Geopolitics Will Affect Markets In Ways Not Seen Since the 1970s

By Vincent J. Truglia

Markets are faced with geopolitical risks they are not used to coping with, at least since the 1970s. What is different now? The standoff in the Ukraine and the bluster coming out of China and Japan alone have the potential to impact the worldwide economy in ways not seen for decades. These may seem like pretty strong words, but I believe markets do not understand what they facing.

Arab-Israeli War of 1973

In the 1970s, the Arab-Israeli War caused an economic and political upheaval, which literally took decades to resolve. The Iranian Revolution of 1979 was the second phase in this geopolitical cycle. However, the sudden collapse of the Soviet Union in 1991 seemed to change everything. The world was no longer a bi-polar world with the US and the Soviet Union fighting it out on every front.

Country Risk

During the 1980’s investors’ problems related to the emerging debt crisis.  However, since that was primarily centered in the banking system, it was easier for regulators to contain, and as such remained simple country risk. During the 1990s, and the first decade of 2000, financial markets again primarily dealt with individual country risk, but now those risks were centered in bond markets and required different solutions.  Nonetheless, there were certainly plenty of financial crises to go around. We had the European Monetary System (EMS) crisis of 1992-93, the Italian political and economic crisis of the early-to-mid 1990s. For many, it may seem like a long-time ago, but we even had a major economic and political crisis in Canada in 1994-95.

Tequila Crisis

In 1994-1995, we had the so-called Tequila Crisis, which involved Mexico nearly defaulting on its debts. Mexico was rescued by the US and the major international financial institutions, but at a heavy political cost. It was forced to democratize to a degree it had not done so for many decades. Yet, even there, despite the domestic political reforms, it still was not a worldwide geopolitical crisis.

East Asian Crisis

In 1997, we had the East Asian crisis, but once again, it wasn’t a geopolitical crisis, but rather was the result of economic decisions made in ASEAN countries themselves. In addition, I would argue the 1997 crisis had its origins in China’s unification of its exchange rate in 1994, which was in effect a depreciation of the RMB. This proved disastrous for ASEAN nations, and one could even argue helped make the Korean crisis worse.

Russia’s Default

Our next major country crisis happened in 1998 when Russia defaulted on its domestic debt. This caused a temporary closure of world bond markets, but was quickly resolved because of the strong health of the US banking system, which enabled bond markets to return to normal in a relatively short time. There were definitely impacts of the Russian crisis felt in other countries around the world, such as Brazil in 1998-99. But all in all, the crisis seemed to pass without forcing the world into recession.

Dot.com Bubble

The next major crisis did not involve country risk per se, but rather the bursting of the tech bubble in 1999-2001. This had a big impact on stock markets around the world, but was primarily centered on the technology sector itself, and less on imbalances in the rest of the US and worldwide economy.

9/11

Needless to say, 9/11 shocked financial markets, but although this was a traumatic event, its economic impact was not long lasting.

Although this was obviously a geopolitical event, since it involved small groups of Islamist fanatics, and despite the fact that it helped change the dynamics of politics in the Middle East, markets were basically able to shrug it off.

The Two Gulf Wars

I could also have discussed the First and Second Gulf Wars, but in both cases they were not geopolitical game changers affecting the worldwide economy.

Ukraine is Different

Why is Ukraine a game changer? First, the West ignored the Russian Federation’s warning about encroachment on its border for the last two decades. It appears that Western elites simply assumed that with the collapse of the old Soviet Union, a modern version of the Russian Empire would not reemerge. They were obviously wrong. As I have written in past blogs, the creation of the Eurasian Economic Community, which is a modernized version of the Russian Empire, is already up and running, resulting, as I have often point out, from over 70 treaties among the various countries involved.

Mistreatment of Russian Speakers

Russian speakers and Russian citizens have been treated as second class citizens in numerous countries in the former Soviet Union, worst of all in Estonia and Latvia. Governments in Ukraine have also mistreated them, whenever that government won with a majority made up of Western Ukrainians.

Putin Has the Go-Ahead

The situation is now even more complicated, because the Russian parliament has already given authority for Putin to decide on his own what type of military action, if any, he wishes to pursue. When we are trying to figure what a single individual will decide, I would argue that is an impossible task. As I have written before, he is in the driver’s seat. Given the illegitimacy of the government in Kiev, and the nature of the present Ukrainian coalition, I expect the most likely outcome to be an invasion of the Ukraine. I just don’t know how deep and far will it go.

Since the Russian army is already undertaking military exercises, not just along the Ukrainian border, but also in Abkhazia, which Russia helped gain independence from Georgia in 2008, it appears the Russian Army is training for a possible movement into Odessa, and from there it is a short distance to Trans-Dniester.

Powerless to Stop Putin

Frankly, the West is completely powerless to stop Putin. Bluster is useless. The Ukraine is of little importance to the US. However, Russia’s help with Syria and Iran are more important. Even Tony Blair has recently argued that the West should join with Russia to stabilize Syria, even if that means keeping Assad in power.

Without Russian assistance, Iran remains unsolvable.

Back to Markets

Russia will soon shut off gas to the Ukraine. Unless paid, the lines shut on May 1. Germany can backflow some gas to Ukraine for a while as it can to some of the other Eastern European countries, but not for long, because Germany has only a temporary excess of natural gas. Sanctions imposed by the West will likely cause retaliation by Russia. A war in the Ukraine can easily tip Europe back into recession. If gas supplies are not maintained to Italy, which requires gas through southern Ukrainian gas lines, Italy will definitely slump back into recession.

The Baltic Menace

We can’t forget that it would be quite easy for Putin to move his army into Estonia and Latvia. Technically the US and the rest of NATO would be obligated to help these two small, unimportant republics. I truly doubt Obama would risk war with Russia over these distant lands. From my point of view, if Putin does move and the West does nothing, which I hope we will do, then it will prove how the European map has reverted to its pre-World War I imperial model.

Japan and China

Making matters worse was Obama’s recent statement that the small Diaoyu Islands in the Pacific, which are merely administered by Japan, are covered by Article 5 of the Japan-US Treaty of Joint Cooperation and Security; basically meaning that if these disputed islands are attacked, the US is obligated to help Japan. That is one of the dumbest things the Administration has done to date re foreign policy.

First, the Japanese took these islands from China in 1895. The Cairo Conference and Potsdam Conference legally returned them to China. It then gets even messier. There was another 1951 Treaty, which gave the US trusteeship over another set of small Japanese islands in the region, excluding the Diaoyu Islands. A number of years later, the US unilaterally extended its trusteeship to the Diaoyu Islands despite strong objections from China. In 1971, the US began the process of returning Okinawa, the Ryuku Islands and several other islands to Japan. In the 1970s, when Japan and China were moving to reconcile their long-standing issues, the leaders left a final decision on the Diaoyu Islands to a future date. Then in 2012, Japan purchased these islands according to the Chinese, and “nationalized” them. Nonetheless, they clearly belong to China, not Japan.

The Chinese assume we are not going to go to war with China over two small islands which have been in dispute for decades and where the Chinese claim is much stronger than the Japanese claim. My fear is either the Chinese or the Japanese may make a miscalculation. A military confrontation between Japan and China with US involvement would the worst of all possible worlds. Therefore, investors for the first time in decades need to keep their eyes on major geopolitical developments in a way they have not been used to doing in recent years. Until now there has always been an expectation that things will be settled peacefully. That may not be the case today, especially in Eastern Europe and the Pacific.

As always, Clear and Candid.