Risks Remain Elevated
- The market’s response to political risks was relatively muted in 2017. The disconnect between the political and economic as well as financial markets performance is a potential risk in Citi’s view.
- Unless they cause a global recession, geopolitical events have historically not caused a synchronised and sustained sell-off in the financial markets. Attractively priced equity and bond markets can perform well as long as the crisis is not systemic, allowing investors to reap benefits from regional diversification.
Some of the main political signposts and geopolitical risks that could move markets in 2018 include:
- The US is pursuing significant changes in its trade relations, including NAFTA and with China.
- While not their base case, Citi analysts think trade wars could be a major downside risk for global growth, with countries most affected being those most open and reliant on foreign capital flows as well as external demand such as China, Mexico and Canada.
- Geopolitical tensions in North Korea could escalate, including more aggressive missile tests and military confrontation.
- Citi analysts believe global risk aversion could likely rise, hurting financial market sentiment and the global investment climate – particularly if the US was involved and if tensions with China rose.
- 2018 will be the first year of President Xi Jinping’s second term and will also mark the 40th anniversary of China’s “Reforms and Opening Up”, potentially creating policy uncertainty in China.
- There may also be changes to China’s monetary policy. While the current central bank governor may extend his term, he has grown increasingly hawkish. On the other hand, a new governor may bring about an unknown policy bias.
- The UK may hold an early election or could fail to agree a transition deal for the time when it exits the EU in Spring 2019.
- Citi analysts think signs of a harder Brexit are likely to be concentrated in the UK, hurting business sentiment and weakening the sterling further.
- The Italian election in Spring 2018 could result in a euro-sceptical government or result in extended political instability.
- Citi analysts think a center-right victory looks increasingly likely in the 2018 general election, although alternative options featuring one or more populist parties in power are possible.
- Tensions in Syria, between Turkey and Iraq, Iran and Saudi Arabia, in Egypt, Yemen, or around Israel could escalate.
Citi analysts believe that if the turmoil includes major oil producers, oil prices could spike. Otherwise, the geopolitical risk premium would rise further, but the initial effects may be fairly localized.
While political risks exist in various countries, they are unlikely to cause a synchronized and sustained sell-off in the financial markets as long as a global recession is avoided. History shows that attractively priced equity and bond markets can outperform as long as the crisis is not systemic. See table. This suggests that investors can still reap benefits from regional diversification.
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