Heightened geopolitical risk has become the new normal, with uncertainty surrounding policy, international relations and political leadership now a driving force behind financial market volatility and sentiment. In this report, the J.P.Morgan Research team takes a closer look at some of the main themes and sources of increased geopolitical risk and how these risks could impact markets.
Major geopolitical tail risk scenarios for 2019
The U.S. – China trade dispute
Despite positive developments on trade negotiations between the U.S. and China in recent months, the changing nature of their relationship appears to be a more permanent phenomenon. Currently, about half of China’s exports to the U.S. ($250 billion) and 85% of U.S. exports to China ($110 billion) are subject to different levels of penalty tariffs, ranging between 5% and 25%. The original March deadline for negotiations has been extended, with President Donald Trump and President Xi Jinping expected to meet one more time to potentially complete a trade deal. Reports from the most recent round of talks were constructive with expectation that any trade agreement will likely involve a significant increase in China imports from the U.S. But both sides have acknowledged much work remains to be done. The existing tariffs may follow a gradual phase-out strategy, subject to enforcement mechanisms attached to regular review meetings. This means a status quo of existing tariffs in the near future. The U.S. negotiators continue to emphasize necessary changes on structural issues, including intellectual property protection, forced technology transfer, joint venture requirements and economic discrimination against foreign companies.
“It is evident that China is continuing to show a willingness to narrow the U.S.-China trade deficit by increasing imports from the U.S. However, the U.S. has also continued to emphasize the need to address structural issues and so the gap between the two sides remains wide,” said J.P. Morgan Morgan Chief China Economist and Head of China Equity Strategy, Haibin Zhu.
In the short-term, the immediate risk of a tariff war has been minimized, but medium and long-term competition between the two superpowers will likely continue, with recent trade frictions marking the start of a changing bilateral relationship. China aspires to reshape its economy through “Made in China 2025”, a 10-year plan it hopes will usher in the fourth industrial revolution and secure its dominance in global technology. But as the rise in U.S.-China trade frictions shows, these aspirations will be challenged if they continue to be implemented through existing industrial policies and controls on market access.
"The trade friction between the U.S. and China is just the beginning of a changing bilateral relationship that will likely reshape the global economic and geopolitical landscape in coming decades. While the trade tariff risk has been reduced, in our view, the core areas in dispute concern technology, including export controls, a ban on technology transfers and cross-border investment and possible sanctions on companies,” said Zhu.
What is made in China 2025?
China’s current supercycle is winding down, with the old drivers of the economy—export and investment—slowing. Along with stubbornly high debt levels, trade friction with the U.S. and a shrinking work force, China is looking to implement “Made in China 2025,” a 10-year, hi-tech dominance plan. While ambitious, the plan does not make China’s rise inevitable. Deleveraging and public sector restructuring are needed to keep China from slowing to less than 4.5% and to avoid zero interest rate policy over the next decade.
Venezuela sanctions
The U.S. has imposed sanctions on Venezuelan officials and state-owned oil and gold companies in an effort to cut off critical income streams for Venezuelan President, Nicolas Maduro, who is seen as an illegitimate leader by President Trump’s administration. The clampdown on state-backed oil firm Petroleos de Venezuela S.A. (PDVSA) effectively halts the $11 billion worth of crude flowing from the country to the U.S. every year. The U.S. challenge on military-backed leader Maduro through sanctions creates a significant cash flow problem for Venezuela, which is already in a deep state of economic crisis. Hyperinflation, power cuts and food and medicine shortages have forced millions of Venezuelans to flee their country in the last few years according to the U.N., with U.S. sanctions and multilateral diplomatic isolation led by Latin American democracies (the Lima Group) intended to push democratic reform. While the current U.S. sanctions on oil are putting economic strain on the country, Venezuela has taken action to replace the 500,000 barrels of crude per day previously shipped to the U.S. PDVSA is now producing less Diluted Crude Oil (DCO), which requires significant imports of diluent that until recently came from the U.S. Gulf Coast. To offset this dip in DCO output, PDVSA has increased the production of lighter crudes and upped exports to refineries in India.
Venezuela’s economic crisis in numbers
The government has not produced fiscal data in years, but real GDP is estimated to be about half of its 2014 level. Hyperinflation is currently running at around 1 million %, eliminating the value of people’s wages and savings and the nation has defaulted on $63 billion of sovereign debt.
1M% hyperinflation
$63B sovereign debt
Source: J.P. Morgan estimates
Oil cartel OPEC and its allies, known as OPEC+, have cancelled their April meeting and are set to meet in June to discuss and assess the existing cuts in their plan. The main topics of debate will likely include whether the cuts announced in December 2018 need to be extended after taking into account the impact of U.S. sanctions on Venezuela and Iran sanctions waivers.
The situation remains fluid, with the Treasury Department indicating the sanctions could be lifted if there were “concrete, meaningful and verifiable actions to support democratic order,” which would include a democratic transition of power to interim President Juan Guaido. If U.S. sanctions were to be lifted, it could quickly return some of the Venezuela supply that has been impacted due to sanctions.
“For oil markets, the risk to Venezuela’s oil is an additional supply side risk which will likely tighten oil markets more than markets are pricing in at the moment. This could impact the decision OPEC and its allies make at their next OPEC+ meeting,” said J.P. Morgan Head of Global Oil Market Research, Abhishek Deshpande.
“Overall, Venezuela still needs investment to ramp up its production sustainably. In that context it remains to be seen whether Guaido would stick with OPEC+ quotas or not, post transition. This could represent a threat to Saudi supply,” Deshpande added.
The U.S. debt ceiling
The debt ceiling debate has come back to the forefront in recent weeks as debt limit suspension legislation expired on March 1, with the debt limit reset at $21.98 trillion. Following this lapse in legislation, U.S. Treasury Secretary Mnuchin announced first steps to keep the government from exceeding its debt limit, by declaring a “debt issuance suspension period.
”When the debt limit becomes binding, Treasury is allowed to use “extraordinary measures” to avoid hitting the debt ceiling. Those measures include temporarily replacing non-marketable Treasury debt held by federal trust or investment funds (which are counted toward the debt limit) with a different obligation that is not subject to the debt ceiling.
“Based on our forecasts, we project Treasury will exhaust these extraordinary measures by the end of August. At this time, Treasury could draw down its cash balance, which would likely be under $200 billion, allowing borrowing to continue well into September,” said J.P. Morgan Head of U.S. Dollar (USD) Government Bond Strategy, Jay Barry.
Treasury maintains a large cash balance to mitigate operational risks and so it is unlikely to draw down its cash balance significantly once extraordinary measures are depleted, meaning Congress will need to pass new debt ceiling legislation by early- to mid-September, according to J.P. Morgan estimates. In an extreme scenario where Congress does not pass legislation to raise the debt limit before all of Treasury’s available resources are depleted, it would result in a passing what is known as the “drop-dead” date. A “technical default” would then take place, where Treasury would miss a coupon or principal payment on an outstanding obligation, but where the delay is quite short-term (less than a few days) and is not viewed by the market as reflecting a real deterioration in the solvency of the U.S. While this outcome is very unlikely, there is room for political uncertainty to increase market volatility.
“Markets have thus far shown little sensitivity to the debt ceiling debate: we find that short-term debt Treasury Bills cheapen as investors shun securities that could be impacted by a potential technical default, but this usually does not occur until one to three months before the expected “drop dead date,” Barry said.
We project Treasury will exhaust extraordinary measures by the end of August, but by drawing down on its cash balance, borrowing could continue well into September.
Jay Barry
Co-Head of U.S. Rates Strategy, J.P. Morgan
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The Government of Venezuela (including the Central Bank of Venezuela) is targeted by US sanctions which prohibit dealing in new debt or equity issued by it, or any entity owned or controlled by it, after the effective date of the sanctions program (together “Sanctioned Securities”). Additionally, Petroleos de Venezuela SA (“PdVSA”) has been designated as an OFAC Specially Designated National, and US persons are generally prohibited from any activity with PdVSA; various licenses, however, may impact the permissibility. Nothing in this report is intended to be read and construed as relating to, encouraging or otherwise approving or promoting investment or dealing in such Sanctioned Securities. Clients should be aware of their own obligations and those of JPMorgan Chase & Co, its affiliates and/or subsidiaries under applicable US sanctions when making investment decisions.