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Geopolitical risk as a source of social, economic, and financial uncertainty across the globe has surged since the start of the Russia-Ukraine conflict on February 24. The spike in geopolitical risk will probably surpass the stress witnessed over the 9/11 terrorist attack. The 9/11 2001 tragedy was related to an act of terror directly leading to the 2003 Iraq war. Over the past 120 years, the 9/11 attack ranks third in the scale of geopolitical risks. WWI and WWII started on spikes of geopolitical threats, followed by realisation and escalations of conflict. The Korean, Gulf and Iraq wars were protracted conflicts that did not escalate beyond their region. The 3-year Korean war tested the fragile balance of powers between the US supporting South Korea versus the China-Soviet Union alliance supporting North Korea. A peace treaty was never signed and both countries are technically still at war. The Gulf and Iraq military conflicts raised the overall terrorist threat with devastating expressions in Paris and Brussels in 2015 and 2016.
The current conflict involves a global power. Russia has about 850k active military personnel against 3.3 million for NATO and 200k for Ukraine. NATO allies dwarf Russia on aircraft, armoured vehicles and naval fleet by a factor of 5, 4 and 3 respectively. However, in the number of nuclear warheads and number of tanks Russia equals NATO military power. The disruption of a normal, democratic and peaceful course of relations between ‘the West’ and Russia has never been so acute as today. The October 1962 Cuban missile crisis was over and done with in exactly 13 days.
Heightened threats of adverse geopolitical events impact the business and financial cycle. The impacts can be measured through the obstruction in trade channels, deviations of capital flows, increased volatility in macro-economic indicators (GDP growth, fiscal impulse or inflation) and lower levels of sentiment, confidence.
The current, multiple standard deviations, upside shock in geopolitical risk will resonate and depress global potential growth over 2022 to 2024. Countries closer to the conflict will see a greater negative impact on potential real GDP growth, slower growth in total factor productivity (technology) and higher military spending. Early evidence is present across Eastern European countries but also Germany. The German ZEW index measuring economic growth expectations fell by 93 points this week towards -39, a drop never before witnessed in the history of the index.
The immediate reaction of financial markets to the conflict was a short-lived drop in US stock markets. Taking February 24 as the starting point, a low was made on March 14 followed by a steady rise that results in a +3% to +5% across Nasdaq, S&P 500 and Dow Jones indexes during the conflict episode. Rates on 2-year Treasuries dropped from 1.58% to 1.35% by March 1 but quickly took their cue from the FED, who were rolling out a steady policy rate normalisation. 2-year Treasury rates closed at 1.93% last week. In stark contrast, we pencil in a stable 2-year German rate fluctuating between -0.30% and -0.40%. The recovery in German or other Eastern European equity market was also present, yet, less pronounced between +1% and +2.5% as of February 24.
Notwithstanding, short-term market gyrations are hiding what we see below the surface when geopolitical threats increase in a sustained manner. At current threat levels, expect fixed investments across firms and industries to gradually decline by about 1.5% over the next twelve months. Expect also that labour conditions will start to deteriorate as companies start to pause hiring as they prepare for downside earnings adjustments.
Expect companies and industries, negatively exposed to increased geopolitical risk, to underperform average market results. On the other side, some industries will tend to outperform once higher geopolitical threat and conflict becomes embedded in the financial system. High fixed cost and R&D heavy companies operating in airline, automobile or pharmaceutical industries suffer, while companies with lower variable cost structures tend to resist and outperform. Also, be aware of government involvement as energy and food inflation will nurture activism. The political zeal calling for nationalisations in utility sectors in order to control, limit spiralling prices for basic goods will become part of their agenda
The spike of geopolitical stress in combination with the lingering pandemic-induced economic uncertainty is not a recipe that inspires market stability over the medium-term. Moreover, central banks have decided to protect their inflation fighting credentials, literally, ‘at all cost’. Even at the cost of causing recessionary risks to rise and materialise. They are aware that long-term damage inflicted by persistent unanchored inflation has to be avoided. Even if today’s labour market is healthy, the longer inflation remains too high for comfort and off target, the higher the probability that rising unemployment makes an unwelcome comeback.
Trade, cyber, chip wars, as displays of economic wars, have littered a protracted growth path since the Great Financial Crisis of 2008. Today, trying to recover from the ills caused by a global health crisis, we add military conflict and geopolitical risk levels not witnessed over the past 70 years.
De-escalation among all parties, not resulting in a pause but a full arrest of the military conflict, should be the only acceptable solution to cease human suffering and distress. Global geopolitical risk has risen to unbearably high levels. Correlation between threats and acts of military conflict run at about 0.60 since 1900 and 0.45 since 1985. We can only hope for a steep drop in geopolitical stress but have to prepare for less obvious scenarios.