2019 Outlook

Like previous “year ahead” reviews I have published on EconVue, this is not intended as a prediction of how events will necessarily unfold in real life. Instead, as always my intent is above all to consider the main risks to the stability to the international political and economic environment in various regions of the world that I am relatively familiar with.

Europe

Italy’s banking system and the overall economy’s health (i.e. high unemployment levels, lack of competitiveness) remains a concern. The second biggest European economy is too big to fail and too big to be saved by the EU. In the pre-Euro past, Italy could use devaluation to regain competitiveness but that is no longer an option for the Italian government. As a result, high levels of unemployment have persisted since 2008. This has led to budget deficits and the recent downgrading of Italian bonds, which many Italian banks hold in large amounts. Further downgrades of the country’s bonds might trigger a banking crisis, and in such a scenario it does not look likely that the current populist government in Italy can count on much needed support from EU institutions such as the ECB, given its anti-EU stance.

Germany’s main vulnerabilities stem mainly from:

1. radicalized politics given due to anti-immigrant sentiment: AfD might soon become the most important political power;
2. trade frictions with the US and the rest of Europe: given that the German economy is excessively dependent on exports, given the US is unhappy to and Europe is unable to absorb German exports at the current unsustainable rates, Germany might be forced to rely on greater access to the Chinese market for its exports. The cost may be to partially relinquish control of the enterprises which will sell into the Chinese market (ie via PE investments from China). Not to mention the pitfalls of relying on exports to a market itself largely dependent on exports elsewhere;
3. Deutsche Bank investigations might lead to a collapse of the bank, which is too big to fail, though not too big to save. To save it, Germany will likely have to take decisive actions which would contravene EU law. This would set a bad example to countries such as Greece and Italy, to which Germany has been preaching what it soon may not be in position to practice.

The prospects of the other two of the big four powers in Europe, namely France and Britain, are fairly bleak in the short term as well. The violent protests in France are a demonstration of the inherent instability of the elitist French political system and the periodic violent attempts to reform and/or restart it. Macron will likely continue to lose popular support given the inadequate handling of the protests so far, which will further hinder his ability to govern effectively in 2019. As for Britain, it is facing the prospect of exiting the EU without a deal. This would deal such a devastating blow to the British economy, given its reliance on exports to the EU, that it is likely that the backstop agreement on Northern Ireland will be accepted in one way or another. What that basically would mean is that in essence Britain as a whole (not just Northern Ireland) will remain part of the Customs Union and will be bound by some EU regulations indefinitely, while losing the ability to influence them. Either scenario (hard Brexit or de facto remaining in the EU while losing one’s “voice”) will likely cost Theresa May her job as Prime Minister.

Russia

It is a well-known fact that Russia depends on oil and gas revenues for its public finances. With oil prices at historically low levels, the risk is that the Russian state will not be in a position to balance its budget and maintain macro-economic stability, already under severe strain due to US and EU imposed sanctions. Putin has always maintained a balance between, on the one hand, the so-called Russian “liberals” who favor relative openness of the country and trade and financial links with the West (even despite recent frictions), and on the other hand, the so-called “siloviki”, or top level security and military services personnel. In a scenario in which Russia undergoes a major economic crisis in the next few years, it is likely that the balance of power would tip seriously in favor of the siloviki. This might lead, among other things, to Russia engaging in military conflicts on a greater scale in order to deflect attention from its own internal problems. It might also lead to greater influence internally to voices advocating the closing off of the Russian economy, as the economic crisis will be perceived to have been caused in part by the openness of the Russian economy and the vulnerability of the economy given 1) general lack of competitiveness globally, and 2) the impact of the sanctions, which the West could impose at any time. Yet those same voices (eg Glazyev, Starikov, Dugin, Fursov, etc) advocating the return to a Soviet style economic order also have advocated the territorial expansion of the Russian state, and Eurasian integration with the “Stans” and even Turkey, given that the current population and territory of the Russian Federation would not be able to sustain a closed off economy. Such opinions are becoming more and more mainstream in Russia. Whether a USSR II will work in practice if and when it is established is another matter, yet I am afraid that an attempt to rebuild the Russian Empire will be made one way or another.

China

As in Russia, in China there are similar clans and factions vying for power. Experts claim that over the past year Xi Jinping’s power has solidified and he has skillfully managed to achieve balance between the various Chinese clans: President Xi has proven to be a highly effective, decisive, and genuinely popular leader. The biggest threats to the status quo and internal balance which has been achieved are 1) the level of indebtedness of Chinese companies and consequent bad debts that Chinese banks hold, which could trigger a banking crisis; and 2) the trade war with the United States, which among other things have disproportionally hit some regions (e.g. Guandong province) more strongly than others. This could lead to serious regional tensions which could complicate central governance.

The difference between China and Russia is that the voices advocating openness and trade and investment links with the outside world are much stronger. Given China’s competitiveness globally, this is natural. Therefore, the most likely outcome is for the Chinese government to seek to reduce tensions with the United States, so China can be expected to do its best to accommodate many of President Trump’s demands. China will likely continue to play a positive and constructive role in mediating negotiations with North Korea as well. Yet one area where China is not likely to compromise is the South China Sea. Due to the enormous geopolitical significance of the region to the country, its military presence and buildup there will persist. China’s main trade routes go via the South China Sea, and as already stated above, international trade is extremely important to the country’s well-being.

As for the Silk Road initiative, in prior reports I had stated that my expectations were for Chinese direct investments along the “New Silk Road” and elsewhere to slow down and switch from private to state companies (due to recent capital controls disproportionally constraining private actors). This has largely materialized. Chinese direct investments in general have also become more “strategic” in that they seek to enhance the competitiveness and core competencies of Chinese companies. Yet given the “barren economic landscape” along the New Silk Road (namely, in Central Asia and Eastern Europe), achieving these goals will be impossible in the BAR (“Belt and Road”) region. Therefore, I expect that the practical significance of the BAR initiative will diminish further in 2019. Instead, China will likely focus on FDI in more mature markets such as Japan, the UK, Germany and Italy.

USA

The biggest short-term threat to the United States is that the Fed is reactive, not proactive (despite perhaps prevailing opinions to the contrary), in an environment when a market correction can take place at any time after a long and stable decade of post 2008 recovery. The fundamentals of the US economy have otherwise never been stronger, and even possible negative impacts of the trade war with China (eg higher costs of China-imported industrial goods for US companies) will be insignificant. The US is now self-sufficient not only in food production but also in energy, its manufacturing sector is recovering due to protectionist policies and the lower cost of production via automation (so lower labor costs in China and elsewhere now offer no competitive advantage), and its economy is not dependent on exports (the US exports less than 8% of its GDP, and half of that within NAFTA).

The biggest mid to long-term threat to the United States economy is the lack of investments in infrastructure – both in terms of maintenance and upgrading to modern technologies (eg smart cities, etc). The results could literally cost American lives as decrepit infrastructure could fail at any time with little advance warning. In this context, it is unfortunate that Chinese infrastructure investments and indeed outstanding expertise and efficiency in this sector cannot be utilized to bridge this critical gap in America’s economic competitiveness. Yet to expect that such investments could be allowed in this 

sensitive segment of America’s economy is truly unrealistic as the US would block them on national security grounds. Even more unfortunate is the fact that it is not clear where else the funds for such upgrades will come from. One of President Trump’s biggest failures so far has been his inability to deliver on promises to invest in infrastructure development programs; his indeed massive spending proposals have been stuck in Congress and he failed to utilize the Republican majority in both houses of Congress. Yet this is understandable given that many in the Republican Party are unwilling to spend more given the rising national debt – to which recent tax cuts have added another 1.5 trillion USD – which is roughly equal to the size of Trump’s proposed new spending on infrastructure.

This failure to deliver on promises of infrastructure renovation is already hurting President Trump’s chances of reelection in two years, given the failure to deliver related jobs to a constituency (blue collar workers in “red” states) he relied heavily on in 2016. In the longer term, lack of adequate and modern infrastructure equipped with or fit for the latest technologies will certainly limit US economic growth.

Middle East

In my 2018 overview, I expressed the opinion that while Syria would stabilize, Saudi Arabia and the Kurdish areas in Iraq and Syria might become the main sources of instability in the region. This is exactly what happened. In 2019, I would expect that these trends will persist. The Saudi regime is facing a tough transition from a world of high oil prices to a situation which makes it difficult to balance its budget. It is unclear how the domestic policy reforms of MBS and his anti-corruption drive will play out in such an environment. Internationally, despite tensions with Turkey over the Khashoggi murder, MBS seems to have solidified good relations with the US, Russia and China, which would certainly help the survival of his regime. As for Kurdish areas in Syria, given the US plans to withdraw from the region most likely Syrian government control will solidify but the price for Assad will be de facto federalization and decentralization over many issues – yet Turkey and Russia will likely “veto” the declaration of formal autonomy. The biggest danger to the Kurds comes from Turkey and not from Assad, as is evident from the Kurds’ invitation to negotiate with the Syrian government forces regarding “normalizing” relations with the regime. The very real threat of Turkish invasion also means that in reality US withdrawal from Turkey will not be as abrupt and prompt as Mr Trump would have us believe: not so much because the US is “married” to the Kurds as allies but because of the growing mistrust between Washington and Ankara (seen as way too friendly with Russia for a NATO Member).