Geopolitical Outlook 2018

The Issue With Forecasting

While every year holds its own distinct global risks and opportunities, the world appears particularly vulnerable as it enters 2018. The form Brexit will take is still unclear, there are new tensions in the Middle East to go along with the eternal tensions we have grown accustomed to, Europe threatens to disintegrate in multiple secession efforts similar to Catalonia, two unstable leaders continue to sabre rattle threatening war on the Korean peninsula and the world’s stable leader, the United States, doesn’t seem so stable all of a sudden.

Here, we break down the regions and issues traders need to be aware of. 

Brexit (UK and EU)

The Brexit negotiations are now underway to secure the UK’s exit from the European Union, and a two-year transition arrangement is being negotiated. However, with the details of the post-Brexit financial arrangement and trade terms still to be fully fleshed-out, the prospect of major political instability playing out domestically may cause parliamentary deadlock, and, at the extreme, the downfall of the minority Conservative Party government (a 33% possibility).

The shock impact of the vote to leave the EU has been long factored into assets, with the pound staging a gradual fightback in 2017, trending higher from a low of $1.1950, to $1.3650, as the economic and political fallout has been weathered (see “Pounding back,” below, right). The FTSE-100 is higher, trading around 7,400, but on a flat trend during the second half of 2017, with the UK 10-year benchmark sovereign bond yield flattening out around 1.35%, having reversed its fall by initially preempting the Bank of England’s monetary tightening.

Amid inevitable pockets of currency instability in 2018 caused by economic factors, including interest rate differentials, growth and inflation prospects, the pound should continue to gain against the dollar in 2018. The currency will be supported by progress on the trade discussions, following an agreement in principle to a €40 to €50 billion ($47.16 to $58.95 billion) “divorce bill” payable gradually over several decades, and a fudged resolution to the Irish border anomaly the Democratic Unionist Party supporting the Conservatives is seeking assurances on.

A hard Brexit based on World Trade Organization (WTO) rules (40% probability) is the least likely outcome as Europe’s policymakers play out standard game theory in their mutual interest against the backdrop of increased lobbying, from Germany’s manufacturing industry and others. The pound will gain from the Bank of England tightening monetary policy further, with one or perhaps two more interest rate increases to slow inflation, although the scope for this will be lessened by inflation easing and weak economic growth. Weighing on confidence, the UK Parliament will stretch the Brexit bill debate, but as details surrounding trade rules are cemented this will build confidence, and encourage investment, supporting the pound, and bolstering the FTSE250 share price index, while undermining the FTSE100  Index which is more dependent on dollar earnings. 

The tail risk possibility of complete breakdown in the talks process would also impact on continental European assets that are otherwise taking their cue from changes in ECB strategy and macroeconomic fundamentals.

Italy

Perhaps the biggest tail risk affecting the euro currency and European assets in 2018 is attached to the forthcoming parliamentary elections in Italy, given the prospect of a hung parliament (75% probability) and victory for the euro-sceptic Five Star Movement (M5S; a 45% probability) reinvigorating the populist revolt that has swept across the continent. 

Italy still has a huge sovereign debt to service, bank sector instability to resolve, and there is talk of leaving the Eurozone, all of which would have huge repercussions for Europe following Brexit, putting the euro under pressure and reversing the equity market run driven by improving macro-fundamentals (see “Euro at turning point," left). 

The elections – to be held by May - could take place as early as March, and will be based on a new electoral law enabling political parties to participate as coalitions. It suggests that although M5S is in position to be able to secure victory, presently running the incumbent Democratic Party (PD) extremely close in the opinion polls, the more likely scenario sees the return of Silvio Berlusconi’s center-right party, Forza Italia (FI; a 65% chance), supported by the secessionist Northern League and the smaller far-right party, Brothers of Italy, in pursuit of a broadly market-friendly agenda, but with more devolution.

In light of these prospective coalitions forming, the inexperience of the Five Star Movement in government will prove less concerning than the euro-sceptic stance that it, and other parties, have adopted, especially if the new government ultimately favors staging a referendum on Italy’s continuing membership in the Eurozone; this is considered only a 25% probability mainly because it remains an extreme threat by those who seem to be softening their demands.

Given the possibility coalitions are unable to gain a majority, resulting in extended political uncertainty, one possible outcome is a grand coalition between FI and DP, perhaps with current Prime Minister Paolo Gentiloni remaining in office. Such an outcome (45% probability) would, if stable, underpin Italian assets, and the euro, under the assumption the government would then make consensual progress on tackling the deficit and debt burden — partly by pursuing more privatization — and restoring confidence to the banking sector.
 

Secessionist risk

The populist revolt against globalization, mass migration, marginalization of ethnic and cultural regional differences, and the capacity for copycat self-governance claims will continue to spark global breakaway movements amid the emergence and rise of political parties, and insurgencies, intent on forcing status referendums sparking violent confrontation and instability (as in Catalonia). At the very extreme, as in Ukraine’s eastern Donbass, this instability will not only heighten political risk premia, but also cause major economic dislocation, while underpinning exchange rate volatility, compounded perhaps by other factors such as commodity shocks and the ability, or not, of national governments to quell these threats using measures such as devolution, fiscal spending (where the capacity is available), and recourse to repression on constitutional grounds.

Few secessionist movements have the potential to be as destructive as Ukraine’s, with most generally a medium-to-low risk to assets, including several in Europe: Belgium (Flanders), France (Corsica), Spain (Catalonia and the Basque region), Italy (Veneto, the autonomous region of South Tyrol, and Sicily) as well as pockets of central and eastern Europe. Counter-intuitively, the issue of Scottish independence may resurface as a result of the Brexit negotiations providing an unfair advantage for Northern Ireland, which, given the majority remain vote in Scotland, and the prospect of a steady recovery in oil prices may begin to increase support for the breakaway denied by referendum in 2014. However, support for independence has fallen away sharply and a repeat vote, which may only confirm the unionist outcome last time, would not be possible until the UK’s Brexit arrangements are known.

Of all the secessionist risks, the biggest ones are likely to occur in sub-Saharan Africa, in Cameroon for instance where Anglophone violence in a predominantly francophone country highlights tenuous national sovereignty in countries with tribal and regional divisions, or where colonial disparities are left unresolved. One country which may move towards dissolution is Kenya, where political exclusion and the violence surrounding disputed elections is highlighting deep divisions now encouraging regional governors and parliamentary members favoring secession to become increasingly vocal in their demands for self-determination. This could begin to more seriously impact on the Kenyan shilling in 2018, especially if mass violence erupts, increasing sub-Saharan risk premiums that are already factoring in the rising debt trend on the continent increasing the demand for creditor support.

War on the Korean peninsula

North Korea’s emergence as a nuclear-armed nation has contributed to a heightened risk of military conflict in east Asia, and the danger in that regard is growing as 2017 comes to a close, with Japan recently echoing (albeit in softer tones) U.S. threats to resort to force if the regime in Pyongyang continues to maintain a belligerent posture. Neither U.S. President Donald Trump nor his North Korean counterpart, Kim Jong-un, appears to be inclined to adopt a more conciliatory stance, and with the administration in Washington facing make-or-break mid-term Congressional elections in November 2018, Trump can be expected to ramp up his rhetoric in an attempt to invigorate his base ahead of the voting.

Given the Trump administration’s apparent lack of interest in pursuing negotiations with Pyongyang, which in any case will cease to be a credible option if the U.S. Congress renounces the nuclear agreement concluded with Iran in late 2015, the reliance of both sides on chest-thumping gestures will heighten the risk of mistakes that lead to conflict. The U.S. administration’s threats to impose economic penalties on China if it does not bring North Korea to heel will do little to foster the sort of cooperation among the global powers that might convince Kim to retreat.

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About the Author

Chris McKee is president and CEO of PRS Group, which provides quant-driven political and country-specific risk forecasts. He is also CEO and portfolio manager for PRS’ parent Gavea Emerging Markets. @prs_group