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Looking Ahead – The Four “Known” Unknowns

For those exhausted by the nature and sheer volume of news, fake news, tweets, alternative facts, talking heads, populism, extremism and pure partisan blood-lust, we regret to inform you that 2019 does not portend much respite.

As our annual preview of the coming year goes to print, there are four significant “known unknowns” looming that could have a significant impact on the global operating environment:

  1. The 2018 U.S. mid-term elections to be held on Tuesday, 6 November
  2. The investigation led by the Special Counsel Robert Mueller III into Russian interference in the 2016 U.S. presidential election and related matters
  3. The withdrawal of the United Kingdom from the European Union (Brexit) on 29 March 2019
  4. The state of the U.S. and global economies

The Mid-term Circus

History and most credible polls suggest that the Democratic party will take control of the House of Representatives in the United States. Credible analysts and pollsters suggest a pick-up of between 30 and 40 seats resulting in something approximating a ten-seat majority. Meanwhile, in the Senate, analysts see more of a toss-up with most expecting the Republican party to retain its razor-thin majority or perhaps even pick-up a seat. The challenge to having great conviction in this scenario is that while national polls suggest a Democratic wave, the reality is that control of the House will come down to the relatively few seats that are truly up for grabs between the parties, while the surreal push and pull between conservative populism and progressive outrage continues. And while leadership of the Democratic party has succeeded in tamping down calls for impeachment – concerned as they are that such calls will be as much a call-to-arms for Republicans as for Democrats – it is also unclear what effect the denouement of the hearings and votes on the Brett Kavanaugh nomination to the Supreme Court will have on the electorate. It is also important to keep in mind that this mid-term, even more than most, is a referendum on the sitting president. Donald Trump’s approval ratings fell within the first few months of his presidency, but have held remarkably stable, in the mid-40s since – throughout the Russia election interference scandal, the immigration debate, the Charlottesville aftermath, the widely derided Helsinki ‘summit’ and press conference with Russian president Vladimir Putin and the guilty pleas and convictions of Michael Cohen and Paul Manafort respectively. In other words, despite the sturm und drang, the atmospherics around this presidency is the ultimate Rorschach test, with all the unpredictability and imperative for turnout that suggests.

Should the generally predicted baseline prevail – Democrats seizing control of the House while Republicans maintain a very slim Senate majority – what will ensue will be legislative gridlock, especially when considered against how little was achieved legislatively when the president’s party controlled both houses of Congress. On the other hand, if stimulative fiscal policy and regulatory roll-back represent the best environment for the stock market, gridlock in Washington represents a not so distant second. With the tax legislation now passed and implemented, direct fiscal stimulus via infrastructure spending on hold, further deregulation and executive orders should continue to provide market-friendly atmospherics. Amongst the concerns for corporate decision-makers, however, is the ephemeral nature of policy-making in this fashion, as supporters of the executive orders issued by the late Obama administration can attest.

There is an additional appeal to Republican voters continuing to support the President despite his non-ideological decision-making, frequent faux pas, unique communication style and comportment deemed undignified by many of his critics: the President has been committed to fulfilling his campaign promises regarding judicial appointments – and not solely at the Supreme Court, despite the media attention, but throughout the federal court system. By loading the bench with jurists who’ve passed the ideological litmus tests of key Washington think tanks and who are relatively youthful, the President can alter the balance of the judicial branch for years beyond his own tenure. But, continued progress on this front is entirely dependent on the GOP maintaining its Senate majority.

The Russia Investigation

It is not possible to predict with any certainty the outcome of the Mueller investigations, given the breadth of the mandate, the professionalism and integrity of the special counsel himself, the leak-proof character of his office and the head-spinning velocity of the news cycle. However, it is fair to assume that there will be no further ‘bombshells’ before the election, lest they be viewed as politicized, especially in light of the partisan reactions to the vacillation by former FBI director James Comey regarding the Clinton investigation in the run-up to the 2016 election. Assuming that Democrats take control of the House and, therefore, the majorities and chairs of the various House committees, the nature of Congressional investigations will certainly intensify.

Should these investigations and the Mueller office results yield material for articles of impeachment, absent a Democratic majority in the Senate, removing the President will be all but impossible. Indeed, as we’ve seen in the past, the president’s own party must ultimately turn for such a move to be successful. Richard Nixon’s approval ratings were in the 20s when he resigned. As stated above, Trump’s approval ratings are in the 40s and remain in the 80s amongst Republican voters. Nevertheless, the political climate portends further focus on partisan politics rather than moving to a legislative agenda, even if removal of the President currently looks highly unlikely.

Nonetheless, Russia’s objectives and motivations remain unchanged. President Putin has stated that the collapse of the Soviet Union was the greatest geopolitical catastrophe of the 20th century, and the expansion of both the EU and NATO have only served to strengthen his resolve. Russia has not only endeavored to push back directly (the annexation of Crimea and occupation of eastern Ukraine), but also to undermine the nobility of the democratic experiment in the United States and to aggravate the extreme ends of the debate on emotionally and historically fraught issues. Having said that, given it represents a mere 1.5 percent of global GDP, the benefits of such action don’t necessarily redound to Russia. Indeed, the big winner is China. The U.S.’ domestic political polarization, blame for the global financial crisis, opprobrium for the Iraq war and other perceived examples of foreign policy overreach, allow China to propagate an alternative narrative as it further entrenches its position on the global stage.

Brexit Looms

While it is tempting to think that gladiatorial combat in Washington is everything, an unprecedented event looms on the other side of the Atlantic: the departure of the United Kingdom from the European Union. While politically and historically this is much more than a trade deal, the processes of separation and negotiating a future relationship are mired in the quotidian details of a trade deal – deals which often aren’t concluded until the eleventh hour. This process appears little different, notwithstanding the ramifications should the two sides fail to reach a deal: reversion to WTO rules and no template for a future economic relationship. Brexit occurs at midnight CET on 29 March 2019. Between now and then much remains to be done, but the most significant work remains on the British side (indeed this is realistically now less a negotiation and more an exercise in minimizing damage), leading, as it will, to what will be an extremely close vote amongst members of Parliament. At the time of writing, the most fundamental question remains – will MPs allow a deal to pass containing a Northern Irish ‘backstop,’ continuing customs union and non-specific language about the future relationship? The EU’s position, especially it’s adherence to the ‘four freedoms’ (freedom of movement of goods, services, capital AND persons) has remained essentially unchanged. Our base case remains that a deal will ultimately be struck but, given how unknowable the fallout will be (though the UK government’s own impact assessment shows that over the next fifteen years industrial sectors will be worse off under every Brexit scenario), risk of the UK crashing out remains uncomfortably high.

Global Downturn…When?

A looming question for policymakers and corporate decision-makers alike is when the U.S. and global economies will begin to turn down. Many economists and analysts are starting to anticipate a U.S. recession between late 2019 and 2021. While the technical start of a recession is difficult to predict and even more challenging to characterize in advance, what is indisputable is that the current expansion is one of the longest in post-war U.S. history. Regardless of when and how recession hits, a significant concern is that there aren’t a lot of tools in the toolkit with which to combat the effects. Fiscal stimulus, in the form of the tax cuts, and deregulation are coursing through the economy, and at some point, their impacts will be muted. While the Fed has initiated a tightening cycle, interest rates remain low and the balance sheet remains bloated, meaning monetary firepower is limited.

Significantly, American policy moves are having an impact abroad – starting with vulnerable, yet bellwether geographies, such as Argentina, Turkey and South Africa. While each of these countries has idiosyncratic, native problems, they are nonetheless examples of the extent to which the global economy remains at the mercy of U.S. policymaking – policies that are driving a strengthening dollar, for instance. Finally, China’s condition has changed since the last economic downturn: growth has slowed, and debt levels have risen – simply put, China is not in a position again to play the rescuer role as it did following the 2008 Financial Crisis.

Above All, a Rising China

While these four issues play out, the single biggest geopolitical event of the twenty-first century, the rise of China and nature of its relationship with the United States, continues to evolve. Alibaba founder, Jack Ma, has warned that the trade tensions between the two countries could continue for the next twenty years. He’s right, because the dynamic is bigger than a battle between two strong-willed leaders and that dynamic is something that no CEO, board, entrepreneur or political leader active today has ever experienced: the supplanting of one country by another as the world’s largest economy. While the relative handful of times this has happened in history have generally been accompanied by conflict, clearly the prospect of war between nuclear superpowers is unthinkable. However, conflict through other means (trade wars, proxy wars, strategic and economic jockeying for influence) will be the norm.

Bearing in mind that Chinese actions are proportionate to its growing economic prowess, the big question will be the nature of the U.S. response: To what degree will the United States defend the global architecture (institutional framework, strategic alliances, rules and norms, economic interconnectedness) that it designed and perpetuated and how accommodative will it be to China’s legitimate claim to a bigger seat at the global rule-making table?

For corporate decision-makers and economic policy-makers alike, the bottom line remains that the U.S./China relationship is simply the most important bilateral relationship, with the biggest global consequences, for the foreseeable future. Whether that relationship is generally cooperative or conflictual, in an environment in which low-to-mid-single digit growth is the global norm, will have profound implications for the efficient allocation of capital, labor and other vital inputs to GDP. An early example of this was the drama surrounding the Chinese company ZTE earlier in 2018. American sanctions, before being reversed, nearly put a company with $17 billion in revenue and 75,000 employees out of business, only reinforcing the rationale behind the “Made in China 2025” initiative for Chinese self-reliance in key technology areas.

The most obvious arena of the U.S./China relationship has been in trade. Much has been made of tit-for-tat imposition of tariffs, with proponents of U.S. policy touting the ability to tariff many more Chinese goods as supporting the notion the U.S. has the advantage. But of course, China has an arsenal of weapons other than tariffs with which to fight back. They can substitute (for example, shift more orders to Airbus rather than Boeing); they can restrict access to vital rare-earths metals; they can suspend IP protections, such as they are, in China; and they can restrict Chinese tourism into the United States, increasingly the largest single U.S. ‘export’ to China (there is precedent for this: China restricted tourism to South Korea following the deployment of the THAAD missile defense system and in front of the PyeongChang Olympics). There is no question that China has engaged in policies that the U.S. and other countries are rightly indignant about – from forced technology transfer and dumping, to industrial espionage and IP theft. But with only 16 percent of Chinese exports going to the U.S. (in 2000, only five countries counted China as their largest trading partner. By 2017 more than 100 countries did), tariffs may not be the most effective tool to coerce a change in behavior. And it does not help that concurrently the Trump administration has pursued trade disputes with many allies in the EU, Canada, Mexico and Japan. For purposes of confronting Chinese economic behavior, the adage of Winston Churchill rings true: “The only thing worse than allies is not having any.”

Meanwhile, the two key areas of Chinese policy will continue to generate risk of confrontation: the militarization of the South China Sea and other areas of the western Pacific and the Belt and Road Initiative (BRI). China continues its territorial claims in the region despite the rulings of UN bodies, and it has now militarized a number of the newly constructed “islands” at the same time as the U.S. Navy continues to engage in ‘freedom of navigation’ activities to actively push back on sovereign notions. Risk of inadvertent conflict and resulting escalation remains heightened.

The Belt and Road Initiative serves multiple ends: expanding the Chinese sphere of influence, modernizing the trade corridor between China and Europe and enabling a giant ‘make work’ project for the increasing Chinese labor force and spare industrial capacity. In the near term, two major concerns arise: First, BRI countries are taking on debt to pay for these substantial infrastructure projects, which not only potentially renders their economies more vulnerable (particularly if the economic returns on projects don’t justify the costs), but also makes the assets vulnerable to Chinese repossession should the debt prove unserviceable (as evidenced by the Hambantota Port Development Project in Sri Lanka). Second, the BRI goes through or around some of the most politically contentious, economically important, and militarized areas of the world: India and Pakistan, Central Asia, the Middle East and East Africa. And these areas are also within the spheres of influence of the United States and Russia – again setting the stage for potential future conflict.

While Xi Jinping has positioned himself as the champion of (aspects of) ‘globalization,’ the reality is that China isn’t really liberalizing. The Chinese Communist Party retains its primacy and the government restricts the free flow of capital, information and goods with the rest of the world. However, in an environment where the U.S. role in the world is questioned, China is putting forward a viable alternative narrative which must be considered and worked with going forward.

Populism Persists

Finally, the forces driving populist politics continue to remain unaddressed. Brexit, the Trump election, the rise of the AfD in Germany, the rightward swings in Hungary and Poland, the right/left populist government in Italy, the likely second-round candidates in the Brazilian presidential election in October 2018 are all examples of the political expression of populist narratives. In the U.S., incomes have remained flat since 1970 after adjusting for inflation and the financial crisis and ensuing ‘great recession’ led to the biggest rise in wealth inequality in U.S. history. Indeed, the white working-class share of total income stood at a mere 27 percent in 2016, down from 45 percent as recently at 1989. While Donald Trump may not prove to be the solution, the dis-affected ‘middle class’ anxieties are indeed real and in urgent need of being addressed.

There have been periods in which populist candidates have been voted into office in great numbers and trade restrictions have taken hold. In the past, these have tended to occur during times of economic downturn – something to consider in this moment of comparative economic strength. But two-track economies easily obfuscate the real picture to the economic and political elites.

Conclusion

2017 started with a week in which Xi Jinping dazzled Davos as the champion of the global free trading system and Donald Trump articulated a dystopian vision of “American carnage” in his inaugural address. 2018 has seen major world leaders including Japan’s Shinzo Abe, the IMF’s Christine Lagarde and France’s Emmanuel Macron openly criticize the United States while seated on stage with Vladimir Putin at the St. Petersburg International Economic Forum and the surreal images of Trump giving equal weight to the claims of Putin and the U.S. intelligence community, his reference to Canadian prime minister Trudeau as “dishonest and weak” while lauding the dictator Kim Jong-un. The global economy is growing but showing signs of stress; stock markets have rocketed but the era of free money is coming to an end. But these phenomena have conspired to mask an evolving tectonic shift in global economic and strategic power that will dominate the operating environment for the coming decades. An American president doubling down on eschewing globalism for populism in front of the UN General Assembly, while being laughed at for aggrandizing the administration’s accomplishments, may not portend the actual end of Pax Americana. And Pax Sinica remains uncertain and won’t materialize for years, if at all. It’s the interregnum that prevails, and that necessitates objective analysis that is rigorously clear-eyed about the unprecedented nature and speed of change.