Fri, Sep 9, 2022
Geopolitical risk is a constant, but in the midst of a pandemic, a war in Europe and a climate transition that is not nearly as advanced as it needs to be, the nexus between geopolitics, economics and business seems to have tightened. The U.S. remains the largest power economically, militarily and diplomatically, but China is rising and may threaten each of these. All this is against a backdrop of poor global economic performance, with a recession looming in the U.S. and Europe and with China set to post its weakest growth in decades (barring 2020) this year. We outline some near- and mid-term key geopolitical and geoeconomics risks below, which are notable for being very likely, very impactful or both.
After shutting down the Nord Stream I pipeline for maintenance in late July, Russia resumed gas flows at 20% capacity. A further shutdown in late August–again for maintenance–has since been extended. Gas prices in Europe went vertical upon the announcement of a second shutdown. If Russia wants to weaponize energy exports to Europe, it is incentivized to do it sooner rather than later. Europe is scrambling to find alternative supplies for energy, build storage capacity for liquified natural gas (LNG) and also to cut demand for energy. Furthermore, Russia has limited use for the foreign reserves it receives from Europe for gas exports given the sanctions that have been imposed on banks and the central bank. One reason Russia may slow gas exports down to a trickle rather than cutting them off is that its natural gas infrastructure would suffer from the latter, and with sanctions, Russia would have trouble importing the necessary parts to repair it. If Russia cuts off gas to Europe entirely, we expect a recession in the eurozone shortly thereafter. The EU hit its target for replenishing gas stores (80% of storage) two months early in late August. If this winter brings mild temperatures and China’s economy remains in the doldrums so that Europe isn’t competing with China for LNG, the EU may face only high gas prices rather than actual shortages and factory shutdowns. This will exacerbate inflation and the cost-of-living crisis in the eurozone. The European Central Bank has signaled clearly that it is willing to hike rates in the face of a recession in order to restore price stability. We expect Europe will be in recession early next year. The downturn will be much deeper if the winter is a cold one and rationing is implemented. The European Commission is in the process of renegotiating the pricing of energy markets in Europe so that consumer energy bills reflect the average cost of electricity rather than the marginal cost. This a positive signal after each eurozone country initially scrambled individually to secure alternative sources of gas and storage facilities. The EU may respond to a gas cut off by recycling its NextGenEU funds into the REPowerEU fund, using joint bond issuance to accelerate the green transition.
The U.S. was already facing an energy crisis even before Russia’s war on Ukraine in February this year. The crisis was driven by both demand and supply factors. With more aggressive fiscal stimulus measures in the U.S. than in Europe, demand for energy has rebounded to pre-pandemic levels. But supply was unable to ramp up as quickly for three main reasons: first, there has been chronic underinvestment in fossil fuels since 2014, when the oil prices plummeted in the so-called “Thanksgiving Day Massacre.” Second, the ESG movement has further exacerbated this trend, as institutional money has steered clear of the oil patch. And finally, a number of older, less productive refineries were mothballed during the first Covid lockdown and so a bottleneck remains even with greater oil production. Given the oil market is global, Russia’s war has pushed prices even higher. We expect the White House to focus on reducing energy costs by continuing to release oil from the Strategic Petroleum Reserve and negotiating with other energy producing countries (in particular Venezuela and Saudi Arabia) to encourage higher production from OPEC. The government may also impose a gas tax cut, but some of the benefit will go to oil producers and not consumers. These measures might help on the margins, but gas prices will remain elevated. One proposal to reduce gas prices in the West is to impose an oil price cap on Russian oil. An oil price cap is likely to be leaky, as India and China would likely buy oil at just above the cap and OPEC+ would resent the cut in prices. Energy costs in the U.S. remain well below those in Europe but are still highly visible and energy is difficult to substitute. Gas prices at the pump have come down recently and inflation probably hit its peak in July, but prices remain elevated. Inflation will likely continue to be a substantial issue in the mid-term elections and could hurt the Democrats’ performance.
Ukraine and Russia account for over one-tenth of all calories traded globally, produce 30% of the world’s wheat exports (as well as 60% of its sunflower oil) and provide at least half of the grains for over 26 countries. Grains already harvested in Ukraine have been stranded because the ports were blocked and militarized. On July 22, Ukraine and Russia struck a deal (brokered by the UN and Turkey) to unblock three Ukrainian ports in the Black Sea. So far, over 30 cargo ships have exported food from Ukraine. This has alleviated some pressure on food prices, though there is quite a backlog of food exports after the previous 5 months of port closures. Russian farmers can still produce, but exports have been hampered by sanctions. Russia is the largest supplier of fertilizer in the world and announced an export ban in early March. With China also imposing an export ban on fertilizer, there is now a disastrous global shortage that will reduce crop yields going forward. China may further exacerbate the food supply crunch because six of the provinces hit by drought this summer accounted for roughly half of China’s rice production in 2021. According to the UN’s Food and Agriculture Organization’s (FAO) food price index, food prices rose by 7.9% in August over a year earlier, down from 16.6% in July and 23.1% in June.
Food insecurity sparked the Arab Spring in 2011. Rising food and energy prices prompted protests in Sri Lanka that ultimately resulted in the president and prime minister’s resignation. Higher borrowing costs in emerging markets and a stronger dollar make it more difficult for emerging markets to continue subsidizing food. But without these subsidies, starvation and social and political unrest may ensue. Developed economies are exposed to the food insecurity crisis as well. Inflation, driven in part by higher food and fuel prices in the U.S., is a major campaign issue that may lead to a change in who controls Congress.
Tensions between the U.S. and China have persisted under the Biden administration. Amidst a global shortage of semiconductors, exacerbated by sanctions on Russia (a producer of nickel, aluminum and palladium, key inputs into semiconductors), Taiwan’s strategic importance as a producer of sophisticated semiconductors continues to grow, though this may abate as a global recession reduces consumer demand for big-ticket purchases and causes demand for chips to severely ebb from their highs. Already, semiconductor companies report rising inventories and slowing demand. The U.S. and its allies will be unable to build self-sufficiency to reduce its need for Taiwanese semiconductors quickly; the process will take years, not months, though the recent passage of the CHIPS Act will help, benefitting the entire U.S. semiconductor sector considerably on multiple fronts, and in a way that will eventually trickle down to most consumers. A test of strength between the U.S. and China over Taiwan may eventually come, but we expect China is playing a long game and that open conflict between the two superpowers will be avoided.
While China’s zero-COVID policy has evolved since the beginning of the pandemic to be more strategic and surgical, it is still being used where there are outbreaks. Exposure to the virus has broadened significantly, with all 31 mainland provinces recording cases and over 13% of GDP is currently under some form of lockdown according to Goldman Sachs. President Xi has publicly declared the zero-COVID policy a success, so we see very little chance he will reverse it before the October Communist Party Congress, at which he aims to be appointed to a third term. Lockdowns will therefore persist, and we expect additional factory closures that will exacerbate global supply chain issues. If the path of the coronavirus disease thus far is any indication, there should be a rise in cases as autumn arrives that will prompt more widespread lockdowns. Even after the Party Congress, China will have difficulty pivoting from a zero-COVID policy to learning to live with the virus. China has not had the same waves of infections that the West has faced, and so there is lower natural immunity. Furthermore, the Sinovac vaccine–which the vast majority of vaccinated Chinese people have received–has a lower efficacy than mRNA vaccines. China’s elderly population in particular has a vaccination and booster rate below 60%–significantly lower than the rate in the West. This means that the decoupling between new infections and hospitalizations in the West may not apply to China and learning to live with COVID-19 will take longer in China than it has in the West. President Xi may continue to pursue a zero-Covid policy into his third term.
In addition to their many legitimate uses, cryptocurrencies in particular have long been used to facilitate the movement of money to sanctioned parties. With Russia’s recent prohibition on the use of digital assets for payment, the “crypto winter” that began several months ago, an explosion of sanctioned entities and parties, economic stress around the world and increasingly protectionist policies being promulgated, expect to see major prosecutions and enforcement actions in the next quarter. We expect U.S. regulators to take a much more muscular approach to both traditional sanction enforcement and to the investigation and regulation of the movement of digital currencies. This may mean a crypto-economy redefining prosecution. Countries in Asia have made aggressive moves, suggesting they will harshly punish those who are involved in certain kinds of crypto insolvencies, and U.S. enforcement authorities have started taking a more aggressive posture towards the characterization of certain crypto assets. And recent crypto bankruptcies means that important legal questions, particularly the legal dimensions of so-called hypothecation agreements for digital assets, are on the threshold of having an initial answer. As these answers come, conforming changes will be rapid and, potentially, costly. And as additional meltdowns and collapses of certain exchanges are certain, consumers and crypto investors will pay a hefty price for eventual regulatory certainty. The strongest may eventually prosper, but as the tide goes out, there will be many more casualties.
Sri Lanka was the first middle income country to default this year, beating even Russia to the punch. Soaring food and energy costs and dwindling foreign exchange reserves forced the government to decide whether to continue subsidizing essentials for its population or repay foreign creditors. Although Sri Lanka was the first emerging market economy to face this stark decision, it will not be the last. The IMF’s latest World Economic Outlook suggests growth will slow for emerging markets from 6.8% in 2021 to 3.6% this year. External demand for developing economies looks weak: the U.S. and eurozone are likely to go into recession over the next 18 months, and China is set to log its weakest growth in several decades (barring 2020). With the Federal Reserve hiking rates aggressively, borrowing costs are rising across the globe and the U.S. dollar has appreciated considerably. And with a significant proportion of trade denominated in U.S. dollars, imports will be more expensive for emerging markets. Foreign denominated debt will be more difficult to service as well. China is the world’s biggest bilateral creditor, but the terms of its lending are unknown and it has so far been reluctant to accept any write-downs. This will make debt restructuring negotiations much more onerous and drawn out. All of these factors could create a perfect storm for emerging markets. Still, many developing economies have better external balances than in past crises, have beefed up their foreign reserves, borrow more in their local currency and have central banks that proactively hiked rates in this cycle. A lost decade in emerging markets may therefore be avoided. In previous emerging market sovereign debt crises, the brunt of the impact was felt on the debtor country and its regional neighbors. The blowback on the West in terms of economic growth is therefore likely to be limited.
Following Prime Minister Mario Draghi’s resignation, Italy will now hold snap elections on September 25. The elections introduce both political and economic risk. A center-right coalition led by the Brothers of Italy (FdI), is the most likely government to emerge. While FdI and its likely partners, Lega and Forza Italia, have toned down their anti-European rhetoric, their policies will be populist in nature and may not involve the kind of restraint necessary to bring Italian finances in line with the EU’s fiscal rules. The new government will have to submit a budget immediately and will have until the end of the year to comply with a number of targets for its use of money from the Recovery and Resilience Fund (RRF). If Italy fails to achieve the latter, it will not receive the next tranche of funding. Italian bond yields have been rising ever since the European Central Bank (ECB) announced it would end its quantitative easing program, which was compressing borrowing costs in the eurozone. With a blow out of Italian spreads over benchmark German bonds, the ECB announced a new anti-fragmentation tool to address an “unwarranted” rise in eurozone borrowing costs. Called the Transmission Protection Instrument (TPI), this new tool is of unspecified size and involves a number of triggers for qualification, including fiscal sustainability, compliance with the fiscal rules and meeting RRF targets. At the moment, it is unclear that Italy would qualify for use of this instrument that was largely designed to suppress its spreads. Italian bond yields fell in the immediate aftermath of the TPI announcement but then ticked back up to levels they reached before the announcement (ameliorated somewhat by significant reinvestment of the Pandemic Emergency Protection Programme away from core eurozone countries towards Italy). Investors seem unconvinced by the tool, and may test it in the run up to or aftermath of the elections. If the TPI does not succeed in containing Italian borrowing costs, we could see the Euro crisis erupt once again. Either the ECB will have to deploy the TPI convincingly, or it will have to force Italy to accept the full conditionality of access to Outright Monetary Transactions (OMT). There is a chance Italy would reject the latter, but we expect the eurozone will do the bare minimum at the last possible moment to keep Italy in the eurozone.
When the pandemic hit, a number of countries were unable to get access to personal protective equipment and the risk of having global supply chains became crystal clear. Economists proffered that supply chains would regionalize or production would be brought onshore. Even U.S. Treasury Secretary Janet Yellen popularized the phrase “friend-shoring.” There is unfortunately no easy metric for globalization, but there are many proxies and the data doesn’t suggest that the world is definitively deglobalizing. World trade to GDP rose for decades before flattening out over the past few years. China became the top destination for new foreign direct investment (FDI) in 2020, overtaking the U.S. FDI into China in the first half of 2022 rose to 723 billion yuan ($112 billion), on track for another record year. A U.S.-China Business Council poll found 78% of American multinationals in China have not moved any segments of their supply chain out of China over the past 12 months. That said, over 20% of American multinationals are pessimistic about the five-year business outlook, double the percentage last year. Companies make decisions about production based on hard calculations for their bottom line over the medium to long-term. Foreign companies can plug into sophisticated, deep supplier networks, large and efficient ports and an able workforce in China. And while many started off using Chinese inputs for exports, they now want access to a big and growing economy. Still, trade tensions between the U.S. and China persist. Just because deglobalization hasn’t taken hold, it may yet still. This would add to the inflationary pressures that the Fed and other central banks are already battling.
When the U.S. weaponized finance in response to the Russian war on Ukraine, it led some economists to surmise that this marked the beginning of the end of the U.S. dollar serving as the global reserve currency. The dollar’s share in foreign exchange reserves has fallen from 71% in 2000 to 59% in Q3 of 2021. But this is still roughly triple that of the second-placed euro. One quarter of former dollar reserves flowed into renminbi. The remainder have gone into smaller economies like Australia, Canada, Singapore, South Korea and Sweden. These economies have all joined in the sanctions against Russia, with the exception of China. They are hardly an obvious bolt hole in future geopolitical conflicts. And in any case the loonie, won and krona are all backed by Fed swap lines; in an emergency they are protected by dollars. Moreover, there is no reasonable alternative to the dollar. For the renminbi to dethrone the dollar, it would require full convertibility and China would have to open its capital account. As China tries to balance longer-term goals such as financial stability, common prosperity and climate change with shorter-term economic growth, it is unlikely to relinquish control over the financial system and capital account. Cryptocurrencies are volatile, particularly in a bear market, and stablecoins are usually backed by dollars. In a multipolar world, we may eventually find alternatives to the dollar, but it seems unlikely we will replace it. If the dollar were to lose global reserve status, the U.S. would lose its exorbitant privilege of having seemingly insatiable demand for its debt.
The open conflict in Europe is a trigger for many of the geopolitical risks we see over the short- and medium-term. As Western sanctions on Russia bite and Russia weaponizes energy, the siege-like standoff between the West and Russia may escalate. Combined with developments in the cryptocurrency space, this will create regulatory and enforcement activity. Risk discounts for this activity should be considered closely in deal-making and investment, and compliance spend will unquestionably go up across the board, but particularly with respect to sanctions and ultimate beneficial owner verification. China’s role in the war on Ukraine remains ambiguous, and China will continue to take note of the weaponization of finance against Russia. Tolerance for high inflation, food insecurity and a cost-of-living crisis will wane as Europe and the U.S. tip into recession over the next year amid aggressive rate hikes. China will probably avoid recession but will post the weakest growth on record save the depths of the pandemic. Economic growth heals all wounds and the global economy will be in short supply over the next year. Geopolitical risk is pervasive and firms would be best served by boosting resilience and awareness rather than trying to avoid it.
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