Investors' Guide to Geopolitical Risk
Lately, news stories have been filled with geopolitical developments, including Chinese balloons, the ongoing war in Ukraine, trade disputes, and the U.S. debt ceiling standoff to name a few. Yet, the Federal Reserve's Geopolitical Risk Index has eased, moving back to its long-term average, as you can see in the chart below. So, should investors be concerned about these geopolitical developments? Or is it business as usual? We believe the answer is both. Let's examine some of the recent geopolitical tensions and their potential impact on investors.
Back to business as usual?
Source: Charles Schwab, Macrobond, Board of Governors of the Federal Reserve System as of 2/10/2023.
Index level 100 represents the baseline for the index.
Last November at the G20 conference, Presidents Joe Biden and Xi Jinping pledged to stabilize the tense U.S.-China relationship. Thus far, an easing of tensions has been elusive. The purpose of Secretary of State Blinken's trip that was cancelled in the wake of the incidents involving Chinese spy balloons earlier this month was to establish a floor in deteriorating U.S.-China relations. The postponement of Blinken's trip was not welcome news for Beijing, whose focus for 2023 is a domestic economic recovery, rather than international relations. In contrast, the U.S. administration may seek some improvement in relations so the Blinken trip could be rescheduled. There is a short window to do so before the start of China's National People’s Congress in early March. This setback will likely make it harder for them to manage potential upcoming flashpoints—events at which trouble, such as violence, flares up—in the coming weeks and months that have potential impact to financial markets.
Flashpoints that could escalate tensions:
- There are plans for Taiwan visits by House Foreign Affairs Committee Chairman McCaul (likely April) and House Speaker McCarthy (later this year). China's reaction to the McCarthy trip could provoke an even stronger reaction than former Speaker Pelosi's visit last fall.
- If Chinese companies are found to be providing significant aid to Russia's war effort, it could spur calls for secondary sanctions on China. It looked like China had largely refrained from providing material help, but a few recent press reports suggest there may be more military equipment sales than previously thought, in violation of Western sanctions.
- How far-reaching the administration's forthcoming executive order on U.S. investment in China will be is yet unknown. The widely held expectation is that the order will limit investment in a narrow range of sensitive industries that have military applications (such as A.I. and certain high-tech equipment). Yet, it's possible that a broader ban on U.S. investment in Chinese firms emerges alongside legislate efforts to ban TikTok.
Despite these potential flashpoints, we feel that a continued rise in tensions with the U.S. this year is unlikely to have much impact on China's economic recovery, which will depend mainly on domestic strength stemming from the post-COVID rebound in consumer demand.
The market appears to be pricing in hope that the intensity of the Ukraine war subsides and perhaps even moves toward a negotiated resolution, potentially ending military hostilities and limiting risks of re-escalation. It seems likely that any path to end the fighting would involve resolving Ukraine's claim to Crimea, which was seized by Russia in 2014. Any move by Ukraine to retake that territory may be Putin's red line. Should Ukraine cross into Crimea after continuing to push through Kherson, the risk of escalation by Russia could rise.
An escalation could take the form of further large-scale attacks on civilian infrastructure or restrictions on export capacity through military constraints on the use of Black Sea shipping routes. But even more worrisome, escalation may take the form of using prohibited nuclear, biological, or chemical weapons to defend what Russia sees as Russian territory, preemptively striking arms shipments to Ukraine by members of NATO, or even purposefully or inadvertently drawing neighboring countries into the conflict with either intentional or unintentional military strikes.
What we do know is that a long history of drawn-out conflicts involving oil producers tends to effect energy supply and prices. We initially observed it in 2022—but its full impact has not yet been realized. Today, oil tankers carrying Russian oil that had been going to Europe must now ship their cargo further to have it reach customers in India and China. These longer voyages are tying up oil tankers for longer timeframes and creating a global shortage of available ships. At the same time, China's demand for oil is rebounding from below trend levels. If the transportation shortage translates into tighter supplies or higher prices it could slow global growth and lift inflation.
Oil tanker shipping rates soared even as containership rates fell
Source: Charles Schwab, Drewry, Bloomberg data as of 2/10/2023.
United Kingdom-European Union
After years of negotiations, the European Union (EU) and the United Kingdom are nearing a deal to amend the Brexit agreement's requirement for customs controls at the Irish Sea to prevent a hard land border between Northern Ireland and the Republic of Ireland. The European Union had expressed concern that lifting customs and controls at the Irish Sea would turn Northern Ireland into an illegal backdoor for U.K. goods entering the EU single market.
News reports last week seem to indicate that the EU has agreed to remove most customs controls and checks for goods originating in Great Britain whose destination is Northern Ireland, and to only apply full controls and checks for goods whose destination is the Republic of Ireland and the broader EU single market. If implemented, this would meet a longstanding British demand to treat goods differently depending on their destination and greatly lower the probability of a European trade war that could increase inflation in both territories by disrupting their free trade agreement.
While an agreement on customs controls significantly increases the probability of a deal, technical and political obstacles could still derail a compromise and subsequently result in a trade war:
- After initially agreeing in 2019, the U.K. now objects to Northern Ireland being subject to a foreign court of justice and has demanded that a separate arbitration panel be created to oversee any potential bilateral disputes.
- Northern Ireland must comply with EU single-market rules on issues such as value added tax and state aid, which is very controversial in the United Kingdom.
- The British government is dealing with domestic opposition from hardline members of the Conservative Party and unionist forces in Northern Ireland, which may push any deal to be put to a vote in Parliament.
The United States hit the debt ceiling on January 19 (for a deeper look at what it may mean see Mike Townsend's recent article: U.S. Hits Debt Ceiling: Will It Impact Investors?). A deeply divided Congress still has five or six months to find a path to raising it and avoiding a default or funding delay in the U.S. Treasury market, the deepest and most liquid market in the world, and a central component of the global financial system.
There are no other countries we can look to as a guide on the impact of a debt-ceiling-driven default. Only Poland, Kenya, Malaysia, Namibia, and Pakistan currently limit the amount of government debt. Why so few? Likely because there is no evidence to suggest it limits spending. In fact, Poland's state auditor found that the government used "unprecedented mechanisms" to spend more than rules allow. Notably, Australia policymakers abandoned their debt ceiling entirely in 2013 after six years of repeatedly having to increase it.
Countries with a debt limit
Source: Charles Schwab, created with mapchart.net as of 2/9/2023.
In the U.S., the two sides appear to be at an impasse:
- Republicans say they won't agree to a debt limit increase unless it accompanies spending cuts (although most spending appears to be off the table).
- Democrats say they will only support a debt limit increase without cuts or other changes.
But, as Mike Townsend points out, the fact that talks about a resolution are taking place several months ahead of the default deadline could be a positive sign.
- Taiwan-China: Surveys of Taiwan's people do not reflect a strong enough preference for the democratically elected leaders to declare independence from mainland China. Yet Taiwan will hold presidential elections in January 2024 and independence may be discussed. The candidate for the current ruling party (DPP) is likely the current vice president, who has been more outspoken on the issue of Taiwan's independence than the sitting president. Any talk of Taiwan independence could weigh on market sentiment, stoking concerns of the prospect for a tense four years under his presidency. On the other hand, if polls during 2023 show a potential win in January by the pro-mainland KMT party, it may lower tensions.
- United States-North Korea: Washington has been largely ignoring North Korea, despite a sharp increase in missile firings in 2022. But a major new provocation, such as resuming nuclear tests, may compel a tougher response.
- Iran-Israel: Israel's new government reportedly staged a drone attack on a military complex in the Iranian city of Isfahan at the end of January. With talks on the Joint Comprehensive Plan of Action (JCPOA) still stalled, there are concerns Iran is enhancing its uranium-enriching capabilities. Escalation between Iran and Israel could ramp up and ensnare other countries in the region. Oil shipments from Iran are suspected to be evading sanctions, which could be re-enforced, and result in an increase in energy prices.
While threats flare up from time to time, it is important to keep in mind that geopolitical risks are an ever-present part of investing. Despite the recent news of geopolitical tensions, the risks are not necessarily higher now than on average in the past. But even when geopolitical risk is "average" it remains an important consideration. That is one reason why it is important to diversify, which may lessen the volatility that can result. As always, we will continue to keep a close eye on these developments and how they may impact investors.