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Geopolitical risks to financial markets - what's next?

As Coronavirus dominated headlines over the last year, geopolitical tensions between some of the world’s biggest nations continued simmering in the background.

    

Written by Tamikah Bretzke

Investment Writer | Colonial First State 

With several Coronavirus vaccines now being distributed, world economies and financial markets can continue their recovery. But they’re not out of the clear yet. While Coronavirus dominated headlines over the last year, the geopolitical tensions that once took a backseat to the pandemic continued bubbling behind the scenes. From an end to Brexit negotiations, to ongoing tit-for-tat tensions between the US and China, China’s controversial change for Hong Kong, and a strain in relations between Australia and China, financial markets could be faced with a number of new risks. Below, the team takes a deeper look at some of these risks and shares some insight for the future.

The US and China

Less than a month after signing the phase-one trade agreement, the Trump administration hardened its stance on China following the rapid spread of a respiratory disease that emerged from a Chinese wet market. As world economies locked down and financial markets grappled with the flow-on effects of Coronavirus, the US and China began engaging in a tit-for-tat war of words on various issues, threatening their already tenuous alliance – from trade and intellectual property theft, to Taiwan, human rights abuse in Hong Kong and calls for an enquiry into the origins of Coronavirus. More recently, the US ordered an end to Hong Kong’s special trading status which drew rebuke from China, and also passed measures through Congress to ban foreign companies from listing in the US if they fail to comply with US auditing standards – an act that has been deemed politically oppressive by the Chinese foreign ministry, which has been hesitant to comply with foreign auditing practices.

What could this mean for markets in the coming year?

While president-elect Joe Biden has yet to announce his approach to China, markets anticipate a change of tactics – rather than a total change of strategy – for existing issues with China. Both the Democratic and Republican members of Congress are largely united in the position on China and view it as a long-term strategic rival. But unlike President Trump’s aggressive, tit-for-tat and often abrupt policy stance, Biden could adopt a more measured, two-pronged approach to geopolitical relations: re-engaging China to manage tensions while also strengthening ties with US allies to contain China – for example, by collaborating on a global framework of enforceable trade and cyber security policies that could hold countries like China accountable. Indeed, if Biden should take a less direct approach by banding with allies as well as achieve an open dialogue with China rather than rely on the use tariffs as leverage, share markets (which will benefit from vaccines, but which may still have limited upside potential over the medium term) could experience a degree of stability.

Hong Kong and China

After operating under a one country, two systems scheme since the late 90s, China announced a controversial national security law for Hong Kong, which for decades has been the mainland’s most democratic, independent city. China now has more active state management over Hong Kong, giving authorities new and extensive powers that go beyond the traditions of common law. China also has the authority to punish crimes it deems a threat to national security (such as secession, terrorism and collusion with foreign forces) with sentences of life in prison. A number of countries have criticised China’s human rights abuse – including Australia, the UK, Canada, Japan as well as the US, which declared it would no longer recognise Hong Kong’s special trading status and that it would impose a range of sanctions on the Chinese individuals responsible for the law. By operating as a separate customs territory to China, Hong Kong has served as a gateway between China and the rest of the world and has become a centre for global trade.

So, what could these changes mean for financial markets?

Hong Kong’s greatest economic significance to China is its status as Asia’s global financial centre – the conduit through which goods and global capital flow into China and its share and bond markets. By removing Hong Kong’s special status, the region could be treated the same way as the mainland, which is currently subject to US tariffs. This could have less of an impact on China, which has grown significantly over the last two decades, and have more significant effects on Hong Kong, which has already experienced volatility from Coronavirus and months of anti-government protests (see Figure 1 for 2020 Hang Seng returns).

 

Still, while cities such as Shanghai have strong financial services sectors that serve mainlanders, retaining Hong Kong as a financial hub has become increasingly more important to China in the face of various US sanctions on Chinese companies listing in the US. The greatest short-term threat is China’s draconian approach to Hong Kong, which may provoke the US and its allies to adopt harsh financial sanctions which further threaten Hong Kong’s role as a financial centre. This could include sanctioning major Hong Kong-based financial institutions, restricting the activity of US financial institutions in Hong Kong, or even forcing Hong Kong to suspend its peg to the US Dollar (USD).

Figure 1
 
Source: Factset

Australia and China

While Australia and its largest trading partner, China, have historically enjoyed cordial relations, their relationship began rapidly deteriorating after the Australian government excluded Huawei from its 5G roll-out, supported the call for an independent review into Coronavirus, lobbied for Taiwan to be admitted to the World Health Organization, and criticised China for its actions in Hong Kong. China has since warned its students against Australia as a study destination and has engaged in ‘economic coercion’ tactics by enforcing tariffs on Australian goods such as beef, barley and wine. After China publicly aired a series of grievances against Australia, Australia and Japan agreed to a defence pact to reinforce their military ties – together, releasing a statement declaring “trade should never be used as a tool to apply political pressure”. While China insisted the crux of the breakdown is Australia’s repeated wrong acts and remarks and its provocative and confrontational actions, the government has reportedly made a number of attempts to contact China – so far with little success.

What could this mean for Australian investments in future?

To date, a rebound in economic activity and a surge in iron-ore prices has helped the Australian economy out of recession and boosted the value of the Australian Dollar (AUD) – up about 9.7% on currencies like the USD (as at 31 December 2020). However, the impacts of tensions with China on Australian exports remains a latent risk. Some industries have already been impacted so far – for example, China’s 200% tariff on Australian wine exports, which led Treasury Wine Estates to fall from $17.70 in January to a low of $8.18 in November (see Figure 2).

 

Looking ahead, it’s likely that China will continue – and may even intensify – its intimidation campaign against Australian exports as a way of cornering Australia into submission and cracking the US alliance in the Asia Pacific. Even with a redirection of exports to other parts of the world, the Australian economy could experience a shock to demand – one that not only places pressure on the companies involved in the provision of goods and services, but which also results in a hit to gross domestic product, the depreciation of the AUD, and a reallocation of funds to other financial markets if there is a reduction in the rate of return on Australian investments.

Figure 2
 
Source: Factset

Brexit

After an extended and contentious period of indecision, Prime Minister Boris Johnson’s 2019 re-election set the UK on the path of certain separation from the European Union. With a post-Brexit transition expiry of 31 December 2020, the Johnson government had the difficult task of negotiating trade terms with the union’s many members, including the likes of Germany, France and Denmark – or, in the event it failed to reach an agreement, risk defaulting to existing World Trade Organization arrangements. Thankfully, after months of negotiations, the two parties reached a withdrawal agreement to determine how the UK and Europe will live, work and trade together in future.

So, what could this agreement mean for financial markets?

Though an initial agreement has been reached, the decision-making behind Brexit may be ongoing for some time. However, from 1 January, some important changes were implemented – including a new UK immigration system, changes to travel and residency across Europe, and new limits and taxes payable on the goods and services bought and sold across borders. Some of these changes could impact businesses – at least in the short to medium term – resulting in paperwork and delays at borders. And if either the UK or Europe should take issue with any of the terms, they may trigger a dispute which could result in tariffs. So while markets may be positive on the agreement overall after experiencing a degree of volatility over the last five years (Figure 3), there may be volatility for investments in future as the UK and Europe continue the transition.

Figure 3
 
Source: Factset

We can’t forecast the future, but we can still forge ahead

As vaccines are distributed across the world, financial markets (at least in developed nations) will continue recovering in the year ahead – driven by the return of consumer confidence and the associated rebound in economic activity. However, there could be as many risks as there are opportunities for investments, particularly as economies continue stabilising from change. This includes geopolitical tensions, which could remain a key influence on markets over the next year. 


Though fluctuations in financial markets can feel unsettling, it can help to maintain a long-term view of investing. That’s because history shows us that markets not only fluctuate regularly for a number of reasons, but that they do eventually recover over time. For example, global shares returned about 10% per annum in the decade following the Global Financial Crisis (see Figure 4), and after declining in early 2020, rose from March to December to deliver positive returns for 2020 (Figure 5).

Figure 4
 
Source: Factset
Figure 5
 
Source: Factset

At this time, it seems markets have already begun pricing in the return of investor confidence and economic activity. However, while investors can’t forecast the future, they can still forge ahead – and our team can help. As conditions evolve, the Colonial First State Investments team will continue monitoring market developments and remain in close communication with our skilled investment managers to identify the risks and opportunities in investing. As we learn more, our team can not only make more informed decisions about our investments on behalf of investors, but can also keep them informed of the latest insights and market developments – each step of the way.

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