Oil shocks and silicon shortages—the high cost of geopolitics

Geopolitics is back. War in the Middle East is the latest in a series of shocks that demonstrate the power of politics to shape economic and market outcomes. There could be worse to come. Like Middle East wars of the past, the conflict between Israel and Hamas that broke out in October is a human tragedy with the potential to disrupt the world economy. A conflict largely confined to Gaza, similar to what followed the kidnap and murder of three Israelis by Hamas in 2014, would increase the already high cost in human life but likely have a limited effect on oil prices or global growth.

A sharper escalation—not a high probability but a distinct possibility—could bring Israel into direct conflict with its regional enemy Iran, a supplier of arms and money to Hamas. In that scenario, Bloomberg Economics estimates oil prices could soar to $150 a barrel, comparable to the move seen during the 1990-91 Persian Gulf War. That would drag 2024 global growth from 2.7% down to 1.7%—lowering output by about $1 trillion.

Russia’s hot war

In Ukraine, the economic effects of Russia’s invasion are direct and devastating. GDP in 2023 is set to be 27% below its prewar level. Russia, meanwhile, faces a future of economic and financial isolation from the West. The consequences will be comparable to the impact of apartheid-driven autarky on South Africa in the 1980s. By 2032, Russia’s GDP will likely be 12% smaller than it would have been if the Kremlin had kept its troops at home.

Almost two years since Russia’s tanks rolled across the border, the intensity of the effect on the broader global economy has faded. Back in August 2022, though, with Russian supplies turned off and winter on the way, European gas prices surged above €300/MWh—more than 15 times the historical average. That came close to tipping the euro area into recession. The European Central Bank is still battling above-target inflation.

US-China cold war

For the US and China, hopes that the Biden administration would bring a restoration of constructive relations have so far been in vain. President Joe Biden has kept his predecessor’s trade war tariffs in place and gone further with a ban on sales of leading-edge semiconductors to China. The costs are clear. In 2022, for goods facing trade war tariffs, China’s exports to the US were down more than $150 billion relative to the pre-trade war trend.

There are, of course, also winners. Mexico, Vietnam and Thailand are among the low-cost manufacturing centers that have picked up more trade with the US as imports from China get the cold shoulder. Security hawks argue that higher prices and slower growth are a price worth paying to insulate economies from geopolitical risk. In economic terms, though, as trade starts to flow on channels dictated by politics rather than commercial incentives, it’s the costs that are front and center.

Risks ahead

Other risks have yet to crystallise. Taiwan makes most of the world’s advanced logic semiconductors and around 35% of lagging- edge chips as well—with much of the remaining 65% produced elsewhere in Asia. Globally, 5.6% of total value added comes from sectors using chips as direct inputs in production—almost $6 trillion. Total market capitalization for the top 20 customers of Taiwan Semiconductor Manufacturing Co. is $6.7 trillion.

Taiwan also sits on one of world’s biggest geopolitical fault lines and near the junction of two tectonic plates—bringing a heightened vulnerability to earthquakes, both literal and figurative. If a disaster took Taiwan’s semiconductor supply offline, Bloomberg Economics estimates a drag on global GDP of 4%, not far from the impact of the global financial crisis or the Covid-19 pandemic. Washington’s security hawks, always eager to find the next source of global risk elsewhere in the world, might also take a look at challenges closer to home. The November 2024 election is shaping up to be a rematch between President Biden and ex-President Donald Trump. Last time around, that ended with an angry mob of Trump supporters, convinced the election had been stolen, storming the US Capitol.

Markets at the time paid little attention, with equities, Treasury yields and the dollar basically unmoved. Back then, though, the US economy was accelerating out of Covid lockdown, the 10-year Treasury yield was just over 1% and the US wasn’t surging military supplies to Ukraine or moving aircraft carriers into position in the Middle East. With current military commitments and the condition of the US economy and markets, a repeat post-election performance might have a significantly bigger impact.

Yards and fences

What to do in the face of rising geopolitical tensions? A return to the go-go years of politics-free globalisation is not a possibility.

The UK experience after Brexit demonstrates the dangers lying in the other direction. Since voting to leave the world’s biggest single market in 2016, the UK has seen weaker investment and productivity gains, placing the economy on a slower growth path, which may have already cost about 3% of GDP.

Splitting the difference, the Biden administration’s “high fence, small yard” mantra sounds about right. In a world of geopolitical tensions, advanced technology with national security implications needs to be behind a high fence. In a world where cross-border trade, investment and technology transfer are significant drivers of rising prosperity, the size of the yard should be kept small.

There’s even an upside from geopolitical competition. Workers in Arizona, Dresden and Japan’s Kyushu Island are cheering the arrival of billions of investment dollars as TSMC diversifies its geographical footprint. The technology in the new Huawei phone suggest the US semiconductor ban may have accelerated China’s indigenous innovation. Developing economies from South Asia to Africa and Latin America hope the struggle for geopolitical influence brings US investment dollars to compete with China’s “Belt and Road” spending.

The big picture, though, is that the return of geopolitics adds a significant risk to the global outlook. And the details on the height of fence and size of yard required to contain that risk remain to be determined.