I started the year unusually worried about geopolitical risks. And as the year has continued, I have continued to worry despite decent global economic growth. I believe geopolitical risks are perhaps the biggest risks to the global economy right now. So I want to give voice to that ahead of the market open.
Geopolitical risks at the highest in 15 years
Here’s how I started the year at Credit Writedowns. These were the very first sentences I wrote in 2018.
Given the economic data, I am starting 2018 in a surprisingly downbeat mood. Everything I see is pointing to continued expansion in the global economy.
Yet, rather than focus on that bright picture, mentally at least, I start this year more alarmed at the geopolitical backdrop than calmed by the synchronized boom. Maybe this is just a mood since I tend to discount political factors as the driving force for economic factors, at least over the short- or medium-term. Nevertheless, something has me worried
It’s more clear now what has me worried. It’s the volatility of likely outcomes in important geopolitical areas. We’re talking trade, North Korea, Iran, Russia and much more. Everything is up in the air right now. We have no idea what is going to happen six months down the line in any one of these situations.
So while political factors normally don’t drive the economics over the short-term, they can supply a huge exogenous shock.
So, it makes sense that Saxo Bank’s Geopolitical Risk Index is now at the highest level since 2003.
The Geopolitical Risk Index (GPR) has reached its highest level since the 2003 invasion of Iraq. The previous high was last August due to North Korean tensions. h/t @Dembik_Chrispic.twitter.com/NodfXb3YoY
— Ole S Hansen (@Ole_S_Hansen) March 15, 2018
Trump’s most aggressive impulses were held in check in 2017
There are a lot of factors at play right now. And I will get into some of them shortly. But most of it is driven by US President Donald Trump. He doesn’t want anyone to know what he will do ahead of time. Uncertainty is a weapon for him. He has said so. And he has brought that weapon to the world’s political stage.
A lot of this uncertainty has been driven by the constant change of personnel in the Trump Administration. Many of the people who signed up with Trump have not proved to have the same ideas on where US policy should be. And despite Trump’s more controlling instincts, during 2017 he listened to these competing visions and showed a good degree of policy restraint.
For example, ahead of the inauguration, Trump floated the idea of recognizing Taiwan. That would have been a monumental change in US foreign policy. China said it was a “non-negotiable” item and Trump backed down. The ‘Taiwan Card’ immediately faded from discussion as a bargaining chip.
The North American Free Trade Agreement is another area where Trump was cajoled into showing restraint in 2017. His instinct was to pull out of NAFTA altogether. Instead, he has started a renegotiation process.
2018 will be marked by ‘Trump Unchained’
The dismissal of Rex Tillerson as Secretary of State and the way it was handled mark a clean break. Gary Cohn was already out as his economic adviser. But it was the Tillerson fiasco that made plain Trump is cleaning house. He is purging all vestiges of opposition to his ‘America First’ doctrine. What Trump wants now is a top-down approach, where he calls the shots and his cabinet executes. That’s a lot easier if they are of the same mindset.
Gary Cohn’s replacement, Larry Kudlow is a supply-sider who agrees on domestic policy with Trump. He was not brought in to engage Trump. He was brought in as a salesman. His job is to sell Trump’s economic agenda to Wall Street. And Kudlow will then have to coordinate with Secretary of State Mnuchin and Commerce Secretary Ross on how to do that on trade. That’s where the pitfalls lie for Kudlow because Trump will want him to toe the protectionist line. And Kudlow is a free-trader.
Apparently, the next to leave is the National Security Adviser McMaster. John Bolton is a potential replacement, one who has already garnered opposition in Congress from the likes of Kentucky Senator Rand Paul. But if someone like Bolton does get into position, it would suit Trump’s instincts for an aggressive policy against Iran and North Korea.
Will an aggressive ‘America First’ foreign policy work?
So, 2018 is shaping up to be a defining year in geopolitics.
On Iran, Israeli Prime Minister Netanyahu is privately predicting that Trump will abandon the Iran nuclear deal. What happens after that is unclear. But it gives either Israel or the United States the cover to stage a military operation against Iranian nuclear facilities. What happens with North Korea will be instructive.
There, Trump has reversed US policy and decided to meet North Korea face-to-face as equals. Many in the foreign policy community are saying this plays into North Korea’s hands. Allegedly, the North Koreans are looking to drive a wedge between South Korea and the US. Moreover, they also say the North Koreans don’t plan to offer any concessions. This is merely a stunt.
But from the Trump position, it is an ultimatum. When Trump meets Kim Jong Un, he will likely say, “meet our demands for disarmament or face destruction”. What other message can he deliver? He is not going to meet the North Koreans and leave empty-handed without issuing an ultimatum.
And then, there’s Russia. It’s not clear where Trump is going on this. He has belatedly issued sanctions and joined Germany and France in support of the UK regarding the Salisbury poisoning. But I don’t see him going much further. Vladimir Putin will seize the initiative. And likely, the Europeans will be left to mount a response with or without the US in tow.
Potential exogenous shocks also include trade
Any one of these situations can blow up. Several involve possible military confrontation, oil price spikes and damage to energy infrastructure. But I haven’t even mentioned the trade side of things. In 2017, Trump did not keep his promises on trade. The domestic agenda — taxes and healthcare — took up too much political space. And even now, the Trump Administration is only getting to other key domestic issues like the opioid crisis.
Trade will dominate 2018 as a policy issue. And Trump plans to keep his promises about protecting US jobs. The goal for Trump is to deliver on his campaign promises. And in so doing, he faces hostility from Congress and key business lobby groups. That means he will have to resort as much as possible to executive actions that cannot be challenged.
That means unilateral action, threats and ultimatums to achieve what he wants. To do so while also minimizing the legal ramifications, Trump is likely to lean heavily on national security as the motivating rationale behind protectionist policies. This is what he did with the Broadcom hostile bid for Qualcomm. And I imagine this is what he will continue to do in other trade areas as well.
The risk of a trade war has, thus, increased. It’s still early days. the aluminum and steel carve outs for Mexico and Canada show flexibility. So we will have to see what happens.
The Fed and Trump are the key uncertainties for the US
I continue to believe the US economy will remain on solid ground throughout 2018. Barring an exogenous shock, the trouble for the US is in mid- to late-2019 at the earliest. The Fed will play a key role here. If the US economy slows, the Fed will need to correctly gauge whether it needs to adjust its tightening timetable to avoid a recession. And we don’t know how the Fed will react to incoming data because the Fed’s reaction function has changed with Jerome Powell’s assumption of leadership.
But the real unknown here is geopolitical, much of it driven by Donald Trump. I believe Trump felt frustrated in 2017 by efforts to rein him in. Moreover, the Russia investigation by James Comey and, later, Robert Mueller, is a weight that hangs over his every decision. As Trump’s poll numbers have remained low, as the stock market has begun to falter, and as Republican candidates he backs lose, these frustrations have boiled over.
With nothing to lose, Trump is now ready to cast off his restraints and take bolder and more aggressive actions on trade and foreign policy. What he chooses to do and how other nations respond will define the economic and political outlook later in the year.