The geopolitical landscape has become somewhat more unstable after the last edition of this letter, but by no means is it as unpredictable as it was near the end of 2016, when Brexit and the election of a non-systemic US president shocked the global status quo. The threat of a nuclear holocaust, the fresh controversy surrounding Mr. Trump after Charlottesville and renewed Brexit haggling made sensational headlines, but market reaction has been minimal. In this edition we will attempt to understand the fundamental drivers of the main geopolitical questions we have asked ourselves in May and understand the tame reaction of markets.
But first, let’s take a page out of the playbook of the fictitious world of Westeros: In season 2 of popular show Game of Thrones, Petyr Baelish (“Littlefinger”) has a run-in with Cersei, the Queen Regent. Cersei, followed by 4 Royal guards, threatens him with some business secrets and Littlefinger quips that he would reveal her inappropriate relationship with her brother. As she ostensibly backs down, Littlefinger laughs at her face quipping that “knowledge is power”. Without moving an eyebrow, Cersei orders her guards to cut out his tongue. As they grab him and draw their swords, she commands them to stop. “Power is Power” she responds coolly.
The US’s relationship with China is devolving into that sort of an arm wrestle match. Mr. Trump will take any perceived leverage over his “opponents” and use this to “win” a negotiation. Britain’s negotiation with the EU seems to be going the same way. In fact, the range of geopolitical issues we are now faced with, in this post-2016 world, seem to follow that logic. Negotiation, subtle threats and high-stakes poker, are quickly degenerating into brawls, where the strongest takes all.
Let’s take a look at the subjects we put on the table in April:
Will North Korea be a problem?
Short answer: Probably not for markets. But whatever deals are struck between China and the US in the shadow of North Korea’s rockets will have longer term implications.
The assumed testing of a Hydrogen bomb, following a series of missile launches and other martial acrobatics, have certainly earned Kim Jong Un the top spot on the list of concerns. The world is watching, waiting to see if the North Korean leader will launch a projectile armed with a nuclear warhead against American soil, maybe the base in Guam. This is, however, the wrong question to ask. Any outright aggression would probably cause China to wash its hands of Kim’s regime, starting a very quick countdown to its demise. Mr. Kim enjoys demi-God privileges within his secluded nation, so an assault (to conquer Seoul? To conquer Guam? Just to annoy the US?) is probably not the endgame. In fact, the endgame is probably not Kim’s. The only possible way this ends is with a Chinese intervention, which would unavoidably place China as Asia’s undisputed leader, a goal under the current leadership. By threatening sanctions on Chinese banks, Mr. Trump and his advisors see through that endgame and attempt to come out on top. The problem with this approach is that it ties China’s hands and prolongs resolution, increasing the probability of an accident. It also considerably complicates future trade talks with a significant trade partner that happens to own a lot of America’s foreign debt and a portion of its supply chain. Markets are rightly beginning to worry. Much like Cuba, Vietnam, Afghanistan or even the Korean War, this is a proxy fight between superpowers. So the question becomes: what will it take for China to pull the plug on Mr. Kim? Intimidation or the US yielding to its geopolitical ambitions? As usual, we suspect the answer lies somewhere in between. We do not feel that the situation will resolve itself soon or simply, but that it will serve as a move in the wider chess board between the world’s biggest economies. As this is a binary event (nuclear war or not), we feel that the probabilities for a negative outcome are minimal, therefore, as we pointed out in a previous blog the markets are right not to worry too much.
Will Donald Trump remain President?
Short answer: Probably yes, but that’s not the issue. The question, is will he get anything done? Markets are quickly losing patience and failure to deliver on key objectives (tax, deregulation, spending) could have negative repercussions for risk assets.
The probability of Mr. Trump’s untimely removal from office is still very low. It would require extraordinary effort, an unprecedented bi-partisanship spirit and still it would amount to little more than a legalised coup d’état, in a country that reveres its Constitution. Low approval rates, the Muller investigation, Congressional censorship are all tools that may be used to pressure a sitting President. But removing one is a very different animal. In two previous instances one President quit (Nixon) and another simply apologised after lying under oath (Clinton). So, the probability of impeachment and removal from office is still very little. But the question we should be asking is not that. Instead, it is: how much of his business-friendly and how much of his trade/immigration hostile agenda will he be able to implement? Will gridlock return? As we argued in a previous blog, eight months into the Presidency and gravity is taking hold. On the list of things he can do, the most important is bank deregulation, which doesn’t require significant Congress approval. The administration has already filled Mr. Tarullo’s Fed seat, as the person responsible for regulating the banking system and has been quietly working towards relaxing post-crisis imposed rules on Wall Street. However, the sluggish response following hurricane Harvey, and the surprise budget deal with Democrats, while ignoring the GOP establishment, is not a good sign. Thus, tax reform and significant infrastructure spending are beginning to look less probable going forward. There’s still chance to pass important legislation, but after summer 2018 all eyes will be on the mid-term elections and Representatives who face challenges in their districts might be less willing to compromise. A Democratic House would most certainly result in the return of gridlock.
Will the general election affect Brexit?
Short answer: It already has, in a significant way. Theresa May lost more than her majority. She has lost some of the support from her own party. The question becomes: Will we see a meaningful deal in 365 days’ time?
Following disappointment after the general election, the Tory party lost its majority in parliament, forcing it to make a deal with Northern Irish DUP to maintain power. However, this is the least of Theresa May’s worries. She is now facing increasing opposition from her own party, which removes some of the flexibility she would undoubtedly need when negotiating with Europe. Despite all the rhetoric, fact remains that Europe holds most of the cards. European federalists, like Mr. Juncker, are all too happy with Britain’s opportune departure from the EU, as it leaves them room to move forward with European unification, a necessary step to avoid the eventual collapse of the common currency. The UK accounts for 10% of European exports and its clout may be reduced when some of the services it exports will be reproduced in Frankfurt or Paris. The UK’s card, the amount of money it will pay to the EU, is negotiable, but undisputed. If the UK backs away from agreements it has already signed, WTO rules allow for limited trade warfare and even seizure of assets in foreign countries. With little internal backing, a coalition government and the threat of deposition, it will be very difficult for Theresa May to impose her view of Brexit. Political instability raises the probability of a cliff-edge Brexit, which could have a significant negative impact on the economy. The question now is whether we will see a transitional deal, like the one the PM proposed in her Florence speech, and under which terms. This remains to be answered. As far as markets are concerned, uncertainty continues to plague Britain, which makes them weary of taking a major position on British companies.
Will the Euro implode?
Short answer: Macron’s election and persistent QE have temporarily reduced the probability of that happening. However, we should pay close attention to what happened in Germany’s election. Who Angela Merkel works with will indicate how the next European chapter will unfold.
Mr. Macron’s election, a pipe dream only a few months ago, has galvanised Europhiles as proof that the unification project is still alive and strong, despite rising nationalist backlash. Mr. Macron lost no time proceeding with reforms, no matter how unpopular. He also attacked some Italian business interests. While the latter might appear inconsistent with a united Europe, it is in fact not. Mr. Macron recognises that only a strong France, that can look Germany in the eye, can restore balance in Europe and move the Euro forward. While Mario Draghi’s QE has provided the necessary conditions for the European economy to stabilise and to grow, even he recognises that monetary policy can be no substitute for political will.
Even as an Italian Banker and a French President do their utmost to unite Europe, responsibility and power, at the end of the day, rest in Berlin.
Angela Merkel’s last bid at the Chancellorship succeeded, but the victory was close to being a Pyrrhic one.
The high percentage (13%) of the AfD, the ultra-right wing Party, the re-entry of the business-friendly Liberal Democrats (FDP) into the Bundestag and the losses the ruling Conservative (CDU/CSU) and Socialist (SPD) parties incurred dented sentiment for the 4th straight win of the “Iron Lady”. However, it was the SPD’s announcement that it would not seek or accept a deal to enter the government, which shocked political pundits. This means that Mrs. Merkel can form a government only with the Greens and the FDP together. To enter the government, the FDP have asked for control of the ministry of finance. The party’s ideology is against European integration if it means debt mutualisation, and the finance minister’s de facto position as leader of the Eurogroup would mean that attempts to complete the banking union or install a European Finance minister would face resistance from Germany. Additionally Mrs. Merkel will experience increasing internal opposition. In the Bundestag the far-right party will probably denounce efforts that would reduce sovereignty. Her sister party, the Bavarian CSU has said that they will reconsider working with CDU, unless it effectively puts “Germany First”. Mrs Merkel was reportedly ready to seize the momentum towards European integration, which was shaped after Mr. Macron’s election. The process of forming a government could take months, which may increase market uncertainty. Unless the SPD agrees to a grand coalition or the FDP retreats from its claim to impose its principles through the finance ministry, it will be very difficult for Europe to go forward in terms of unification without German leadership.
The Euro is not indestructible nor is QE a panacea. As long as there is no fiscal union, transfer payments, mutual debt, the banking union remains incomplete and the rules malleable, investors will worry about the stability of the world’s largest collective economy and would be hard-pressed to see the Euro as an alternative to the dollar.
Conclusion
Von Clausewitz famously said that “war is the continuation of politics by other means”. What he failed to identify however, is the mechanism by which subtlety and threat of force are replaced with actual force. We believe that sometimes it may be the inability of leaders to see the full range of consequences of their actions. Sometimes it is their incompetence to manage complex matters, that makes a negotiation boil down to power politics. Most usually however, it is the view that any negotiation is a zero-sum game, with clear “winners” and “losers”. To avoid “loss” some may choose to resort to guns. Modern negotiation theory, however, demands that we take into account the maximum common utility that can be created out of a deal. This holds true for basic corporate M&A as much as it does for politics. Markets are now calm, but they should be aware that when the idea of “mutual gain” is not prevalent in negotiations, then it becomes a true Game of Thrones. And as any avid show watcher will tell you, “in the Game of Thrones, you win or you die”.
Fears and Flows 