Geopolitical time bomb ticks under market rally

The powerful global market rally on hopes for a V-shaped recovery will be put to the test as geopolitical tensions mount between the US and China, with Hong Kong emerging as the new flashpoint in the increasingly fraught relationship between the world's two biggest economies.

Another day of street protests in the central business district of the Asian financial hub came as US President Donald Trump warned of acting "very powerfully" in response to Beijing's plans to enact new security legislation that would allow it to take a harder line on democracy activists.

The firing of pepper pellets by the police rattled financial markets, with the Hang Seng Index tumbling in afternoon trade and the offshore Chinese yuan – which is traded in Hong Kong – falling to its lowest since September.

Washington has signalled it may withdraw the special economic privileges Hong Kong enjoys with the US if Beijing pushes ahead with its plans for tougher national security laws, a move that would undermine Hong Kong's autonomy enshrined in its mini-constitution known as the Basic Law.

The growing tension over Hong Kong caps weeks of angst between the two economies, with Washington raising the pressure on Beijing to make good on its pledges to buy more US exports as part of the phase one trade deal signed in January.

There is a risk growing geopolitical strains could weigh on a muscular rally that has lifted global sharemarkets to their highest levels in 11 weeks.

"The thing that markets are digesting at the moment is geopolitical machinations, which I think are pretty significant. Australia is caught in the middle of a much bigger story between the US and China," said Simon Doyle, Schroders' head of fixed income and multi-asset.

"I don't think we should underestimate the risk of that spiralling, particularly with it being a US election year."

Mr Trump has not only taken aim at China on trade and national security, but has hammered Beijing on its inability to contain the spread of COVID-19.

Both Mr Trump and Democrat candidate Joe Biden are expected to ramp up their rhetoric against China in the run-up to November's US presidential election in a bid to cement votes in heartland industrial states.

Further trade risks

But the resurgent stress in the world's most important economic relationship reflects a long-term battle between the two for economic, trade and technological dominance.

"I think there is a bit of a looming problem. The chest-beating between China and the US is pretty real, it reflects a broad geopolitical positioning of US-China and their dominance in the world," Mr Doyle said.

"The more pressure Trump is under, the more difficult that situation might get. This is going to be a pretty messy story this year."

Australia has not proved immune to heated trade tensions, with China singling out beef and barley exports.

UTS industry professor, and former ANZ economist, Warren Hogan said the targeting of beef and barley would not cause too much economic pain, but cautioned there was a risk from a sharper deterioration in trade relations.

"The China situation is deteriorating in a whole range of different aspects, particularly the US-China relationship," Mr Hogan said.

"We are unfortunately going to be part of that to-ing and fro-ing and it will do some damage to us if they [China] continue to behave like they have."

A deterioration in geopolitics is among many issues that could also sap the market rally of its strength.

While investors have welcomed the flattening of the COVID-19 curve in major economies, there is the risk of a second wave of new cases potentially derailing the growing optimism for a fast-paced economic recovery.

"From a market point of view that's significant in terms of testing that V-shaped recovery scenario," Mr Doyle said.

"If you start to see infection rates rising, the V might turn into a W pretty quickly."

Mr Hogan is also wary of expectations for a V-shaped recovery in Australia.

"The V will be truncated in the second half of this year by the realities of the recession dynamics that have been released on this economy."

A major concern is employers will cut jobs later this year once the government withdraws job support policies, which in turn could deliver a "household income shock" in the fourth quarter.