By RHETT B. ROWE – CEO, Bridge Business Credit

With Research from Capital Economics

The world economy is fracturing into China- and US-aligned blocs. This is very likely to result in shifts in supply chains and reduced technology and investment flows between the two over the coming decade.

As a result of this potential, according to research done by Capital Economics, geopolitical considerations will play a greater role in economic policy than they have for a generation. If the shifts are gradual, economies and financial markets in much – but not all – of the world may be able to adapt without too much cost. However, antagonism between the blocs may mean that the risk of a more abrupt decoupling will cast a shadow over the outlook.

In the 1990s and 2000s, policymakers and corporate leaders in major economies had a common purpose of increasing economic and financial integration. The consensus that this would benefit all started to fray in the last decade. Now, concerns about supply chain vulnerabilities, energy security and, above all, growing animosity between China and the West are causing some of the integration to be rolled back.

This scenario may not simply lead to a rollback of globalization. Some global links could be severed but others strengthened. With the global economy coalescing into two blocs centered on the US and on China, this process has become known as “fracturing.” While the period of globalization during the 1990s and 2000s was driven by governments and companies working in unison, fracturing is now being driven by governments alone.

These developments, according to the research, may not have a major impact on macroeconomic prospects or outcomes in advanced economies, which all sit in the US-aligned bloc. Efforts by governments to secure supply chains for key products and commodities may affect only a small slice of global trade. Policies to shore up supplies of key commodities can add to the cost of greening economies in the short term but are unlikely to alter the long-term trajectory of decarbonization.

At the margin, productivity growth could be lower and inflation higher, but any changes will be small and outweighed by other factors. The movement of some high-skilled workers between blocs may slow, but this is a small part of overall migration flows. The US dollar is likely to remain the dominant global currency and the US financial system will continue to provide the financial plumbing for the world economy.

However, the politically driven nature of fracturing may have a significant impact on the operating environment for US and European firms in those sectors that are most exposed to restrictions on trade, such as technology and pharmaceuticals. Firms and investors will have to operate in a different environment where political considerations play a greater role in decisions over the allocation of resource.

In contrast to the outlook for the US-aligned bloc, the impact on productivity growth in China and some of its allies will be substantial, according to Capital Economics. This is embedded in the idea that China’s growth rate will slow to 2% by the end of this decade.

One consequence is that even if not much appears to change for advanced economies, the shape of the world in 2050 could be very different from what many currently suppose. The share of global output accounted for by the China-bloc has increased sharply over the past three decades, from 10% in 1990 to 25% today. But this surge will peter out over the next few years, in large part due to the productivity sapping effects of fracturing. The China-aligned bloc’s weight in the global economy won’t increase substantially from here.

If a crisis is avoided and fracturing leads only to a partial roll-back of prior decades of integration, most economies will adapt gradually to the new environment. Indeed, some European markets with strong links to the US and Europe could even be “winners” from fracturing.

In this relatively benign fracturing scenario, the financial assets of China, and the economies aligned with China, could face significant negative consequences as fracturing loosens trade and financial ties with the West. However, the impact of fracturing on most domestic market financial assets could be small, with some upward pressure on inflation ultimately leading to slightly higher bond yields and pressure on equity valuations.

There are also more worrying scenarios within this fracturing process that must be considered.

One is that the US- and China-centered blocs don’t hold, and that the global economy splinters into smaller regional or national-level groups. This could entail a rise in supply chain nationalism and a broader pushback against the sharing of technology. The loss of economies of scale would result in a larger hit to productivity growth in advanced economies. And a more disruptive shake-up of supply chains could create more volatility in both output and inflation.

With that said, a comprehensive splintering of the blocs is unlikely. For example, the ties between the EU and the US will remain strong, even if they become strained on occasions.

A bigger risk is that tensions between the two blocs escalate to confrontation, resulting in a broad severing of economic and financial ties. This would be hugely destabilizing: the world’s major economies are now so closely intertwined that even in areas where governments are keen to become more self-reliant – such as semiconductors, batteries, core minerals, and energy – decoupling supply chains will be a lengthy process. An abrupt severing of economic and financial ties would cripple global industry, causing shortages and rampant price rises.

Geopolitical issues inherent in this discussion are critical to future economic factors – a series of potential scenarios we should all pay close attention to and keep in mind as we develop plans for future growth or potential development with our companies and products.