Understanding geopolitical risk

Understanding geopolitical risk

It might seem strange that last Friday’s Israeli missile strike against Iran was greeted with relief in the West, but the attack was at the low end of the range of possible responses. In a world of elevated geopolitical risk the limited nature of the Israeli strike was, in the jargon, ‘de-escalatory’. 

• Tensions in the Middle East and the conflict in Gaza coincide with a full-scale war in Ukraine and the resurgence of superpower competition, with the West at loggerheads with Russia and, increasingly, China.

• Geopolitical risk is back. The Economist Intelligence Unit estimates that 75% of countries are threatened economically by international tensions today, up from about half in 2010. Military spending is on the rise across the world. The US and China increasingly vote on different sides in the UN. A near tripling in the number of countries subject to western financial sanctions since 2010 testifies to growing international discord.

• UK chief financial officers responding to the Deloitte CFO Survey say that geopolitics poses the greatest risk to their businesses over the next 12 months, eclipsing worries about inflation and interest rates. 

• Geopolitical risk is not homogenous. It comprises a range of related and unrelated events. In thinking about geopolitical risk we need to distinguish between the social and political consequences and wider economic effects, beyond the region.

• Geopolitical shocks are not necessarily economic shocks – at least at a global level. The effects on the local or national economy, as in Ukraine or Gaza, can be devastating. Surrounding countries may also be affected, as, for instance, has been the case with Egypt, where revenues from tourism and the Suez Canal have been hit by the conflict in Gaza.

• But the impact beyond the region may be limited or transient. The 9/11 terrorist attack was one of the greatest geopolitical shocks of the post-war period. It triggered US-led invasions of Afghanistan and Iraq, lengthy wars and major political changes in the Middle East. Yet it had little lasting economic impact on the West.

• Contrast this with the impact on Europe of Russia’s invasion of Ukraine. Here energy and other commodity prices and the curtailing of Russian gas exports were the transmission mechanism that turned the invasion into an economic crisis for Europe. The result was high inflation and a weakening of activity, particularly in Germany.

• Energy was also the channel through which the Arab-Israel war of 1973 became a global economic crisis. In response to the US providing military support to Israel, Arab producers imposed an embargo on oil exports. It led to a nearly fourfold rise in oil prices and resulted in much of the West, including the US, Japan and the UK, falling into recession. Spikes in oil prices were also seen following the Iranian revolution in 1979 and the invasion of Kuwait in 1990, both of which also preceded recessions in the West.

• Geopolitical shocks that affect supply, prices or trade have the greatest capacity to wreak wider economic damage. Examples include Houthi attacks on shipping in the Red Sea, potential disruption to semi-conductor exports from Taiwan or the control of rare earth metal exports.

• Financial markets provide another channel through which geopolitical shocks can cause economic damage. Abrupt movements of mobile capital weaken currencies, cause destabilising fluctuations in equity and other financial markets and affect the supply of liquidity and credit. Emerging economies are more vulnerable to such effects than advanced economies, though the latter are not immune. (The 9/11 attacks, while having little lasting economic impact, resulted in the closure of the US equity markets for the rest of the week, an inability to clear cheques because of the suspension of flights and soaring demand for cash.)

• This is not just about shocks. More gradual geopolitical shifts can have significant economic effects too. Rising international tensions have contributed to a weakening of cross-border capital flows and investment and created a more difficult climate for trade. Just as the economic liberalisation of the 1980s to early 2000s helped drive global growth, today’s economic distancing is acting as a drag on activity. 

• The post-cold war era of consensus in the late 1990s and early 2000s now seems like a short interlude from the geopolitical rivalries of most of the 20th century. America was the principal architect and guarantor of the post-war international order. But, at least in relative terms, America is a declining economic power. This speaks to a world where geopolitical risk is likely to remain elevated.

• In one key respect things have improved. The world is better placed to deal with disruption to energy supply than in the past. Energy markets are more efficient, integrated and contestable than they were in the 1970s. Shale fracking has led to a huge increase in US energy production, weakening OPEC’s hold over supply. Consumer nations now have petroleum reserves that can be used to protect against shortages. Renewable energy production is rising.

• All these factors – along with huge levels of government subsidies – mean that the economic fallout from energy following Russia’s invasion of Ukraine was far less severe than had been feared. (At the time a severe recession seemed quite likely.) Europe switched remarkably quickly from Russia to imported liquefied natural gas from the US, the Middle East and Australia.

• Systems and economies are adaptable and responsive. In many respects they have proved surprisingly resilient in the face of the multiple shocks of the last decade or so. Geopolitical risk is unlikely to abate. The need is to be prepared for it.

OUR REVIEW OF LAST WEEK’S NEWS
The UK FTSE 100 equity index ended the week down 1.25% at 7,896. The index dropped on Tuesday as expectations of rapid rate cuts in the US faded.

Economics

• UK inflation fell to 3.2% in the 12 months to March, a lower-than-expected fall from 3.4% the previous month
• Core inflation and services inflation also saw modest declines but remained above the headline reading, at 4.2% and 6.0%, respectively
• UK wage growth was stable at 5.6% in the three months to February compared with the same period last year. Analysts had expected a slight decline
• UK unemployment rose by 0.3 percentage points to 4.2% in the three months to February compared with the preceding three months. Bank of England policymakers will have to weigh continued wage pressures against signs of falling worker bargaining power in deciding monetary policy
• The UK government has advised its port authorities that it will not enforce border checks on food and plant imports from the EU as planned later this month, instead opting for a phased approach, the FT reports
• The IMF published forecasts predicting strong growth in output in the US and emerging markets this year and slower growth in other advanced economies
• US retail sales grew by 0.7% from February to March, the latest in a string of red-hot data from the world’s largest economy
• US president Joe Biden called for a tripling in tariffs on imports of Chinese steel and aluminium
• The price of cocoa, a key ingredient in chocolate, hit a record high following disease and poor weather linked to climate change in west Africa
• The Japanese yen fell to its lowest level against the dollar since 1990. Following this the US, Korean and Japanese governments issued a joint statement that they would “consult closely on foreign exchange market developments”, highlighting concern over currency weakness
• The Chinese economy posted growth of 5.3% in the first quarter compared with the same period last year. A fall in property investment of 9.5% was offset by a 9.9% increase in manufacturing investment. This evidence of manufacturing-led growth will do little to assuage concerns of Chinese industrial overcapacity
• The VIX volatility index, sometimes called Wall Street’s fear gauge, hit its highest level since the aftermath of the Hamas attack on Israel last October. Fears over escalating conflict in the Middle East and fading expectations for rate cuts this year are the likely drivers
• UK prime minister Rishi Sunak spoke of the need to “change the sick note culture” in the UK in a speech on welfare reform, claiming that spending on Personal Independence Payment is forecast to increase by 50% over the next four years

Business

• Troubled UK utility Thames Water could be nationalised with lenders to the operating company facing losses of up to 40% under government contingency plans, the Guardian reports
• Blackstone president Jonathan Gray said that it would take time for private equity firms to return cash to investors. This follows two years of turgid M&A activity that has led to a record backlog of unsold assets
• UK car insurance prices fell for the first time in two years in the first quarter but are still up 43% on the year, according to data from Confused.com and WTW
• Streaming giant Netflix reported a 54% rise in operating income in the first quarter as its efforts to crack down on password sharing last year bore fruit
• Apple removed Meta’s Whatsapp and Threads apps from its App Store at the direction of the Chinese government due to national security concerns
• UK MPs voted to ban anyone born in or after 2009 from ever purchasing cigarettes, leading to an effective ban over time

Global and political developments

• Israel launched missiles against targets in Iran, including the city of Isfahan, which is home to military and atomic sites 
• Prior to this, the Iranian government had said that it may “reconsider” its nuclear doctrine, which it claims is peaceful, should Israel threaten its nuclear installations
• The International Atomic Energy Agency confirmed that there had been no damage to nuclear sites on Friday
• Iranian oil exports are at a six-year high, selling 1.56m barrels a day mostly to China in the first three months of the year despite Western sanctions, according to data from Vortexa
• The Scottish government dropped a target to reduce Scottish greenhouse gas emissions by 75% by 2030 relative to 1990 levels. This follows insufficient progress on emissions reduction
• Peter Murrell, former chief executive of the Scottish National Party and husband of former first minister Nicola Sturgeon, was charged in connection with the embezzlement of party funds
• Police in Germany apprehended two men it suspects are Russian agents who were planning to bomb military and industrial sites to disrupt aid deliveries to Ukraine. Police in Poland also detained a man suspected of passing information to Russian agents
• Indians began voting last week in a six-week election that is expected to deliver another five-year term for prime minister Narendra Modi
• The European Commission said that it seek its members' approval to offer a youth mobility scheme to the UK, allowing young people in the UK and EU the ability to work and study on both sides of the Channel. The Labour Party downplayed the offer, saying it would cross red lines on freedom of movement
• The US House of Representatives approved a new $61bn package of military assistance for Ukraine after six months of delays. Ukraine will face a major challenge deploying new US weapons at speed to stem Russia’s advance

And finally… the largest pumpkin grown in Australia this year has been given a second lease of life after being dug out and paddled down the river Tumut by a former commodore of the local canoe club. The voyage of the 407-kilo gourd is thought to be a first – a hollow victory