Tensions nearing breaking point?

The devastating impact of COVID-19, and the associated ratcheting up of geopolitical tensions, is likely to create an uncomfortable backdrop for investors for the rest of the year and into next.

Coming into this year we always felt confrontational international relations could infringe upon global growth prospects. The social and economic consequences of the pandemic may magnify existing fault lines, and permanently shift trade trends and transnational cooperation.

Financial markets seem to be focusing on three major areas of tension: the US-China trading relationship, the cohesiveness of the European Union (EU) and the conclusion of Britain’s transition out of the EU.

US-China relations heat up

Fear of an aggressive trade war between the US and China undermined sentiment for much of 2019. The escalating measures proposed by the world’s two largest economies challenged decades of rising international trade that helped to power growth.

Just as last year was drawing to a close, President Donald Trump surprised analysts by announcing that the US and China had agreed to an, initial, “phase-one” trade deal. In a collective sigh of relief, economists’ raised their growth forecasts and investors pushed equities to record highs.

The deal was always going to be vulnerable to this being a US election year, adding to uncertainty for financial markets. The devastating medical and economic ramifications of the COVID-19 outbreak have once again played on tensions between America and China, questioning the stability of the agreement.

The pandemic’s disruption means that it is very unlikely that the latter superpower will meet its commitments to buy US products at the start of the year, further souring the relationship.

Donald Trump became increasingly vocal about China’s response to the outbreak in May. He announced measures including breaking off trade ties, restrictions on investment flows and modifying supply chains.

In addition, the Senate passed legislation that may prohibit the trading of foreign equity issues on American exchanges if the Public Company Accounting Oversight Board is denied access to historical financial data. However, this move does not “ban” Chinese stocks from trading in the US.

The blame game, is just starting and may further heat up in the coming months. Meaningful measures and initiatives are being announced by both countries in the skirmishes. But for now, a full-blown trade war looks unlikely.

Europe: united future or fragmentation?

In order for the European project to work, greater levels of integration and cooperation are required. It is all the more important for member states to consider the collective good in times of economic dislocation.

In the early days of the coronavirus, European leaders focused on stability and stimulus at a national level. This country-centric approach risked alienating weaker members, which have less fiscal ammunition available to limit the impact of the pandemic on their economies. This has led to increased concerns that the EU could begin to fragment.

However, in an unexpected uniting gesture, the German chancellor, Angela Merkel, and French president, Emmanuel Macron, announced a joint proposal for the bloc’s recovery. The two leaders suggested setting up a €750bn recovery fund as part of the next EU long-term budget, to be disbursed as direct grants to sectors and regions most impacted by the crisis. The scheme would be financed by direct borrowings by the European Commission from markets and repaid via a long-term binding repayment plan.

The plan includes proposals to establish a green recovery roadmap for each industrial sector and increase the EU’s 2030 target for greenhouse gas emissions reductions. It also takes a significant step in outlining the future of the EU in the long run. The plan suggests a review of competition rules to create “European champions”, signalling a geopolitical commitment to a more interventionist industrial policy.

The plan still needs to get approval from other member states and there is a good chance that it could be radically amended. That said, it still represents a significant step change, particularly for Germany, which has previously rejected the notion of nations sharing debt.

Fraught Brexit negotiations

Boris Johnson’s Conservatives came to power in December pledging to “Get Brexit Done”. Britain officially left the European Union on 31 January and formally entered a transition period.

The pandemic has understandably reduced the focus on the trade negotiations. The third round of talks on the future relationship between the UK and EU concluded last week. Key areas of contention include “level playing field” commitments, the governance of the agreement and cooperation in criminal and judicial matters.

One of the biggest issues which still requires resolving is the so-called Northern Ireland Protocol. The protocol aims to avoid a hard border on the island of Ireland but is being interpreted in different ways. The UK fears that the arrangement may be an infringement on its sovereignty and a risk to the integrity of the Union. The EU is concerned about the issue of single market integrity.

Extension to the transition period

The UK government continues to rule out requesting an extension to the transition period that is due to end on 31 December. The British prime minister seems to believe that extending the talks would simply prolong the negotiations and create even more uncertainty.

Under the Withdrawal Agreement, any extension needs to be agreed by 1 July. If no settlement can be reached, then the UK will start to trade with the EU under World Trade Organisation rules come 2021.

There continues to be speculation about what might happen towards the end of the year. There is the possibility of a short technical ‘implementation’ extension if an agreement hasn’t been reached in time. But, with only one round of negotiations left before the high-level stocktaking meeting in June, the risk of a potential stalemate before the summer is clearly increasing.

Economic pragmatism should prevail

Rising geopolitical tensions may clog up the arteries of global trade, so reducing growth prospects. The hope is that economic pragmatism will eventually prevail. However, in the world of international diplomacy, nothing should be taken for granted.

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