Global Outlook: what could go wrong?

Politics, Security and World Trade: what could go wrong?

By Steven Wieting, Citigroup's Global Investment Strategist

The political turmoil dominating investor sentiment just two years has abated to background noise. But that doesn't mean there won't be shocks in the year ahead as globalisation, immigration and technology continue to disrupt and impact workplaces and communities.

The flash of populist poll booth revolt that led to the election of Donald Trump as president of the United States and a yes vote for Britain leaving the European Union, for now, remains a phenomenon for 2016, having lost momentum to force change last year as traditional political movements again asserted dominance.

With investors expecting relative global stability in politics, international security and trade this year it begs the question; "what could go wrong?"

Populism hasn't gone away

While populist sentiment may have been contained in 2017, it has not gone away. In much of the developed world, many citizens continue to feel angry and insecure about the impact that globalization, immigration, and technological progress have had upon their working lives and communities.

Continued economic growth in the US and a long-awaited pick-up across many European economies may have helped ease these feelings over the last 12 months.

Looking ahead, though, a resurgence of populism remains an ever-present risk, one that could accelerate during a future economic downturn. In some countries, populists may only be one crisis away from winning power. If anything, we believe investors may have become complacent about the risk of international populist contagion – and about other risks.

It was striking how markets responded almost calmly to the significant country risk of Catalonia's voting to secede from Spain in the October 2017 illegal referendum. Despite the potential turmoil, the market's view of Spanish creditworthiness changed very little in the face of the stand-off between the Spanish state and one of its most economically-important regions. Other Southern Eurozone nations saw barely any reaction at all, in contrast to the pricing contagion that was common during Europe's crisis in 2011 and 2012.

Eurozone national Creditworthiness

A credit default swap (CDS) is a financial swap agreement whereby the CDS seller will compensate the buyer in the event of a loan default by the debtor or other credit event. A country's CDS is often used to measure that country's creditworthiness.
Source: Haver, as of 27 Nov 2017. Past performance is no guarantee of future returns. Real results may vary.

The hazards of underestimating risk

The tendency for investors to shrug off risks is also evident in geopolitical security. North Korea's tests of two long-range missiles in July and of a mid-range missile that passed over Japan in August put only brief pressure on South Korea's equity market and currency.

To put it in context, the local financial impact was only roughly as significant as the short-lived bout of investor nerves in late 2016 when it emerged that one of Samsung's smartphone models was prone to battery explosions.

South Korean equities have since recovered even more sharply after the missile tests than it did after the smartphone episode, despite an increasingly heated exchange of words between the North Korean leader and President Trump.

Korean equities' swift recoveries

The Korea Composite Stock Price Index or KOSPI is the index of all common stocks traded on the Korea Stock Exchange.
Source: Factset, as of 27 Nov 2017. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only. Past performance is no guarantee of future returns. Real results may vary.

Alongside international security, trade is something we continue to monitor closely. Fears that the US might pursue a significantly more protectionist agenda – and trigger retaliation from its trading partners – were not realised in 2017.

However, we do not downplay the risks ahead. Because the world economy today is more integrated than ever before, future episodes of trade friction could be relatively more important than local political events. In recent months, the renegotiation of the North American Free Trade Agreement has already caused some unease among investors. While we think the renegotiation will likely succeed it is an area that requires close scrutiny as there are other free trade agreements, like US-Mexico trade agreement, that may yet collapse.

Another potential source of political and social instability is energy. The sharp decline of the oil price since 2014 has already contributed to Venezuela's recent debt default and rising political tension.

In the heavily oil dependent Middle East, there is a pressing need for nations to diversify their economies away from energy, or else face potential challenges to the social order. Below the surface, risks in the Middle East seem to be worsening. Oil wealth has done much to keep these in check so far, but we should not be surprised if this comes unstuck at some point.

Risk management begins with global diversification

As you read through this year's Market Outlook 2018 we emphasise how global diversification across several asset classes may help mitigate the effects of often localized or regionalised flare-ups. Given our positive outlook for 2018, we would also argue that market weakness during such episodes can often make suitable entry-points for investors looking to add to their exposure. In the case of geopolitical events, history shows that initial US equity market sell-offs have taken an average of just one month to reverse with an average gain of 2.5 per cent three months after the event.

It is not our base case that the world will suffer further significant populist shocks, geopolitical security crises, or a trade dislocation in 2018. However, by their nature such developments are unpredictable. Even in the absence of such shocks, investors should not assume that markets will continue to react with the same degree of calm that they did to other unforeseen events in 2017. An increase in volatility seems likely to us, and the time to prepare portfolios against volatility is now.