Why Geopolitics Matter for Inflation and the Macro Outlook

How might geopolitical volatility rekindle inflationary forces central banks have been trying to extinguish, and what does that mean for markets?

De-globalization and the transition to geopolitical multipolarity is likely to stimulate macro-scale inflation across regions. Rising powers in West Asia, South Asia, and East Asia collectively are slowly challenging the multi-decade, US-led order. While not a cohesive bloc, shared interests - and antagonisms - are reshaping global relations.

Specifically, the financial and economic domains are being increasingly politicized along the fault lines of axis and alliances alike. This reshuffling has inflationary side-effects both from coordinated “de-risking” - Europe and the US vis-a-vis China - and from abrupt changes resulting from coercive politics - Russia vis-a-vis Europe.

These new economic relationships are now being altered for geopolitical optimization rather than hyper-integrated efficiency. The resulting changes, delays, knee-jerk reactions across various time frames naturally has downstream inflationary effects. Under the current macroeconomic environment, these risks are elevated.

As global geopolitics move towards multipolarity and uproot multi-decade international protocols and standards, it will lead to more macro-scale risks.

Elevated Geopolitical Volatility

In addition to the Russia-Ukraine war and its amplification of global inflation trends in energy, more recent geopolitical escalation in the Middle East is also taking place. These are not to be overlooked, particularly as Asia becomes the center of economic, financial, and geopolitical gravity in the universe of international affairs.

Red Sea

Iran-backed Houthi rebels continue to attack cargo ships in the Red Sea amid broader escalation in the Middle East. In response, vessels are avoiding these attacks in the vital waterway by sailing around Africa, adding time and costs to the trip. Container prices at one point rose by more than 25% .

Perishable items have a limited life, so the lengthier shipping times can ruin them and make them unsellable. There is also the compounded effect of congested alternative trade routes being flooded with diverted cargo ships.

As Global Trade Magazine wrote: “Due to Panama Canal congestion, a route initially diverted to the Suez Canal will go towards the Cape of Good Hope, adding ten to fourteen days to the journey and extra costs. Shippers now face a dilemma between bypassing the Cape of Good Hope or returning to the Panama Canal with potential queuing delays.”

Furthermore, perishable items are shipped in containers, but some items are switched to bulk carriers, which may make these items harder to handle at ports. Several carriers have also added surcharges.

“The Red Sea crisis is a wake-up call for companies to localize their supply chains” the same publication wrote. Shippers should have alternative sources of raw materials so they don’t have to rely on a single source, which can make supply chains vulnerable to disruption. Diversifying supply chains allows shippers to negotiate better prices and hedge against sudden price increases from a single supplier.

Downstream effects of delayed shipments mean orders may be canceled as customers become unhappy with shipping times. Compounded with other emerging geopolitical disruptions, the cumulative effects could undermine global growth prospects. The macro risk of geopolitical volatility is the disruptions it causes and how it may be a “force multiplier” for stubborn inflationary pressures.

Israel-Iran Flare Up

The Iran-Israel flare up is the latest example of geopolitical volatility unnerving markets and policymakers alike. For a complete breakdown of the recent conflict, see my report from two weeks ago: Iran-Israel Conflict Recap, Outlook.

The escalation briefly rattled markets, but subsequently calmed after it was clear that Israel’s retaliation was more performative than a tactical operation. The underlying concern now is a new precedent has been set. More specifically, Iran attacking Israel directly as opposed to through proxies, its historical modus operandi.

Consequently, the risk of politically-induced supply disruptions are higher, and a subtle geopolitical risk premium may now be baked into crude oil prices. The macro-risk is these conflicts and attacks on cargo ships may compound and further reinforce inflationary trends.

The downstream effects of this dynamic, coupled with independent economic variables could lead to delayed rate cuts. Fed Chairman Jerome Powell’s rhetoric has recently turned more cautious and hawkish. FOMC policy extends far beyond US borders and has a global impact as a function of the dollar’s reserve currency status.

Higher interest rates means the cost of the dollar is higher, the cost of capital more punishing, and investors’ risk appetite threshold is lower. Emerging market economies may find more difficult to attract FDI, and USD-denominated sovereign debt more difficult to service with domestic currencies.

Longer-Term Outlook and Risks

There are also a number of long-term geopolitical risks with inflationary by-products. The prime catalyst would almost certainly be the US-China rivalry. As the world’s two largest economies, shifting bilateral relations have multi-iterated consequences across interconnected industries and sectors. It is therefore the most important trend to monitor in the world of geopolitical risk analysis.

A few of these themes include:

• US de-risking from China: extraction and processing of strategic metals and minerals to reduce vulnerability from economic blackmail

• Europe de-risking from China: diversifying supply chains to limit Beijing’s geo-economic influence

• US-China tech competition and the restriction of certain semiconductors

• Conflict over Taiwan and its impact on the market for semiconductors and global growth

• The geopolitics of space, including militarization and issues over sovereignty

• The global energy transition and its entanglement with many of the overlapping themes above

There are of course other regions of interest e.g. Africa and Latin America, but geopolitical machinations there too will be largely affected by US-China relations. Modern strategies and trends are primarily influenced by past events whose complexity can cloud the outlook for those who have not studied history closely.

At Pantheon Insights, clients receive deep, data-driven insights on modern events, the likely scenarios, and how to navigate the long shadow cast by a region’s history. Shakespeare was right when he wrote that past is prologue. My only humble addendum is in the world of geopolitics, it can also be the epilogue.