Five Major Geopolitical Risks Over The Next 12 Months

[Bearish Global Growth]

COVID will have a long-term impact on the global economy, but other geopolitical risks could also have significant macro and financial market implications. I list my top five risks for the next 12 months and the likely market impact.

1. The economic conflict between China and the US intensifies.
2. Economic and political instability in China.
3. European fragmentation resumes.
4. Unclear results in the US presidential elections.
5. Cyber-attack disables a critical part of US infrastructure.

(1) The economic conflict between China and the US intensifies. Under the phase 1 deal, in exchange for US tariff cuts, China has committed to purchasing $200bn more in US goods than in 2017 as well as to improve its track record on intellectual property rights, technology access, and market opening and to refrain from competitive devaluation. While the trade part is fairly straightforward to monitor, the regulatory part less so, especially as the deal does not include an explicit commitment from China to make legal or regulatory changes. In addition, in the longer run, China and the US have conflicting objectives: China wants access to technology which the US is unprepared to grant due to China’s geopolitical agenda and values; the US wants China to follow the global playbook rules, which China may be unable to do due to its weak rule of law, transparency and government accountability. These create ample risk of renewed economic conflict, most likely through a new tariff escalation and, if the conflict escalates, through additional measures such as limiting Chinese access to global investors and financial markets. Markets would react negatively to such news due to concerns over supply chain disruption, Chinese economic and political instability, global financial stability risks and further escalation of the US/China conflict.

(2) Economic and political instability in China. China has been building imbalances for years: excess corporate sector CNY and USD leverage, excess productive capacity, weak banks balance sheets, and financial repression that has built pent-up demand for foreign assets as well as the highest money balances in the world. COVID-19 could turn out to be a trigger for some of these risks to become full-fledged crises, for instance if a wave of corporate bankruptcies led to mass unemployment or a loss of confidence in the banking system. In addition, there are signs that China’s labour market is weaker than official data suggests, which could see President Xi come under political pressure from within the Communist Party of China (CPC). Because Xi has centralized power as well as increased CPC control over the economy, political instability could have a large negative impact on Chinese economic activity. Global equity markets would react very negatively out of concerns that include global growth, global financial stability, impact on commodities prices and commodities exporters, risks of China imposing capital controls and of defaults by Chinese USD borrowers. The global impact could be so strong as to elicit a global policy response.

(3) European fragmentation resumes. European Union leaders are struggling to agree on a EUR750bn (4% of GDP) COVID-19 recovery fund with the frugal 4 (Sweden, Denmark, Austria and the Netherlands) insisting that the fund consist only of loans, compared with the European Commission initial proposal of two-third grants and one-third loans. The grants were to be funded by joint borrowing by the EU commission on behalf of its 27 members and guaranteed by the revenue streams accruing to the EU budget. If even this limited form of integration fails, fragmentation could re-emerge, most likely through Italy. Italy, with the weakest recovery and the highest public debt in the Euro area, stands to be the main beneficiary of the fund. An EU fund disappointment would deprive Italy of much-needed resources as well as fuel further anti-EU sentiment that has been stronger in Italy than in any other EU country since the GFC. Over the longer run, once the epidemic gets under control, Italy’s inability to function well under a peg with Germany is likely to come back to the fore. The immediate consequence of a delayed or postponed COVID-19 fund implementation would be a widening of Italian spreads. If delayed implementation led to renewed confrontation between Italy and the EU, the more serious redenomination risk could start getting priced in.

(4) Unclear results in the US presidential elections. Polls and betting markets are showing a widening lead of former Vice President Biden over President Trump. However, there are more than 4 months to go before the elections and close results cannot be ruled out. In addition, because of concerns over the COVID-19 contagion, most states will be offering expanded mail-in voting in November, which has proved controversial with President Trump and some Republicans. Furthermore, American society is more polarized now than 20 years ago when close results in the Bush/Gore contest led to the Supreme Court effectively deciding on the outcome. At the time, the losing side conceded right away on TV. This time around the loser could contest the result for an extended period of time. In such an instance, government could become paralyzed, for instance if civil servants stop executing the decisions of elected officials or if Congress refuses to work with the executive branch. This would limit the US ability to respond to domestic or global emergencies. Even without such emergencies, equity markets would sell off largely due to increases in headline risks.

(5) Cyber-attack disables a critical part of US infrastructure. Cyber-attacks have multiplied since the beginning of the COVID-19 epidemic as vulnerability has increased due to more activities moving online when companies are least able to protect themselves. In addition, the nature of the attacks is changing: in April, Israel thwarted what is believed to be the first cyber-attack aimed at real infrastructure and human lives rather than theft of money or of information, an attack on its water system. If the attack had not been stopped on time it could have resulted in chemicals getting mixed in the water in wrong proportions, with disastrous consequences for public health and water availability. The attack is widely believed to have been orchestrated by Iran, and Israel is believed to have retaliated with a cyber-attack on an Iranian port. More recently, Australia’s prime minister has stated that the country was under massive cyber-attack from a ‘state-based actor’ widely believed to be China, possibly in retaliation for Australia siding with the US in its demand for an international inquiry into the origins of the coronavirus. As the US conflict with China and Russia intensifies, the risks of a state sponsored cyber-attack seeking to cripple key US infrastructure are increasing. If successful, such an attack would have a strong impact on economy and markets and likely elicit a policy response to support them.