": Diversify investments not just geographically but also across sectors less susceptible to unpredictable policy shifts and international instability.
  • Consider Increased Defense Sector Exposure: Given the potential for increased global defense spending, evaluate strategic investments in companies within the defense industry.