Looking Beyond Turkey: The Wider Risks

This note follows on from our earlier post about Turkey and some of the economic and financial issues we need to focus on. But looking beyond Turkey, what about some of the other risks facing investors?

There are a number of key geopolitical issues also clouding the outlook for financial markets. How they will play out is hard to predict exactly and likely requires scenario planning that anticipates different actions by the key countries involved.

The three current issues are ones we have alluded to and focussed on before – and are likely to be the three key concerns into next year, too. These are the US-China trade war; and to a lesser degree, Brexit; and US-Iranian tensions.

Global growth is steady…

The world economy is growing at a steady pace, at around 3.9% of real GDP growth according to the IMF’s figures in April. The pace of growth, naturally, varies by region and country, but does not suggest an imminent sharp slowdown. The US is growing strongly (at 4.1%), helped by tax cuts, but its pace of growth will slow as interest rates rise. The euro zone has not rebounded strongly in the second quarter of the year (Q2) after poor weather held growth back in Q1 (in both cases growth came in at 0.4%, compared to 0.7% in each quarter in 2017), but we expect it to grow steadily in the second half.

UK growth, meanwhile, has rebounded more strongly in Q2 (0.4%) after a weak Q1 (0.2%) with the National Institute of Economic and Social Research suggesting it may pick up speed slightly (to 0.5%) in Q3. But uncertainty linked to Brexit and domestic politics may yet restrain investment and hold growth back over the coming year. Japan, also, is growing solidly (at 0.5% in Q2) compared to what the markets have generally come to expect. Meanwhile, headline figures suggest China is growing in line with official projections (around 6.5% for 2018), but policy is being eased significantly, perhaps reflecting concern about what lies ahead, particularly if trade tensions deteriorate.

Inflation is creeping higher on many measures globally, yet the general expectation is that structural factors, which have kept inflation in check, will remain in pace. Certainly, intense global competition will restrain inflation, but it will be unlikely to prevent it from creeping higher, particularly in western economies where employment is high. Inflation is still expected to peak at relatively low rates. Wages will be key to watch, alongside the pricing power of firms. In this context, central banks are either having to normalise monetary policy already – or are planning to do so in the future.

…but tension between the US and China is troubling

In this context the US-China trade war is the big concern. Tit for tat is the way this has evolved so far. The US imposes sanctions. China responds. The US reciprocates. The idea, in game theory, is that this continues until both sides fear the other side will not back down and realise it is in both their interests to stop. This was how the markets hoped it would go, without probably thinking it would get this far. Both the US and China have now imposed severe tariffs on imports from one another.

Higher tariffs are a tax on imports, and hurt domestic consumers as they drive up the price of the taxed imported item. Some domestic industries may be able to substitute products and thus benefit, but it is hard to quantify this, as all too often the items are imported because they are cheaper, better or simply not produced in the home country. Moreover, it is hard to ramp up output overnight and even more difficult to plan to do so in future if you don’t know for how long the tariff will be in place. The trouble is, loss of face also becomes an issue when this approach is taken. Unless both sides want to back down simultaneously, neither side will. It may reflect badly on the leader. Trump, in mid election year, and Xi seem unwilling to change tack. This is where diplomacy and back channels provide an escape. If not, then as the IMF suggested in their forecasts prepared for the recent G20 meeting in Argentina, perhaps 0.4% to 0.5% could be shaved off world growth.

Geopolitical anxiety could also bubble to the surface

The other issue – rarely talked about – is the wider geopolitical relationship between the US and China. It would not be a surprise if this was to trigger tensions in other areas – such as the wider issue of the South and East China Seas, where the lasting problem of territorial disputes persist.

Despite current tensions, I doubt it will seriously change the strong economic and trade interaction between the US and East Asia but it leads to wider issues, including the future role of the dollar as the world’s most important currency. This uncertainty is not enough to worry markets now but is sufficiently important to highlight that how the trade dispute is settled is not just about easing current concerns but it is also about mitigating future issues that may arise.

Markets will now be heavily influenced by trade and tariff responses, particularly in the run-up to the November mid-term elections in the US. If the current strains begin to impact forecasts for corporate earnings, investors in equity markets may become less confident. Also, given the recent problems in Turkey, there is increased focus on currency policy in China, too. This is not because the Chinese currency will suffer a speculative attack but more because of the impact it can have on competitiveness elsewhere.

Other concerns are not as prominent, but they still matter

While markets are used to the unpredictable behaviour of Trump, they may need to think about unpredictable actions, too, in the context of Brexit, and the likely behaviour of the EU and UK government. Markets appear likely to take a view that any move towards a WTO or No Deal is negative for sterling. So the pound looks vulnerable in the near term as the future trading relationship remains uncertain.

Also, one should not overlook the US-Iran situation. This may have already taken a path difficult to reverse. It plays out in both geopolitical tensions and a possible greater risk premium being factored into oil prices.

Overall, the world economy has grown at a solid pace but now as monetary policy starts to tighten – albeit gradually – markets appear to becoming more attentive to where risks may arise. But they should also keep focused on the opportunities, too.

Please remember that when investing your capital is at risk.

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