Squaring Off: A High-Stakes Global Game

Chris Bailey, European Strategist, Raymond James Euro Equities*

If I cast my mind back to the start of the year, one of the words commonly used to describe the global outlook was ‘Goldilocks’ – an homage to the age old children’s story reflecting a world where economies were anticipated to grow neither too fast nor too slow. Whilst headline economic growth rates have not particularly surprised, the same cannot be said about the broader global diplomatic and trade backdrop. Are such shifts a burgeoning threat to both the global economy and the world’s major financial markets over the next year or two?

G2’ Relations

The most powerful bilateral country-to-country relationship in the world today is between the United States and China, or ‘G2’ as many commentators have started to refer to it. China’s singular focus on economic development over the past generation has achieved huge success. In more recent years, the Chinese have made efforts to broaden their global influence as well as their diplomatic and political roles. The recently launched Belt and Road Initiative, with the aim of creating a trade zone stretching from Western Europe back to Beijing (along with maritime trading routes to Africa and South America), is a clever move to curry favour and build economic and diplomatic friendships.

Normally, the new kid on the block would not be a concern or challenge to America’s hegemony, but the heads of old allies are being turned by China’s overtures. For emerging markets, often it is simply a question of basic economics: can more goods and services be exported to China or America over the next few years? For Europe, however, deeper more existential issues are at work.

Struggles in Europe 

Europe has generally struggled over the last decade with far lower average economic growth and financial market performance relative to the United States. The optimism felt 20 years ago about the potential of a single European currency has since been replaced by distrust and a lack of coordination. This has manifested itself in the UK’s populace choosing to exit the European Union and, over the last year or so, ever-rising dissatisfaction with incumbent politicians. France elected a political high office novice, the long-standing German chancellor struggled to put a coalition government together, and Italy’s recent inconclusive election raised the spectre of a more populist/nationalistic political leadership cadre.

With Europe seemingly stuck in political and economic sclerosis, a range of emerging markets are progressively viewing an increasingly confident China as their natural economic partner. The more hard-nosed U.S. trade and diplomatic policies of recent months can either be viewed as a strategic masterclass to lengthen its global leadership epoch or a desperate attempt to stop an inevitable decline by any means possible. The on-off nature of talks with North Korea¹, the pulling away from global agreements with Iran, newly announced trade sanctions against Europe and China, and the extended NAFTA discussions have all made headlines in recent months. This is far from a classic ‘Goldilocks’ scenario.

What’s next?

So what happens next in this high-stakes game? Analysts of such scenarios often talk about ‘credibility,’ and both members of the exclusive ‘G2’ club have their strong positive points, as well as their Achilles’ heels. America has to finance its fiscal deficit in order to keep the economic show on the road, and China needs relative global economic stability in order to continue its fairly seamless rapid development. A deal opening up China’s domestic trade markets in exchange for a continued flood of U.S. Treasury purchases from the Middle Kingdom still remains the central and most likely outcome.

However, there will be bumps in the road. In addition, in terms of long-game players, few have the foresight and focus of the Chinese.

This latter point is manifest in recent Chinese opportunism, which has paved the way to closer relationships with Russia and Iran over recent months. This is more complex than ‘my enemy’s enemy is my friend.’ Instead, it reflects a growing pragmatism in Chinese diplomatic and trade decision making, as Russia and Iran both offer significant commodity supply potential. President Xi’s January 2017 Davos speech extolling free trade is still receiving plaudits, most notably in Western Europe. Looking at a map of the world, the reasons for this start to become more obvious. The potential for Europe’s economies to gain dynamic trade benefits from China remain clear and, given the region’s continued troubled backdrop, getting closer to the Chinese rather than the U.S. orbit has grown more attractive. The coordinated negative reaction by Europe, Russia, and China to the U.S. pulling out of the Iranian deal highlights an ever-closer working relationship.

High Stakes

However, greater coordination is no panacea. A slow slide into a period of disruptions to global trade and diplomatic disagreements with the U.S. is highly likely to be a lose-lose for all involved. It is far better to keep full interaction with the world’s number one economy today whilst pushing domestic change and reform initiatives. In Europe, planning for a lengthy Brexit transition period and measures to make the entire European economy more dynamic should continue to be top priorities. Despite all the negative headlines, this is still within the grasp of Europe’s policymakers. Recent weeks have seen progress in forming the basis of a more extensive regional redistribution budgetary strategy. This is likely to be one carrot offered to the lagging Southern European countries to implement structural reforms that make labour markets more flexible and encourage risk-taking and entrepreneurship. The scope for further progress in developing China’s economy continues apace, as the domestic change initiatives to encourage greater individual consumption are unveiled.

Of course, such arguments in favour of change, reform, and pragmatism apply to the United States as well. Globally, it is a time for a firm debate with calm heads. The stakes could not be higher.

You can read more articles from Chris Bailey and the Raymond James Investment Strategy Committee in the July edition of Investment Strategy Quarterly

*An affiliate of Raymond James & Associates and Raymond James Financial Services

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