2014: THE YEAR OF LIVING DANGEROUSLY
When economics and geopolitics collide
By IMD Professor Carlos A. Primo Braga - October 2014
Let me state upfront that the sky is not falling. Near-term economic prospects have not changed much since 2013, with the world economy expected to keep growing around 3 per cent. Although emerging economies have slowed down, they will continue to be major contributors to global growth.1
There is a feeling, however, that uncertainty is increasing. This is often associated with growing concerns about geopolitical risk. In a recent McKinsey Global Survey, 82 per cent of respondents identified geopolitical instability as the biggest potential risk to global economic growth, far higher than the 27 per cent that identified it as a major risk in December 2013. It is clear that the Russia-Ukraine crisis, tensions in the East and South-China Sea, the Israeli-Palestinian conflict, the civil wars in Syria and Iraq, as well as the "Islamic State" (IS) terror campaign and the Ebola crisis are all influencing perceptions of economic prospects.
Will all this bad geopolitical news have a significant impact on economies, businesses and markets? As always, it depends. There are some obvious cases where geopolitics is having an impact. Western sanctions against Russia are affecting investment plans by companies such as Exxon in major oil and gas projects in Russia. Japanese companies are facing tough decisions about doing business in mainland China in view of territorial and historical tensions. As a consequence, Japanese FDI flows into China have decreased significantly. And containment of the Ebola epidemic in Western Africa via travel and trade restrictions may take some fragile states to the brink of social and economic collapse, with potentially significant fallout elsewhere.
If, however, one takes a broader macroeconomic view and focuses on major equity markets around the world, the results are less clear cut. Despite the growing frequency of geopolitical shocks, the S&P 500 Index was up 4.7 per cent from the start of 2014 to October 20th (when the index closed at 1,904). Admittedly, since September 19th (when the index reached a high of 2,019) there has been a significant correction and increased volatility. But all in all, stock markets seem to downplay the importance of geopolitical shocks.
This is not a new pattern. The conventional wisdom is that with the exception of major global conflicts, financial markets are not driven by geopolitical risk. Since World War II very few geopolitical shocks (such as interstate conflicts) have negatively affected stock markets in a sustained manner over time. The last such instance was the Israeli-Arab war of 1973 because of its implications for oil prices.
The usual explanation for this disconnect between geopolitics and markets is that in most cases the economies affected represent a small share of global GDP and are not major magnets for FDI or portfolio investments. The impact of these shocks therefore tends to be localized, and their fallout – beyond the scary headlines – is not significant from a macroeconomic perspective. According to this view, anyone wanting to divine what will drive markets in the coming months should focus on the actions of Janet Yellen and Mario Draghi, as well as those of the People's Bank of China, rather than on Vladimir Putin's strategic moves or the IS atrocities.
This perspective implies that the evolution of U.S. interest rates, the deflationary winds in Europe (and the European Central Bank's dilemma: to QE or not QE), as well as concerns about a Chinese hard landing, will continue to be the main influences on financial markets in the medium term. Although I tend to agree with this analysis, one cannot avoid wondering whether this logic will continue to prevail in a world characterized by growing interdependence.
The recent evolution of the fear factor captured by the Vix index (which measures the implicit volatility of the US stock market) illustrates this concern. Markets seem to be increasingly worried about the capacity of central bankers to manage economic adjustment smoothly. The noise around the concept of "secular stagnation" — as the dominant narrative for growth prospects in the industrialized world — adds to the fear factor. In such an environment, the accumulation of geopolitical stresses can foster irrational "bearish" behavior, transforming a standard market correction into a rout.
It would be a fool's errand to try to predict what geopolitical shock would take us beyond the tipping point. But the chemistry of increasing financial volatility, unusually low interest rates (feeding asset bubbles), and growing geopolitical tensions suggests that even if a disaster is avoided, 2014 will be a year to remember.
Carlos A. Primo Braga is Professor of International Political Economy at IMD, and Director of The Evian Group@IMD. He teaches in the Orchestrating Winning Performance program and also the IMD-CKGSB Dual Executive MBA, which is designed for high-potential, internationally minded executives who are deeply committed to pursuing a career that leads the way between China and the world. Comments from IMD Professor Jean-Pierre Lehmann are gratefully acknowledged.
1 According to the IMF, emerging economies will grow at roughly 5 percent per year in the next five years, more than double the growth estimate for industrialized countries.