Brace for impact

Feature | 27 January 2017

Roderick Barnett and Emma Whiteacre forecast a trade landscape of reduced demand and increased risk as the events of 2016 begin to take their toll

As President Donald J. Trump is inaugurated on 20 January, political risk insurers like Beazley will be assessing the implications of his international trade and foreign policies. At the coalface of global economic and political trends, we tend to pride ourselves on our expertise in understanding how international developments will play out. But given the thinness of Trump's policy agenda on the campaign trail, and the sensationalism of his rhetoric, there are fewer certainties than ever on which to base our predictions.

We are confident about a few of things however. Protectionism, populism and 'America First' will be the key themes of his administration. And some of the world's most sensitive geopolitical relationships will be shaken, and may be destabilised, by the president's refusal to observe diplomatic niceties and accommodate difficult regimes. But we expect President Trump to eventually move to a more nuanced and pragmatic approach to economic affairs and international relations than he indicated on the campaign trail.

In our view, he will inevitably become more constrained in his ability to act by the checks and balances of the US political system, albeit one with a broadly sympathetic Republican-controlled Congress.

Admittedly, early indications are not supportive of this latter prediction. International diplomacy is a very delicate game, one to which, at the time of writing, Trump has betrayed either an astounding obliviousness or a cynical disregard. According to Secretary of State John Kerry, he has not sought State Department recommendations before speaking to foreign leaders.

He provoked consternation in Beijing by congratulating Taiwan's newly-elected leader and subsequently referring to her as 'president', thus shattering the sensitive balancing act that Washington has performed for decades in maintaining strong informal economic and defensive relations with Taiwan, while not challenging Beijing's 'One China' position.

Antagonising Beijing is consistent with Trump's populist pledges to the disillusioned voters in America's traditional manufacturing heartlands, to whom he has persuasively made the case that responsibility for the decimation of their industries lies with China. He has threatened to impose 45% tariffs on Chinese non-oil exports, bring cases against it at the World Trade Organisation, and to label it a currency manipulator, a technical measure that triggers retaliatory action.

Sovereign defaults in emerging markets

From a political risk insurer's point of view, this is, broadly, bad news. A trade war between the world's two largest economies can only have a negative impact on global aggregate demand, irrespective of what other supply sources benefit from the deflected demand. The emerging markets in which we write most of our business tend to be the ones where the marginal impacts of softer demand translate most quickly into sovereign and credit stress. Against this backdrop, it seems inevitable that this will make contract frustration risks on sovereign and sub-sovereign obligors more challenging to underwrite.

Moreover, beyond trade relationships, the maintenance of cordial relations between the US and China is hugely important to progress in all areas of international cooperation. We see a generational shift of global power and influence towards China and away from the US, and note that this process will inevitably cause acute anxiety on America's part.

A belligerent stance from Trump in response could potentially jeopardise bilateral partnerships across all aspects of global geopolitical affairs, and in the world's most important political, economic and security institutions, raising political risks right across the board. While traditionally, political risk underwriters have focused their attentions on developing markets, 2017 may see demand from a much broader territorial base.

Weakening trade agreements raising the risk temperature

Similarly, Trump's plans to renegotiate or scrap trade agreements will hurt global growth. The North-American Free Trade Agreement (NAFTA) is firmly in his sights. Mexico and Canada have signalled a willingness to discuss terms, but maintain that the agreement benefits all parties given the deep interlinkages between the three economies, and the extent to which US manufacturing is dependent upon NAFTA supply chains.

Mexico is likely to suffer an additional economic blow from the threatened deportation of illegal immigrants. Overall, Mexicans in the US send home US$26bn each year, so their removal and the building of the proposed wall would be highly economically damaging. Mexico would also suffer from lower foreign direct and portfolio investment flows due to its worsening trade relationship with the US.

The political consequences from such economic shocks will be significant. President Enrique Peña Nieto has seen his approval ratings plummet since hosting Trump during the campaign. His Institutional Revolutionary Party (PRI) faces a tough challenge to retain the presidency in 2018
(the incumbent himself can't stand).

We see a high likelihood that, on his third attempt, left-wing populist Andres Manuel Lopez Obrador (AMLO), an equal and opposite to Trump, will take the presidency as the economic consequences of Trump's measures bite and Mexicans give vent to their frustrations at their treatment at the hands of their northern neighbour. This will do little for FDI flows into Mexico and is likely to have a depressive effect on demand for trade credit insurance.

Looking more broadly, the Trans-Pacific Partnership (TPP) that links twelve countries, excluding China, is now unlikely to be ratified. This means the promised boost to intra-regional trade and economic activity will be lost. The geopolitical ramifications will perhaps be more profound, however. The pact would have bolstered US influence in Asia, making it a more effective counterbalance to China, whose activities in the South China Sea - island building, military build-up - pose an increasing threat to regional security. While the US is sure to maintain its own defence patrols in the region, not least because US$1.2trn of US trade passes through the waterway each year, a weakening of its economic standing in the region will leave the one-time TPP partners more vulnerable to Chinese economic and military encroachment.

As political and economic tensions rise in this region, we anticipate trade flows will lessen but expect interest across the full range of political and trade credit risk classes will intensify, at least until it is possible to separate rhetoric from reality more easily.

NATO under threat

Trump's disdain for NATO, which he believes is too heavily dependent on the US, and under-funded by Europe, is also a concern.

The commitment to mutual defence is an important bulwark against Russian expansionism. As we have seen in Ukraine, President Putin is not afraid to exploit weaknesses in the former Soviet Union, and we caution that we could well see further Russian manoeuvring this year. Coupled with the still-parlous performance of the Russian economy, this makes most domestic political and credit risks rather unattractive.

Middle East focus likely to narrow

The political risk climate across the Middle East, always complex, will be impacted by a Trump administration in myriad ways. The president-elect's robust stance against radical Islam will ensure that the US remains engaged militarily in the region, but with a far narrower focus.

He has not yet enunciated a clear policy on the most pressing question, the war in Syria, but has hinted that he will break with the Obama administration's support for the rebels seeking to overthrow President Assad. This would move the US away from a potential conflict with Russia, which has fought to defend Assad, and could translate into a realpolitik alliance with these former opponents to defeat the so-called Islamic State and other radical Islamists across the region.

This will certainly be the focus in Iraq, where broader US backing for the government is likely to be scaled back over the longer term. In our view, this risks leaving Iraq more vulnerable to Iranian reach, particularly given the heavy presence of Iranian-supported Popular Mobilisation Forces.

Trump's admiration for strong leaders is likely to translate into support for regime stability, bolstering for example Egyptian President Abdel Fattah al-Sisi. His preferences could have a definitive impact on the balance of power between the region's arch-rivals, Iran and Saudi Arabia. Trump has called the Iran nuclear agreement "one of the worst deals ever made by any country in history", but it will not be an easy matter to backtrack on it; more likely, it will stall in place.

The Saudi Arabian regime will be glad of Iran's setback, threatened as it was by the prospect of a thawing of the West's stance towards Iran. Still, the monarchy will not have an easy relationship with Trump, who has far less incentive to court the regime than his predecessors, given America's increasing energy independence.

From an insurance standpoint, a relative weakening of the Saudi relationship with the US, when its economy is experiencing severe fiscal pressures and it is engaged in a costly and difficult war in Yemen, will raise both political and contract frustration risks and provoke a more cautious underwriting stance.

Emerging markets are likely to suffer

Globally, the economic implications of the forthcoming Trump presidency for emerging markets, where we write most of our business, are likely to be net negative, by our reckoning. There will be some bright spots, and in particular we are optimistic for decent growth to return to developed markets in 2017. We project a tangible boost to the US economy from Trump's mooted fiscal stimulus, although we also caution that it will raise longer-term budgetary costs. We also expect a cyclical - albeit lacklustre - recovery of the Russian and Brazilian economies.

But we are concerned that the global financing climate will be harder for the emerging markets in 2017. Our thinking is as follows: protectionism will dampen US demand for exports from all its trading partners, or in some cases close off the US market altogether. The aggressive reflation of the US economy through tax cuts for business and a spending boost on infrastructure and the military will necessitate faster-than-anticipated monetary tightening on the part of the Federal Reserve. This will serve to attract capital away from the emerging markets; the relative scarcity of capital will make financing external deficits and debt more expensive.

In such an environment, we would expect to see increasing incidence of capital controls, which will raise currency inconvertibility/exchange transfer risks as overseas entities are prevented from repatriating funds. Many central banks around the world will need to follow the Fed in raising interest rates to support their currencies, but where domestic demand in their own economies falls short, tighter monetary policy will serve to constrain economic activity.

The prospect of a tighter global credit climate, in a time of rising foreign-denominated public debt burdens across many emerging markets, will make contract frustration risks on sovereign and sub-sovereign obligors more challenging to underwrite. These trends have already been in play over the course of 2016, with sub-Saharan African commodity exporters like Mozambique, Zambia, Ghana, Angola and Nigeria all facing a debt squeeze as a result of weaker currencies. We expect more countries to experience debt strain in 2017. Of the larger economies, we think Kenya, Mongolia, Russia, South Africa and Turkey will find the external climate tough this year.

Reduced demand and higher risks

In conclusion then, we at Beazley are expecting the political risk insurance market to be operating in a lower demand, higher risk environment this year as the world comes to terms with a Trump presidency. As the dust settles, however, we think that Trump's international policy will be moderated by the exigencies of global affairs.

The US economy enjoys a position of strength and global pre-eminence for many reasons - the depth and sophistication of its financial markets; the degree to which the economy is diversified and its advanced manufacturing and services base; the reserve status of the US dollar; the hard power of its unparalleled military and the soft power of its intellectual, corporate and moral capital. Self-imposed isolationism and diplomatic provocation would very quickly undermine many of these advantages and have significant domestic economic consequences, as well as raising security threats and antagonising the global creditors on which it depends.

Trump is unlikely to be immune to these concerns, and ultimately, if his policies fail to deliver to the electorate the promised economic returns, he will struggle to gain re-election in 2020. He will, moreover, be strongly encouraged by the machinery of state to operate within more traditional norms than he has so far displayed.

For political risk insurers, this translates into heightened caution as we start 2017, with the hope of better times ahead.

Roderick Barnett is a political and trade credit risk underwriter at Beazley London, and Emma Whiteacre is a country analyst at the insurance firm

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