By Ioannis Tirkides
2023 has been a year of turmoil, of wars and geopolitical upsets. It has also been a year of weaker economic growth with only a few but notable exceptions, not least China, and the United states. Interest rates peaked in this part of the cycle and bond prices fell for the most part. The much heralded recession didn’t really arrive, though it looked like one in many places, not least in Germany and other parts of Europe. Equity markets trended higher through much of the year, despite fat valuations. Money moved out of bonds and gold strengthened, reflecting the geopolitical uncertainties and declining confidence in governments more generally.
For 2024, the omens are not very bright, as many of the processes that started in the last couple of years will reach their climaxes. So, we may expect even more uncertainty and heightened volatility, with quicker changes of fortunes. A recession may arrive in the end, in the second half of the year presumably, as Europe stagnates, and China continues to rebalance its economy away from real estate and infrastructure investment.
We discuss the outlook for 2024 in a holistic approach. We discuss the coming elections, war and geopolitics, and the underlying economic realities. We conclude that wars will drag on, and the risk of escalation will remain high. The exuberance that markets exhibit currently, driven by expectations that central banks will arguably cut interest rates from early on, is premature. Geopolitical risks are not priced in, and there will be surprises.
In this article, part one of two, we focus on elections, war, and geopolitics. We will discuss the economic outlook in conjunction with geopolitics, in a second part that will be published separately with a week’s difference.
The coming elections and their significance
2024 will be a year of elections, far and wide, in counties and regions, where about 40% of the world’s population resides. There will be elections in key places, in Russia in March, in the European Union for the European parliament in June, and in the United States in November. The significance of these elections lies in the fact that they happen at a critical time when the world is in transition in so many different ways, and change is directional. Thus, the decisions that will be made by the elected leaders in western societies in particular, in the next four or five years, will determine the 21st century, literally. And the range of possible outcomes can be quite broad, from a large scale regional war to war with China, and to the collapse of global trade, with untold consequences for all countries. What is scarier perhaps, we are too complacent in how we assess and understand risk, and we thus tend to underestimate the fragility of some of our societies in the west.
While elections will be very different from one another, they will tend to share many common features. Protectionist tendencies are on the rise, harbouring the constant risk of disruptions in trade and investment. Subsidies for home industries will continue to rise. The United States and the European Union as well as China, have implemented massive packages of subsidies in recent years. The so called Inflation Reduction Act introduced by the Biden administration in the United States, is a massive package of subsidies and tax benefits for companies. In Europe, after Covid, and especially after the eruption of the war in Ukraine, the European Commission has become very flexible on subsidies and state aid. This protectionist trend will continue into 2024 and in the foreseeable future and will coexist with a push to reduce supply chain vulnerabilities.
The elections in Europe and the United States are likely to hold more surprises. In Europe, the far right are on the rise and are expected to win more seats in the European parliament. But these forces have a different perception of geopolitical risks, than the mainstream, and look upon the war in Ukraine with more apprehension and are less ambitious on the green agenda. In the United States, the political and social divides are very deep, and will get deeper if the electorate comes to perceive the election as unfair, if Trump is disqualified from the ballot or if the count is too close in some states.
War and geopolitics can be very disruptive for the economy and society. Relations with China are on the balance and can get materially worse as Europe and the United States implement their so called derisking policies. We tend to underestimate the degree to which the international system is intertwined, and the extent to which China in particular is part of the wealth and wellbeing in the west. China is a large holder of American debt, which bids up the exchange value of the dollar and permits domestic consumption levels that wouldn’t otherwise be possible. The overvalued dollar keeps imports cheap and inflation low. While globalization has its critics, inflation in the west was low for so long because of cheap Chinese goods to a large measure. A war between China will change all that and should be inconceivable, but it is not!
Geopolitics and war
Two years into the war in Ukraine, realities on the ground are vastly different. Russia now occupies a significant portion of territory in Ukraine. A large portion of the Ukrainian population, more than ten million people according to estimates, left the country, and too many of its young are sadly casualties of the war. Yet, a peace agreement to end the war remains elusive and the risk of escalation is still on the table.
The sanctions that have been imposed against Russia are not exactly working as intended, which shows how little understanding of economic matters, the geopolitics people have. By weaponizing the dollar and by seizing Russian dollar reserves, the international economic order has been upended, to the detriment of the west unfortunately. The now BRICS-Plus group of countries led by China and Russia, seeks to divert trade between them outside the dollar system, which will in the long run, undermine the position of the dollar as the global reserve currency. As a result, the sustainability of the debt structure in the west, with a substantial portion of it held internationally, is more questionable now. A sovereign debt crisis may be slowly unfolding, if inflation returns as it might, and interest rates stay higher for longer.
The war in Gaza
The war in Gaza is very complex in terms of what it entails and the extent to which it can escalate. The impossibility of a one state solution, and the rejection of a two state solution by Israel and Hamas, does not leave many options on the table. Israel wants to eradicate Hamas, and then install a civilian government in Gaza under its security control. This will undoubtedly prove extremely challenging. If the Palestinian Authority in the West Bank could
also govern Gaza, that would be ideal for Israel, but it unlikely to happen. So, Israel will have to reoccupy the strip and take responsibility for its reconstruction and civil management.
Israel faces threats from multiple fronts: from Hamas in Gaza; from Hezbollah to its north; and now from the Houthis in Yemen, who are attacking commercial vessels in the red sea blocking Europe’s best supply route from Asia. But the real threat for Israel comes from Iran, a much larger country, with regional ambitions and significant military capabilities.
But even if Iran’s geography and terrain makes it unconquerable by conventional means, Israel, with help from the United States, can still strike pre-emptively. For Israel, the threat it faces is existential. Bogged down and consumed in wars of attrition, by fighting Hamas and Hezbollah, is not exactly an envious position from a strategic point of view. Israel is getting exhausted this way, while its greater enemy, Iran, grows stronger. This is why Israel may be tempted to strike pre-emptively, which will only escalate the war to a regional level.
Conclusion
A war between Israel and Iran may never happen, but the probability of it occurring is not negligible. Too many parties, nation states and Islamic groups, want it. If the war in the Middle East does escalate to a regional level, the implications for economies and markets will be tremendous. But none of this is priced in. Markets trade to perfection almost, and valuations in many instances are too pricey. The world is at the onset of a difficult transition, and it will get bumpier from here.
We will discuss the economic outlook separately in a forthcoming article next week.
Ioannis Tirkides is the Economics Research Manager at the Bank of Cyprus and President of the Cyprus Economic Society. Views expressed are personal. The article is also published on the blog of the Cyprus Economic Society.
