World pulling apart
Evidence of global economic and geopolitical fragmentation continues to accumulate
June has been another consequential month of global economic and geopolitical restructuring. Just over the past week, there has been confirmation of the end of the post-Cold War peace dividend at the NATO Summit, US and Israeli military action against Iran, and a rapidly weakening USD. Many core features of the global operating environment are being rewired in real time.
This note discusses seven recent global economic and geopolitical developments that provide insight into how this new world is shaping up.
Elsewhere, I recently recorded a podcast with Taimur Baig at Singapore’s DBS Bank, building on my last note (‘Capital wars’). We discussed a wide range of global macro/geopolitical issues: Trump 2.0, the different perspectives from Europe and Asia, the global economic outlook, US fiscal, capital flows, and more. It’s available at:
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1. Tariffs are here to stay
The 90-day pause period on the Liberation Day tariffs ends on July 9. Despite recent chatter, it is unlikely that any significant trade deals will be finalised by then; so far, the light UK/US deal is the only signed deal. The most likely outcome is for a continuation of the 10% tariffs for most countries: negotiations will continue, extending to a wide range of bilateral issues (defence, currency, tax, and more) with the Liberation Day tariffs remaining as a threat (watch for Canada, the EU). Although 10% may be seen as a positive result relative to the April 2 rates, this US tariff rate is ~4x higher than the 2.3% rate in 2024.
This is consistent with the playbook that Mr Trump used in his first term: maximalist demands that were subsequently walked back and aggressive deadlines that were extended. However, it is very unlikely that tariffs will be negotiated away. Mr Trump wants to create incentives for industrial activity to locate in the US. And the tariffs generated revenue of $22 billion in May, which is >$260 billion on an annualised basis; indeed, the White House OMB and CEA estimate $2.8 trillion in tariff revenue over the next decade. This revenue will partly offset the costs of the ‘one big beautiful bill’ that is working its way through Congress: these fiscal considerations will become an increasingly important consideration given the projected fiscal track of the US.
2. Rewired global trade
China has been hit by massive US tariffs, escalating to >150% after Chinese retaliation to the Liberation Day tariffs (54%) before being provisionally negotiated down over the past month. Unsurprisingly Chinese exports to the US reduced sharply in April and May, down by ~40% relative to December/January. But overall Chinese exports held steady: lower US exports were offset by increased exports to the EU and ASEAN. Part of this was likely rerouting of Chinese exports to avoid the US tariffs; exports from Vietnam to the US were up sharply in March/April. And US imports and the overall trade balance were about the same in May as 12 months ago despite the tariffs.
Some of this also reflects diversion of Chinese exports to (largely) non-tariffed markets like the EU; this dynamic will be a source of growing tension over time. Indeed, Chinese exports have been rotating away from the US towards non-Western economies (ASEAN, BRICS) for some time. This rewiring of China’s trade flows for both global economic and geopolitical reasons will be accelerated by the US tariffs. I also expect that China’s exports/GDP share (currently ~21%) will reduce over time, as domestic demand becomes a more significant contributor to China’s GDP growth.
3. Peak West
The barricades outside my front door disappeared as NATO leaders left town on Wednesday after agreeing to substantially increase military spending (to 3.5% of GDP, plus another 1.5% in supporting areas). Over the next decade, Europe will develop significantly strengthened military capabilities. It was an on-brand performance from NATO SG Mark Rutte, with a significant supporting role by the Dutch King and Queen; agreement was reached and President Trump left satisfied – avoiding a Presidential blow-up, with risks to Europe and Ukraine – in contrast to his abrupt, early departure from the G7 Summit in Canada a few weeks ago.
This success aside, there are clear fault lines across the Western alliance. The sustainability of US support for Ukraine, and Mr Trump’s commitment to NATO’s Article 5, is still shaky. NATO is alive for the moment – a critical goal, given the reliance of Europe on US military capabilities. But we are well past ‘Peak West’, seen after the initial strong, coherent Western response to the Russian invasion of Ukraine.
Beyond the weakening security guarantees, the US is also less willing to underwrite the global economic system: from tariffs, to the absence of international policy coordination at the G7, as well as questions about the future of USD swap lines from the Federal Reserve, which provide liquidity to other central banks in times of crisis. Alternative arrangements will be developed over time, but this withdrawal of US economic and security leadership raises the likelihood of major shocks.
4. European hard power
European defence budgets are set to rise substantially, although most countries are unlikely to achieve the ambitious 3.5%/5% targets over the next decade. Germany is an exception, with an aggressive investment plan announced, together with several Eastern European and Nordic economies. There will support Europe’s industrial sector, which has been hammered by high energy costs and weak global demand over the past several years. Increased government investment in security and infrastructure more broadly is an important reason for the more positive economic outlook in Europe, particularly in Germany.
However, the extent of the economic benefit will turn on the ability of Europe to produce more of its own military equipment. On average, ~30% of European military budgets are spent on equipment: this share will need to increase to catch up for sustained under-investment. And of the equipment spending, a substantial amount (>50%) is imported from the US (planes, air defence systems, and so on) with just ~25% from European sources. To strengthen Europe’s defence industrial ecosystem as well as its strategic autonomy, the aim is to increase this European share to 50-60% over the next decade: this expected increased demand is reflected in the surging share prices of European defence firms.
5. Pressures building
Previous notes have identified exchange rates and capital flows as a key marker of emerging changes in the global economic system. There are a few striking developments over the past weeks. Perhaps most obviously, the USD remains under significant pressure against the euro: the euro is now trading at 1.17 against the USD, strengthening by >3% over the past month (and 11% since January), with 1.20 a common target in the near-term. This reflects increased hedging activity as well as capital reallocation.
Similarly the CHF, NOK, and SEK have appreciated strongly against the USD, despite their central banks all cutting rates in June. The Swiss yield curve is negative out to about four years, with a possibility that policy rates may be cut below zero. Capital inflows are creating challenges; and these pressures may become more acute. Similarly, many Asian currencies have strengthened markedly against the USD this year. A major exception is the CNY, up by just ~2% since January, which creates a competitive edge for the Chinese export machine. These material exchange rate movements will create tensions over time.
My sense is that the Trump Administration is comfortable with a weaker USD; Mr Trump is on record multiple times on the disadvantages of a strong USD. And there is still some downside potential: despite recent depreciation, the USD is still sitting around decades-long highs in real terms (~15% above its post-1973 average).
6. Slowly then quickly?
There has been much talk of capital reallocation away from the US since Liberation Day, with the weaker USD one marker of this (particularly in a context that would normally support the USD). But the data shows only modest evidence of an exit of foreign capital from US markets. There was an outflow of foreign capital of ~$50 billion in April, the highest for a few years, driven largely by foreign selling of US Treasuries, as well as some equities. But this is a relatively small amount: total foreign holdings of US securities are ~$31 trillion.
However, there is accumulating anecdotal evidence with respect to capital reallocation away from the US by European pension funds and other institutional investors. Given the heavy concentration of investment in US markets, it is likely that this process will continue as US risk and return is re-assessed by investors – through both changing marginal flows as well as the selling of existing US assets. Home bias in capital allocation will become increasingly prominent.
7. Globalisation continues
Despite all of the turbulence over the past several months, as well as long-standing concerns about deglobalisation, world trade flows continue to be resilient. Merchandise trade volume growth strengthened in the year to April, and container shipping movements in May indicate health. This may partly reflect some front-running of US tariffs, but the broader picture is of resilience. This is even more pronounced in terms of exports of commercial services, particularly digital exports. It is a reminder that opportunities exist despite the challenges of tariffs and global economic fragmentation: there is as much trade diversion into different markets as there is trade destruction.
But there are areas in which globalisation dynamics are weakening. The latest UNCTAD World Investment Report, released last week, showed a weakening in FDI flows in 2024 for the second year in a row. Indeed, world FDI flows as a share of GDP remain substantially below the levels seen prior to the global financial crisis. Interruptions to globalisation are more likely to been seen in terms of capital flows than in trade flows.
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