Introduction and highlights
We see geopolitical risk as a material market factor in 2019, especially in an environment of slowing growth and elevated uncertainty about the economic and corporate earnings outlook. Market attention to global geopolitical risk has hit a high. At the center of the geopolitical debate? Increasing rivalry between the U.S. and China across economic, ideological and military dimensions. We take a deep dive into the race between the two countries for global technological leadership.
Focus risk
European fragmentation
BlackRock Geopolitical Risk Indicator
Source: BlackRock Investment Institute, with data from Refinitiv. Data as of October 31, 2019. Notes: We identify specific words related to this geopolitical risk in general and to our top -10 risks. We then use text analysis to calculate the frequency of their appearance in the Refinitiv Broker Report and Dow Jones Global Newswire databases as well as on Twitter. We then adjust for whether the language reflects positive or negative sentiment, and assign a score. A zero score represents the average BGRI level over its history from 2003 up to that point in time. A score of one means the BGRI level is one standard deviation above the average. We weigh recent readings more heavily in calculating the average. The BGRI’s risk scenario is for illustrative purposes only and does not reflect all possible outcomes as geopolitical risks are ever-evolving.
Market attention to European fragmentation has declined from its May peak, as acute risks to European integration—beyond Brexit—have subsided. We take a deep dive into this area and identify flashpoints that could reverse this trend.
In 2018, we highlighted three major threats to European integration: Brexit, Greek and Italian fiscal policy, and creeping authoritarianism in Central and Eastern Europe (CEE). In Italy, we worried that the formation of a left-right populist government opened up a path toward full or partial breakup of the eurozone. In CEE, we saw the rise of authoritarian governments leading to division within Europe over economic and foreign policy. Lastly, we forecast a protracted period of transition for the UK. Our base case was that of Europe “muddling through” – tensions would rise, but not boil over.
Risk scenario description:
Tensions between Italy’s populist government and Brussels rise over spending rules and other policies, and Italy threatens to leave the bloc. This scenario focuses specifically on Italy, but we see Brexit uncertainty and trade frictions posing additional challenges to Europe.
Our view:
The centrifugal forces that had previously preoccupied markets – Italy, far-right populist parties in core and Eastern Europe – have receded for now, yet could be reignited in the event of an economic downturn. The top fragmentation risk in the near-term is a no-deal Brexit. The UK is legally set to leave the EU on Oct. 31. At the time of writing, parties have resumed intense negotiations for a deal. Should a deal not be secured by Oct. 19, Johnson would be forced to request an extension – which would likely be granted. In all scenarios, an election appears likely soon after Oct. 31.
Background
- Two forces have driven the rise in European populism and anti-establishment sentiment over recent years: economic prolonged disenchantment for many and a growing unease with immigration.
- The European economic and monetary union remains a half-built house – facing deep structural headwinds to growth and with both monetary and fiscal policies severely constrained.
- Brexit has, for now, inoculated EU voters against Euroscepticism. Lingering disputes between Brussels and Central and Eastern Europe (CEE) governments over migration burden-sharing and rule of law present an ongoing challenge.
Key issues
Our outlook today has turned more constructive. Of the three risks we flagged, only Brexit remains acute. We remain vigilant to the undercurrent of anti-establishment sentiment in Europe, particularly in a context of slowing growth. Populist sentiment is closely associated with economic anxiety. With this in mind, we find it notable and concerning that the latest breakout of anti-EU populism occurred amid peak post-crisis cyclical performance for the eurozone. We worry fragmentation risks may rise in the event of an economic downturn, which Europe is ill-equipped to handle forcefully.
Brexit: The political situation in the UK remains in flux, yet recent developments have widened the distribution of possible outcomes. Parliament succeeded in passing legislation to block a no-deal Brexit, and the Supreme Court ruled that Johnson’s suspension of Parliament was unlawful. The UK is legally set to leave the EU on Oct. 31. At the time of writing, parties have resumed intense negotiations for a deal. Should a deal not be secured by Oct. 19, Johnson would be forced to request an extension – which would likely be granted. In all scenarios, an election appears likely soon after Oct. 31. With four parties polling evenly, the outcome of an election is uncertain.
The fiscal grenades: Italy and Greece: A miscalculation forced the populist government in Italy to dissolve itself, paving the way for a moderate coalition between the center-left Democratic party (PD) and the anti-establishment Five Star Movement. Weak polling by both parties suggests they will stay together until 2022, when the next president is elected. Conflict over the 2020 budget is unlikely, with a confrontational government in Italy and a more conciliatory Commission in place. In Greece, elections brought to power a center right government committed to its surplus target. Faster-than-expected growth could prompt tax cuts, thereby boosting government popularity and growth further.
Central and Eastern Europe: Tensions between CEE governments and the EU will likely remain frozen. Though the European Parliament has opened disciplinary procedures against Hungary and Poland for their attacks on the media and politicization of the judiciary, both countries have agreed to block sanctions against the other. Incoming European Commission President Ursula Von Der Leyen will seek compromise with CEE countries—evidenced by her appointment of CEE ministers to key Commission posts—yet disputes over environmental policy and migration could create friction. Proposals linking EU funding to performance on rule of law will likely generate opposition among CEE governments.
Policy hotspots
We outline below three policy areas in focus for Europe. We don’t see any of these issues as a serious challenge to European unity, but each has the potential to to escalate tensions with the U.S. Combined with the complications of Brexit, these policy issues could strain each individual member state’s relationships with the U.S. on one hand, and the EU on the other. This would increase the potential for European “fraying,” rather than fragmentation.
U.S.-EU trade: Europe is generally united in taking a more central role in the global trade system. In its dispute with the U.S., Europe has made clear that it will not be the first to take actions, but will stand to defend itself. In this context, we find it notable Europe has refrained from retaliating against U.S. tariffs imposed following a WTO ruling on aircraft subsidies. EU member states will unevenly experience the effects of frictions with the U.S. Different levels of economic ties to the U.S. and varying bilateral political relationships means that certain countries may be less willing to bear the potential cost of a more assertive trade policy.
Technology regulation: Technology is a focus for the new European Commission. Competition policy will be leveraged by the Commission to push back on the market power of U.S. platforms, in order to create space for EU competitors to grow. Likely retaliation by the U.S. (e.g. tariffs) will have asymmetric impacts on member states, creating new sources of tension. Conflicts over data sovereignty loom as Europe’s General Data Protection Regime (GDPR) is due for review in the coming years.
Climate: The political impetus around climate is strong in the EU, evidenced by Von Der Leyen’s proposed European Green Deal. Despite reticence in some countries around the impact of certain climate goals on key domestic industries, broad public support for environmental action will reduce the likelihood of intra-EU political frictions spilling over. Climate policy will complicate relations with the U.S., however, as Europe will likely demand commitment to the Paris Accord as a part of any trade deal. The implementation of a carbon border tax would also create opposition in the U.S.
