2025: The Year of Geopolitics

Let’s face it: Geopolitical risk in finance is considered sexy, but not always market-moving. It is often dismissed as “noise.”

Traditionally, it is traded after the event that triggers a spike in volatility, with most market players likely to sell volatility, betting on a faster return to normal than the news cycle anticipates.

We, however, are not traders. Our goal is to identify sources of potential risk that can be exploited before the event starts happening, as well as to point to potential outcomes that are being overlooked by the news coverage.

We already wrote about US elections here, making a clear - if not overly confident - prediction. If we are right - and we certainly hope we are because we love to be right - geopolitical risk is going to draw even more attention, as most market players believe a Trump Presidency is likely to be more “volatile” than a Harris one.

Our newsletter today revolves around three main topics:

The Gathering Storm

The title is clearly a Churchillian provocation. We are not (yet) heading towards a global confrontation. But there are clear and present dangers to global stability that markets continue to dismiss.

There are many open fronts - economic wars, hot wars, regional conflicts, potential flare points - and de-escalation is becoming increasingly unlikely for a number of them.

Think about it. In early 2022, we used to fear that the Russia-Ukraine war could have led to a nuclear armed conflict between Russia and NATO, and we were relieved when it did not happen. Energy markets, which had gone wild in the early days of the full invasion, quieted down a few months into the conflict.

Fast forward three years, and the Russia-Ukraine war has only become more entrenched, and conventional weapons caused enormous damage to Ukrainian (and now some damage to Russian) infrastructure, while deaths on the battlefield on both sides have reached - conservatively - at least half a million men and women. All this, with no prospect of de-escalation.

Markets have stopped being worried about it. But the more entrenched the war becomes, the harder it is to find an off-ramp for both sides. And Russia-Ukraine is not the only open front globally.

A defining election

The year 2025 is going to be defined by what will happen in Washington, DC, on November 6.

We discussed the US election’s first-hand effects already, but did not address the second-hand effects of a potential Trump Presidency on global affairs.

Unlike what most commentators say - you can hardly find one that is not politicized these days - Donald Trump is not an isolationist. He is a pragmatic advocate for American primacy, with strong “economic revanchism” fueled by a feeling - which is deeply personal - of America’s “lost competitiveness” in certain key industrial sectors.

An acute observer would be quick to argue that the US economy is currently in great shape, driven by a protracted surge in tech stocks valuations - and by the benefits that new technology is producing on the American worker’s productivity. The graph below shows the increase in per capita GDP from 2009 to 2023, as a large gap built up between the two sides of the Atlantic:

For Trump, this increase in both wealth and productivity is not enough. He wants the US to regain its leadership in heavy manufacturing where, he believes, other countries have surpassed it, utilizing free trade to their own advantage.

While tariffs against China - first introduced by Trump in 2017 - were never removed by the Biden administration, tariffs on European steel and aluminum were suspended (but crucially not revoked) until after the 2024 Presidential election.

As a result, Europe stands to lose the most from a party change in the White House. In addition to the steel and aluminum tariffs being reinstated, the talk in Washington is of potential new levies on cars. A manufacturing trade war between Europe and the US could also involve American tech companies being targeted by European regulators, as well as the long-standing issue of common defense and NATO obligations.

This is where politics and geopolitics intersect.

Europe has been preparing for a Trump Presidency, and it is unlikely to be taken by surprise as it happened in 2016. Counter tariffs are likely already being prepared, and a strategy to engage with the Trump administration is already in place.

Europeans could decide to re-engage with China as a result of US tariffs, or soften their position on Ukraine to rekindle energy trade with Russia - as the US has the upper hand on that, too, being among Europe’s largest natural gas suppliers.

But that is not the point. Whichever response Europe concocts, it will be a sign that frictionless trade is over, and in an increasingly multipolar world, alliances are becoming more volatile.

First Germany. Then Japan

We are skeptical that a Trump victory would automatically translate into the demise of NATO, and we do not believe a President Kamala Harris will necessarily mean a strengthening of transatlantic relations.

But with Trump back in the White House, there will likely be an acceleration in the evolution of how many wealthy countries - traditionally US allies - think about their own national security.

The question has been front and center in Europe since the beginning of the war in Ukraine.

While political leaders in major European countries recognize the threat that Russia poses, and the decisions taken throughout these past three years have all been unequivocally supportive of Ukraine, public opinions are not necessarily on the same page.

Europeans have been spoiled for 30 years after the fall of the Berlin wall by Russia’s relative weakness and America’s global dominance. Policy decisions were simple as there was no trade off between friendship with Russia and military alliance with America.

While US military (and tactical nuclear weapons) stationed in Europe did raise the occasional eyebrow, the benefits - being able to keep defense spending at a minimum - far outweighed the drawbacks. Meanwhile, a constructive relationship with Russia made it possible for Europeans - in particular for Germany - to get low-cost energy.

Both sides of the equation have changed. Russia’s thaw with Europe proved to be just a blip in history, and Putin’s invasion of Ukraine - which was meticulously prepared for a year, through accumulation of financial reserves and repeated military exercises at Russia’s western border - has factually ended Europe’s energy ties with Russia. And America under Trump would require European countries to seriously increase their defense capabilities, or risk facing American disengagement.

If “pride” prevails, it is conceivable to think Germany might take radical steps similar Poland’s, which has built Europe’s largest battletank force. Recent news of a military alliance pact with the UK, mirroring a previous one Berlin made with France,

But backlash inside the country is strong among voters, who long for a past of cheap energy and relaxed relationships with Moscow. This tension will need to be resolved one way or the other.

It is not inconceivable that a US withdrawal from Europe - even a stealthy one - would cause many countries to have similar debates. Accept Russia’s role in European affairs, or prepare to dramatically increase their defense budgets.

Either way, building up military capabilities takes time, and as many shrewd commentators have already anticipated, Europe would have a hard time supporting Ukraine on its own if the US decides to turn isolationist. It would have to take increasing risks, exposing its territory to potential Russian retaliation without US protection, hardly an outcome the people of Europe would be excited about.

Geopolitical risk can arise from either scenario. If European countries decide to concertedly rearm, and coordinate expenditures to face the Russian threat, Russia may decide to up the ante and increase provocations. If Europe takes the less confrontational road, and lets Ukraine go, it would create a precedent that would reshape expectations about security in Europe for years to come.

Similarly to Germany, Japan had also been neglecting its defense forces throughout the cold war. The lack of real threats and the US nuclear umbrella - together with its checkered past as an aggressor and imperialist country - made defense policy irrelevant.

But as China’s foreign policy became more muscular, public opinion in Japan shifted, and the country is now actively pursuing rearmament. This is not only evident from the rise in overall spending, but also from the country’s increasingly purposeful role in the defense of Taiwan, which is by now severely threatened by China’s aggressive foreign policy.

A potential US withdrawal from Japan is unthinkable - regardless of who’s in the White House. The negative signal it would give to the world about US-projected power would be a serious policy constraint to any President (there are close to 60,000 US troops stationed in Japan, and they’ve been there since the end of World War II).

But Japan cannot afford to take the risk, so the likelihood that it continues on this path of rearming and helping Taiwan is very high.

The likelihood that this could irk China - which is already actively trying to “strangle” Taiwan by stressing its air defenses, organizing provocations, and planning naval exercises around its shores - is extremely high.

The situation in the South China Sea has not de-escalated for a while now, and it is hard to imagine that this could happen given Taiwanese politics and the above mentioned arms race that Japan has started. Some analysts say China’s window to invade Taiwan is shrinking, and this - they maintain - shortens the timeframe for a potential war to break out.

There are already alarming signs that the war in Europe and a potential escalation in East Asia could potentially combine to produce the perfect storm. The presence of North Korean troops in Ukraine - the result of an abject quid-pro-quo between President Vladimir Putin and North Korean leader Kim Jong Un - is now well-documented. In response, the South Korean government is now considering ramping up aid to Ukraine, including lethal offensive weapons.

A Challenge to the dollar?

Geopolitical risk is not just about wars. It is also about a new global order or a new emerging balance of power.

The writers of this blog have radically different views on whether the dollar’s global dominance will be effectively challenged anytime soon. Alfonso is skeptical, Pedram has more of an open mind.

But neither of us can deny that the recent “weaponization” of the US currency - to enforce sanctions against Russia, for instance - somewhat puts into question its role as a “neutral” means of payment for global trade.

The challenge to the dollar has deep political meaning as it is brought by countries that are now emphatically opposed to the US on the global stage - Russia and China first and foremost. But while criticizing America’s role as a fair global arbiter is one thing, creating an alternative system of payments that is trusted by more countries is an entirely different animal altogether.

For now, middle-income countries have begun discussion on settlement mechanisms that would allow them to use a basket of their own currencies as reference in their direct trade relations, rather than the US dollar.

New settlement mechanism are not per se a particularly strong challenge to the greenback - after all, the euro has been there for a long time, and it is backed by strong economies and constitutes between 15 and 20% of global reserves, but has not come close to replacing the USD.

But the goal is indeed political - also because the dollar has been “politicized,” which is the main reason why many countries no longer trust it. One could argue whether sanctions against Russia or China are right or wrong, but it is clear that using the only true global payment currency to enforce them undermines the widespread trust it has benefited from for many decades past Bretton Woods.

The real question is whether Trump will continue to weaponize the dollar, using the US’s position as the key global financial player to punish enemies in an increasingly polarized world.

Anticipating the effect of geopolitical events on asset classes

Some European equities have already been hit by the increasing odds of a Trump Presidency. This reflects market concerns for potential US tariffs on cars and trucks, which Trump has been frequently mentioning during his campaign.

“A basket of 22 European stocks exposed to US tariffs compiled by Goldman Sachs has tumbled 5% since late September as the former president’s odds of an election victory shorten.

The basket, which includes Diageo, Porsche, Mercedes, Adidas or Moller Maersk is now down 11% this year, compared with an 8% rise for the broader European stock market and 22.5% for the S&P500.”

But second-hand effects of Trump’s contentious stance vis-a-vis Europe could spell more trouble for the old continent, especially if the topic of NATO/defense emerges in the trade negotiations via the military industrial complex participation to European tenders link.

This could potentially generate a structural discount that could sag European equity markets for years to come.

In Asia, a similar discount may be applied to assets in countries that depend heavily on frictionless global trade and US military protection, such as Korea and Japan. They would be hit by a combination of increasing spending needs amidst deteriorating macro backdrops, even if the threat of US military disengagement remains merely on paper.

Conclusion

The impact of geopolitics on global markets, which is often overlooked or underestimated in favor of more traditional drivers like monetary policy or corporate earnings, is poised to increase.

Geopolitical risk is likely to remain front and center in 2025.

For almost three decades after the end of the Cold War, the world has been relatively peaceful. Smaller, localized conflict - even in Europe, when Yugoslavia broke up - happened, but had no large impact on global relations. Trade, in the meantime, became as frictionless as it has ever been.

The Global Financial Crisis confirmed the primacy of technocrats and bankers - the ones who caused it and the ones who fixed were both financial professionals.

Then, in 2014, Russia altered the geography of Europe by occupying Crimea and the Donbas, igniting a war with Ukraine that, a decade later, is still ongoing. The significance of that invasion was not immediately clear back then, but Europe’s dawdling reaction to it showed how the balance of power had shifted since the Yugoslav wars.

In the Indo-Pacific, China has been staging military exercises around Taiwan with an alarming frequency. Military experts have flagged that this strategy has a dual goal - pushing for a peaceful reunification through show of strength, and testing the waters for a potential upcoming invasion.

In other words, the world is not becoming multipolar. It already is. And in a multipolar world, the interplay between geopolitics and financial markets will only grow more intertwined and, potentially, more decisive.

Additional readings:

Why China may be saving its Bazooka for Donald Trump

The quiet Japanese island paradise on the frontline of growing Taiwan-China tensions

A History of Russia 

Putin’s Wars: From Chechnya to Ukraine 

From Deng to Xi, China’s Foreign Policy Identity Has Been Consistent

EU braces for two-front trade war with US and China