Geopolitical. Outlook

Transcription

1 2018 Global Market Outlook Step Forward, Look Both Ways The Macro Picture Geopolitical Outlook Will Markets Be More Skittish in 2018? Elliot Hentov, Ph.D. Head of Policy and Research, Official Institutions Group Transition Challenges Shifts in regional security alliances continue to pose risks for the established international order Fragmentation Process Events like Brexit and the renegotiation of NAFTA can create both risks and opportunities for investors Change Drivers China's increasing importance and strength challenge existing norms and market assumptions

2 What surprised us in 2017 was the extraordinary complacency markets showed to geopolitical surprises: neither the UK s unexpected snap election result nor multiple Trump legislative defeats nor even nuclear saber-rattling with North Korea upset markets more than temporarily. The VIX¹ remained in historically low territory. Stable growth, low inflation and strong earnings, as well as continued investor faith in central bank backstops, seemed to matter more to investors and sent risk assets higher. While 2018 holds fewer electoral milestones than last year, we still believe market participants need to stay acutely aware of geopolitical developments because so much of the global political order is now shifting. As many of the trade and security assumptions of the last 70 years seem less certain, investors need to discern what a new global order might look like. That will have direct implications for political risks, trade flows, commodity markets and, ultimately, global growth. In this regard, geopolitics not only constitutes potential downside risks, but also offers new opportunities worth exploring for global portfolios. For the coming year, we see three vectors of relevance for investors Transitions, Fragmentation and New Change Drivers. 1 The CBOE Volatility Index 2

3 Transitions Heighten Miscalculation Risks Like a patient undergoing an organ transplant, the greatest danger occurs when the old organ is removed and the new organ has yet to be integrated into the body. The greatest geopolitical risks arise after the old rules no longer apply but before the new order s conventions are understood. This is where the chance of miscalculation is greatest. From 1991 to 2008, Western-inspired security architecture and international institutions served as the world s anchor. Since then, this anchor has been decaying, as power has shifted toward Asia, and other regional powers have filled the vacuum of a gradually receding United States. Geopolitical flashpoints carry more risk, especially where there is no longer a predictable US approach. Tail risks such as war on the Korean peninsula may still be remote but are higher than before. Above all, such conflicts could spill over into other international tensions for example, US China relations with potential damage to trade and capital flows. Figure 1 S&P 500 Market reaction to geopolitical events As Figure 1 shows, geopolitical events like military conflicts usually affect markets only for a short time, as some have limited economic repercussions and do not necessarily change fundamentals like earnings and credit risk. Event Dates of market reaction S&P 500 Cumulative decline during reaction Performance, 1 month after reaction Performance, 1 year after reaction Trading days to recoup US operation in Cambodia 29 April 14 May % -1.40% +35.5% 75 October War & Oil Embargo 6 26 October % -13.3% -37.1% 1576 Iranian hostage crisis 2 7 November % +7.7% +29.3% 3 US invasion of Panama December % -1% -3.6% 7 Iraq invades Kuwait 2 23 August % -0.8% +28.4% 115 US embassy bombings in Africa 7 14 August % -3.1% +25.2% 2 Kargil war (India-Pakistan) May June 1999 negligible effect on markets 9/11 attacks September % +12.8% -13.7% 24 Arab Spring reaches Libya 20 February 19 March % +2.0% +6.4% 27 Russian annexation of Crimea February March 2014 negligible effect on markets Source: Bloomberg Finance, L.P. The universe is the S&P 500 Index in the time periods listed above. Past performance is not a guarantee of future results. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect capital gains and losses, income, and the reinvestment of dividends. Performance is calculated in USD. You cannot invest directly in an index. 3

4 Fragmentation Without Replacement The clearest sign of a new era emerging is the dissolution of old structures and institutions. In the early 1990s, we witnessed the disintegration of multinational states, such as Yugoslavia and the Soviet Union, and their supranational organizations like the Warsaw Pact. However, the pieces were reassembled quickly, with Eastern Europe participating in the EU and NATO while parts of the former Soviet Union were reconsolidated into a range of regional alliances. So far we see a gradual erosion rather than disintegration or collapse, though some signposts are similar. Despite the idiosyncratic reasons for Brexit, the renegotiation of NAFTA and the de facto expulsion of Qatar from the Gulf Cooperation Council (GCC), these events are shattering various pillars of the international order. This fragmentation process creates both risks and opportunities for investors. On the one hand, there are costs in the form of direct disruption to trade and capital flows, as in Qatar. The breakdown of economic integration mechanisms also generates opportunity costs when factors that previously underpinned global growth begin to dissipate. This can trigger repricing shocks, notably in currency markets, which are often the first to react, as we saw with sterling after Brexit. The process is nonlinear, with considerable uncertainty as it unfolds. On the other hand, history teaches us that fragmentation can also have a positive result. The collapse of the Bretton Woods system in the 1970s opened up significant opportunities for currency trading. Prospective EU membership in the 1990s helped frame transition strategies for East European countries and attracted Western investment. And in today s Europe, a smaller EU could implement tangible reforms that would make the region more competitive. New Change Drivers While not a new phenomenon, China s rise needs to be considered alongside other geopolitical challengers and their various reactions to transition and fragmentation. For example, regional powers like Russia can act tactically and opportunistically, engendering risk by widening the scope of error and exacerbating crises. These actions have ripple effects, as when Russia s support of the Syrian regime eventually led to mass refugee flows in turn heightening the risk of populism across Europe and instability in transit countries such as Turkey. By contrast, the rise of China has proceeded more strategically and incrementally. China s importance allows it to challenge existing norms and test market assumptions with a number of effects. First, accounting for roughly 40% of global growth since 2008, China already plays a sizable economic role, impacting investment beyond its domestic economy to commodity production in Africa and transport links across Eurasia. Second, with this increasingly important global role, China can actively mitigate geopolitical risks by providing new defensive assets, promoting a new Pacific trade regime and sponsoring new global institutions such as the Asian Infrastructure Investment Bank (AIIB). 4

5 Policy Overview From a policy perspective, most emerging markets have withstood the early part of the US tightening cycle well, aided by a weaker US dollar last year. China s development will heavily affect the policy stance of commodity exporters. Improving global trade volumes may encourage economies whose exports occupy the middle of the global value chain, but long-term risks from protectionism still loom. With regard to structural reform, emerging markets are on divergent paths. Some have made great progress in pension reform and central bank independence as well as reducing the size of the informal economy and helping to build long-term fiscal and monetary sustainability. At the same time, commodity exporters and others continue to face governance and corruption issues. Below we outline some of the major policy changes and chances of progress for major economies and emerging markets in the year to come. Major Economies Monetary Stance Fiscal Stance Key Reform Agenda Type What to watch Chance of progress* United States Tightening Slightly expansionary Tax reform Shift of focus from corporate tax to personal income tax, possible middle-class tax cut and simplification of deductions Healthcare reform Fiscally: some form of Obamacare repeal makes room for tax cuts. Politically: key indicator of Trump s relationship with moderate Republicans NAFTA renegotiation More specific demands from US side, possible wildcat moves by Trump China Neutral Slightly expansionary State-owned enterprises (SOE) Broad goal is putting SOEs on more marketbased footing; two key prerequisites to resolve are debt overhang and excess capacity Capital account Continued gradual opening of capital account and lowering entry barriers to foreign capital Eurozone In transition to tightening Slightly expansionary Fiscal integration Developing European Monetary Fund, European-wide unemployment insurance scheme Banking union Creating European Deposit Insurance Scheme and completing single rule book Japan Slightly expansionary Slightly tightening Labor market Further reforms to boost wages, reduce overworking and narrow labor market duality Source: SSGA Research. 5

6 Emerging Markets Country Key Reform Agenda Type What to watch Chance of progress* Brazil Labor code reform More flexibility in collective agreements and part-time contracts, ending mandatory labor union dues Pension reform Restricting early retirement, decelerating accrual of benefits, limiting payouts of survival benefits, tightening civil service pension rules Central bank independence Removal of president s right to dismiss central bank directors India Banking sector reform Consolidation and professionalization of state-owned banks Cashless society Restrictions on cash transactions, incentives for using bank accounts through subsidy reform, promotion of pension schemes for informal sector Labor market Removing government approval for layoffs in medium-sized businesses, relaxing labor inspection regime Indonesia FDI opening Sector-by-sector relaxation of barriers to foreign direct investment Labor market Liberalizing labor regulations Malaysia Subsidy reform Removal of food and energy subsidies alongside liberalization of fuel markets Ethnic subsidies Reducing Malay-oriented set of rules Mexico Energy reform Ensuring conditions for further outsourcing of Pemex s fields to private bidders High Philippines Corporate tax rate Cut from 32% to 25% FDI opening Constitutional reform allowing higher foreign ownership and opening new sectors to FDI Russia Tax reform Hikes in VAT and income taxes, introduction of deductible allowance, cuts in payroll tax Pension reform Increasing retirement ages, unfreezing second-pillar contributions South Africa Mining sector reform Increase in mining regulations, greater government control over mining rights, additional racial quotas on mining rights Labor market Restrictions on collective bargaining, relaxation of labor rules for SMEs Turkey Labor market Increasing flexibility of labor contracts Source: SSGA Research, Eurasia Group. *The above chances of progress are based on certain assumptions and analysis made by SSGA. There is no guarantee these presumed changes of progress will be achieved. 6

7 Elections Latin America has the busiest electoral cycle in late 2017 and 2018, with national-level elections in six major economies, two of which are parliamentary and presidential at the same time. While the region was often viewed as riding against the populist wave that dominated the rest of the world in , this assumption will be challenged as structural reforms in areas such as pensions and energy are back on the agenda. In Europe, the electoral cycle is quieter than in 2017, but the vote in Italy could be crucial to both the country s political direction and the eurozone s future. In the US, mid-term elections will be closely watched for signs of weakening support for Trump s Republican Party. Presidential Parliamentary 2018 March 18 April Spring May No later than 20 Russia Admission or exclusion of independent opposition candidate Navalny, repercussions of either option Hungary Prime Minister Orban s ability to retain constitutional majority Italy Performance of populist Five Star Movement, new electoral system with restricted majority bonus 27 Colombia President Santos barred from seeking re-election, election may be fought around FARC peace deal June 5 July 1 Mid/late 2018 August No later than 24 October Pakistan Elections may be delayed due to delay in census; overall political stability important to region Mexico Key issues for centrist and far-left candidates include crime, corruption and structural reforms Thailand First election since new constitution approved by referendum in 2016, with uncertain outcome Malaysia Potential snap elections given alleged scandals revolving around Prime Minister Najib Venezuela Crackdown on opposition likely to re-intensify, peaceful election conduct unlikely 7 Brazil President Temer not seeking re-election, pension reform and fiscal policy likely to dominate agenda November 6 United States Primary results in both parties, effects of Trump, seat allocations in both houses Source: SSGA Research. 7

8 Geopolitical Heat Map The heat map below highlights the key points of geopolitical tension we believe investors should monitor in High Washington DC United States London United Kingdom Damascus Syria Moscow Russia Beijing China Global trade and security risks, plus mid-term elections Brussels Belgium Ongoing Brexit negotiations Baghdad Iraq Civil war and Kurdish secession Russian political and military interventions abroad Growth changes the balance of world affairs Caracas Venezuela Sovereign default and economic implosion Barcelona Spain Catalan secession adds another risk to EU politics Rome Italy Elections due before May 2018 Tehran Iran US withdrawal of support for nuclear deal Pyongyang North Korea Nuclear stance heightens tension with the US Source: SSGA Official Institutions Group as of 31 October,

9 Glossary Chicago Board Options Exchange (CBOE) Volatility Index (VIX) An index constructed using the implied volatilities of a range of S&P 500 options to forecast 30-day volatility. North American Free Trade Agreement (NAFTA) A pact negotiated by Canada, Mexico and the US that came into force in

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