Two major fault lines for 2019
In the November 2018 issue of Master Investor Magazine I wrote in this column that there are three dimensions of global analysis: global financial markets, underlying economic fundamentals (GDP growth etc.) and geopolitics. I wrote about the first two last month. This month I want to flag two major geopolitical fault lines that could experience tectonic re-adjustments (aka earthquakes) as early as 2019. They concern America’s relationship with the rising rival superpower, China; and its relationship with its up-until-now friends in Europe.
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Each of these fault lines delineates opposing parties with competing interests. Even minor dislocations can be of potentially high economic risk as they can impede world trade, and therefore growth. Moderate dislocations cause political turbulence, and therefore increased volatility in the global financial markets. Major dislocations could cause – let’s be frank – war.
We have lived in an era of prevailing peace between the great powers since 1945 – give or take a few dozen relatively “minor” wars. Some of them have been internecine like the Vietnam War (1955-75) or the Balkan Wars pursuant to the break-up of Yugoslavia (1991-1999). They have all taken place in marginal or peripheral countries. Butwe should not assume that world peace is a natural state, despite the mutually assured destruction of nuclear war.
On the contrary, history teaches us that the moment when rising nations challenge established hegemons is the most dangerous. Here, I just want to consider how the escalating trade war between America and China is actually becoming a new cold war. Also, I want to examine how America’s evolving (a polite word for deteriorating) relationship with Europe may even accelerate the risks of a US-China clash.
The challenge to the post-1945 states system
We are currently in a transition to a new global states-system. This is replacing the post-1945 settlement, the principle architect of which (paradoxically) was the United States of America. Liberals may not like this very much – but it is happening. The post-1945 states architecture was based on multi-national institutions – with the United Nations (UN) at its centre. The new states system is based on the return of powerfully assertive nation states, mostly led by a new breed of popular (I do not say populist) strongmen. Increasingly, these 21stcentury strongmen rule, not just for years, but for decades.
Most commentators date the post-cold war era in which we live from the breach of the Berlin Wall by protestors on 9th November 1989, some 29 years ago. Then it was clear that the Cold War was over – the West had “won” and state socialism, especially as exemplified by the Soviet Union, had been defeated as an economic model for good. Just over a year after the fall of the Berlin Wall and the self-liberation of the countries of Eastern Europe from communist tyranny, the Soviet Union itself dissolved on Christmas Day 1991. The world seemed to be careering on a new trajectory – one in which capitalism was triumphant and the USA emerged as hegemon, or sole superpower.
But there is another key event from which we can date the age in which we live – particularly if we re-focus away from Europe towards Asia. That date is 4th June 1989. That was the day that the top leadership of the Communist Party of the People’s Republic of China (CCP) lost patience with a brief experiment in relative democracy. The two-month student protest which had brought Tiananmen Square to gridlock was halted. The protestors were massacred.
Having reasserted its absolute authority, the CCP did a tacit deal with the Chinese people. You stay out of politics, which will remain our sole domain: but you are free to set up businesses and get rich. To get rich is glorious, said Deng Xiaoping. The Chinese, who are amongst the most naturally entrepreneurial people on planet Earth, took up the offer with gusto.
Western observers, inured with the idea that capitalism and democracy are the horse and carriage of the modern world, looked on expecting that sooner or later China would adapt to its growing prosperity by aping the Western model of liberal democracy. That didn’t happen. Instead, if anything, China became even more autocratic: using modern technology to enhance the Big Brother surveillance machines used to supress all dissent in the first digital autocracy.
The end of multilateralism
In the time of Trump, Putin, Erdogan, Xi, Duterte and Mohammed bin Sultan, Bolsonaro (not to mention Brexit) multinational cooperation now seems so last century. But what about the collaborative Europeans: Macron, Merkel, Juncker and Tusk? It turns out that they are trying to construct another state, in federal form, to challenge America.
It was the United States, supported by Britain, which propelled the foundation of the United Nations on 24th October 1945, at a moment when much of the world lay in ruins. Then it had 51 members; today it has 193. The UN was underpinned by the UN Charter and by the Universal Declaration of Human Rights (UDHR, 1948). All states that joined the UN would therefore have at least to pay lip service to the values of Western liberal democracy. And a panoply of supra-national or internationalist institutions then began to proliferate: the World Bank (1945), the IMF (also 1945), UNESCO (1946), the World Health Organisation (1948) and so on.
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Within this ideology of collaborative association and collective security the proto-EU emerged with the Treaty of Rome (1958). The flowering of this was the birth of the Euro in the late 1990s which, as I have explained before in these pages was the French solution to the German problem which arose from the re-unification of Germany in 1990. (Paradoxically, however, the same forces that gave rise to international financial cross-fertilisation also resulted in the catastrophe of the Financial Crisis of 2008).
More than that, the elimination of trade barriers and commercial borders gave rise to the form of stateless capitalism that we now call globalism. A small mountain resort in the Swiss Alps became the nexus of the Champagne-fuelled globalist conspiracy – Davos – a name that now rings with infamy in the post-globalist age of economic nationalism…
Then, as if on cue, mass migration came to the top of the political agenda on both sides of the Atlantic at the more or less same time. The over-filled boats travelling from lawless Libya to Southern Italy, or from Morocco to Spain, mirror the caravans heading from Central America to the US-Mexican border. For American Republicans and European populists, the globalist liberal elites who have encouraged the mass immigration of people of alternative culture – some of whom support the doctrines of Islamicist terrorism – are now responsible for the sabotage of national culture and life…
Anti-immigration sentiment – especially on the part of indigenous working class communities whose incomes were most vulnerable to an influx of low-skilled workers who dragged wage rates down – gave rise to the political movement which people on the left call populism. I have argued before that populists are not neo-fascists but are actually traditional conservatives, established conservative parties (like the UK political party of that name) having become both globalist and liberal.
Alternative fur Deutschland (AfD) is now the official opposition in Germany. It is ironic that the populists have gained strength in Europe at a moment when the American president – whose views they share in many respects – has signalled that the NATO alliance may be out of time.
The culture war
Reaction against mass immigration, multiculturalism and globalism occurred at a moment when western society was riven by a social revolution which threatens to transform society in ways that traditional conservatives fear. Conventional feminism has been superseded by the #MeToo movement which, for many men, looks like an attack on masculinity; the gay rights movement – now happily successful in the west – has been superseded by something that many find difficult to understand: namely militant transsexuals and indeed intersex (the precise definition of which eludes me) activists being aggressive about conventional bathroom arrangements. All this is now called the culture war which overlays the widening gulf between conventional left and right.
Interventionism
In the aftermath of the collapse of the Soviet Union the US became more assertive and adopted a strategy of active interventionism – much egged on by, for example, UK Prime Minister Blair. First, NATO attacked Serbia and detached Kosovo as a separate state – in total violation of the UN Charter, by the way, and to the horror of a much weakened Russian Federation. Then the Western alliance invaded Iraq in 2003 on the spurious pretext that it had weapons of mass destruction. (The same Mr Blair was instrumental in propagating this false prospectus). The aftermath of the Iraq war, having smashed all the power structures of that country and several of its neighbours, was to create a massive power vacuum across the entire region into which Iran, Syria and Turkey were ineluctably drawn – with horrific consequences.
After 9/11 (11th September 2001) America acted in its self-proclaimed War on Terror as if its NATO allies did not matter. The 2003 invasion of Iraq was spurned by France and Germany – though “Old Europe”, Poland et al, signed up. Peter Hitchens[I] thinks that the disastrous liberal interventionism of George Walker Bush and Tony Blair and the post-war ideal of internationalism are uncomfortably connected. The idea that states should intervene just because they disapprove of the morality of other governments has proved extremely destabilising. In contrast, the Chinese stance that they wish only to do business with, and have no desire to criticise African governments for their human rights record, has won them many friends across that continent.
At the same time, by re-embodying the Russian threat and by changing European borders by decree, President Putin has given new life to the need to create a new military front against Russia. Yet President Trump has been the most unfavourably inclined POTUS towards NATO since its inception. NATO was always an alliance conceived to counter Russia; but, as far as he is concerned – is Russia the problem? There is a much larger and more powerful country that directly now challenges American supremacy – and that is, of course, China.
This is the single most potent reason why a president was elected in the USA in 2016 who was himself a challenger to the international status quo. This president is not only opposed to the post-war order – he is hostile to it.
Welcome to the new world disorder…
The USA versus China
There was a bust-up in the South Pacific last month. It might be seen in future as the moment a new Cold War began. Such was the furore around Brexit that many British readers might have overlooked a very important incident which was little reported by British media. The event demonstrated beyond doubt that the trade war between the US and China is only tangentially about trade.
On 17th November US Vice President Mike Pence and Chinese President Xi Jinping exchanged barbed comments at the annual Asia Pacific Economic Cooperation (APEC) summit in Papua New Guinea. APEC is a forum of 21 countries which have coastlines on the Pacific Ocean which has held annual meetings since the late 1980s.
The summit ended the next day in unprecedented disarray, with no joint communiqué – for the first time in its history. At this summit, proceedings were overshadowed by the regional (and global) rivalry between the United States and China, of which the escalating trade war is just one manifestation[ii].
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Apologists for the Trump administration will say that the US has, at last, formulated a response to China’s Belt and Road (New Silk Road) programme – China’s strategy of rolling out huge infrastructure projects, executed by Chinese contractors, at favourable rates across Southern Asia and Africa. Launched in 2013, with a projected budget of nearly one trillion dollars, the idea is a blatant attempt to drag developing nations (and their abundant resources) into China’s orbit.
As more states are pulled into that orbit, so fewer states will adhere to the established Pax Americana. So for Americans of a strategic bent, the New Silk Road is a kind of post-modern Marshall Plan designed to promote not just Chinese trade but Chinese values too. A 5,000 mile four-lane motorway linking Beijing to St. Petersburg opened last month. The road runs from western China (Xinxiang – where the native Uighur population is in latent revolt), and then crosses Kazakhstan into Russia. Russia might seem like a threat if you live in Estonia; but Russia is itself now within China’s gravitational field.
One diplomat told Reuters that tensions between the US and China erupted when the Chinese government’s top diplomat, Wang Yi, objected to two paragraphs in a draft document. One referenced unfair trade practices and the reforming of the WTO, while another concerned sustainable development. Chinese delegates were outraged, saying the references were barbs against China. Chinese delegates attempted to bully Papua New Guinea officials into issuing a statement that conformed to Beijing’s outlook. According to AFP police were called by officials at the Papua New Guinea ministry of foreign affairs to eject Chinese officials. The Chinese vigorously denied these claims.
Instead of issuing a document that all 21 participants could agree upon, Papua New Guinea Prime Minister Peter O’Neill announced that he would issue a summary statement. The Prime Minister said the main area of disagreement was the insistence by one country — evidently the US — that the communiqué would endorse the reform of the World Trade Organization (WTO). Mr O’Neill added: “APEC has got no charter over the World Trade Organisation”.
China benefits from the WTO under the current dispensation and therefore does not back reform. European Union proposals to reform the institution are expected to be tabled at the G-20 summit in Buenos Aires, Argentina, scheduled for 30th November 2018. The US is increasingly hostile to the WTO because it believes that it is soft on China – especially with regard to the theft of intellectual property.
Vice President Pence admitted that there had been major differences between the US and China, citing tariffs, quotas and forced technology transfer (aka the theft of intellectual property). He added that the US had concerns over freedom of navigation on the high seas (a reference to Chinese military activity in the South China Sea) and human rights.
After the summit, Vice President Pence warned developing nations to avoid loans that would leave them indebted to Beijing. He said the US was not in a rush to end the current trade war and would “not change course until China changes its ways”.
While the USA can depend on allies like Japan, Australia and Taiwan, nations such as South Korea and the Philippines that have defence arrangements with America will become “fence sitters” according to Minxin Pei, professor of government at Claremont McKenna College in California. These states don’t want to make themselves an enemy of China. I wrote earlier this year about the relentless Chinese penetration of Australia’s economy. Many Australians thinks that their elite have been complacent in letting this happen.
While in Asia, Vice President Pence also tried to pull more nations away from China’s sphere of influence, saying the US provides a better option for nations in the region. He announced a plan along with key Pacific allies to build a $1.7 billion electricity grid in Papua New Guinea. The US also joined with Australia to redevelop a naval base – a show of force which will infuriate Beijing – and held a meeting of “the Quad”, a group that also includes India and Japan, to discuss China’s rising economic and military strength in the Pacific. (There have been rumours that the Chinese are trying to establish a military base on the Pacific island state of Vanuatu).
As a result of this rising geopolitical tension, the US is threatening to raise tariffs on Chinese imports further as early as January 2019. As I write, nobody is expecting Presidents Trump and Xi will reach a trade deal when they meet at the G-20 summit in Argentina in late November. President Trump has previously threatened to pull out of APEC, claiming that its rules unfairly favoured China. For now it is just another forum in which to joust.
Most economists would argue that no one wins a trade war in the long run. Free trade creates a level playing field for producers of goods, wherever they may be; and this always lowers costs for consumers and businesses. But, as we know, productive capacity tends to be located where labour costs are cheaper, causing job losses in the manufacturing heartlands of more developed economies. This prompts claims of unfair competition – something that Mr Trump tapped into during his 2016 presidential election campaign.
In my view, the US-China trade war has only just begun. It might turn out in decades to come to be the harbinger of a more lethal kind of war.
The evolution of the European Union
The European Union (as it has been called since the Treaty of Lisbon, 2011) – or the European Economic Community (EEC) as it was originally called – came about a decade or so after the foundation of the UN at a time when it seemed that states needed to coalesce in order to progress. Britain was not a signatory to the Treaty of Rome (25 March 1957) which brought the EEC into existence. The original six were: France, West Germany, Italy, the Netherlands, Belgium and Luxembourg. For five of those nations the logic was compelling: they no longer had to worry about German expansionism.
Britain, Ireland and Denmark joined the EEC in 1973; Greece in 1981; Spain and Portugal in 1986; Sweden, Finland and Austria in 1995. Ten Eastern European and Mediterranean countries joined on 1stMay 2004; and then Bulgaria and Romania in 2007. Croatia was the most recent recruit in 2013.
Europe: fault lines north-south – and east-west
There are two major fault lines within the EU of which one in particular within the 18-state Eurozone itself. Essentially, the Eurozone rift runs North-South: it reflects the disparity between the surplus countries such as Germany and the Netherlands and the deficit countries which aboard the Mediterranean. (These are sometimes referred to, somewhat disparagingly in my view as the Olive Belt).
Then there is an even deeper fissure on cultural lines which runs East-West. The Western EU states are liberal and relatively amenable to mass immigration; the Eastern EU states are socially conservative, like Catholic Poland, and find the prospect of the obligatory imposition of migrant quotas totally unacceptable.
Let’s look at the North-South rift within the Eurozone first. I call this Brussels versus Rome, but you might also want to call it Frankfurt (the home of the ECB) versus Athens; or even Berlin versus the South.
Brussels versus Rome
The stand-off between Rome and Brussels over Italy’s 2019 budget claimed its first casualty on 12th November. Italy’s major banks were forced to club together to support an emergency bond issue by Banca Carige SpA (BIT:CRG) after the rise in Italian government bond yields – triggered by the Brussels-Rome budget battle – eroded the second-tier bank’s capital base, pushing it to the brink of collapse.
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That intervention averted a failure, and the contagion that would inevitably have followed. But the need for a rescue emphasises that the doom loop (the term used by the World Bank) between Italian government debt and Italy’s banks is an accident waiting to happen. This is a problem both for the country’s banks and for the Italian government.
Since 2008, Italy’s banks have more than doubled their holdings of Italian government debt from €165 billion to €387 billion. This has largely occurred since 2011, when the ECB introduced its programme of making preferential loans to Eurozone banks in order to stimulate lending. These allowed Italy’s banks to borrow from the ECB at fixed rates as low as minus 0.4 percent and to invest the proceeds in Italian government debt (which carries a zero-risk weighting under the Basel III capital adequacy framework). Such a trade made for a handsome carry.
As a result, today Italy’s banks own 20 percent of all outstanding Italian sovereign bonds – 10 percent of their asset base – up from less than 5 percent before the crisis. Now the budget plans of Italy’s new populist government have turned the size of that holding into a major issue for the markets.
After Rome tabled budget proposals that will push Italy’s 2019 deficit up to 2.9 percent of GDP (according to Brussels), the yield on 10-year Italian government bonds has climbed from 1.71 percent after April’s election to 3.27 percent as I write. That implies a major fall in the value of government bonds on banks’ balance sheets, eroding their capital bases. It seems that the European mandarins now believe that the Italians could bring the Euro crashing down…
The Germans versus the rest
In his book Brexit: the road to freedom, Will Podmore explains that the EU was conceived as means to achieve free trade within Europe – much to Germany’s advantage – but was never a free trade enterprise. The founders of the EU – Frenchmen and Germans – never embraced the goal of international free trade. On the contrary, their goal was to protect the EU against foreign competition by imposing tariffs on goods imported from its industrial rivals in America and elsewhere. When the EU talked about free trade, it meant protecting itself by means of treaties against other trade blocs like NAFTA and the Trans-Pacific Partnership. The single currency was largely a successful means by which German exporters could eliminate exchange risk on the part of their major export markets. The outcome is a system which is inherently flawed – and which may not be able to withstand another Europe-wide recession.
America versus Europe
Just before the centennial commemoration of the 1918 armistice President Macron announced that Europe needed to build its own army in order to protect Europe against its prospective adversaries: the USA, China and Russia. That was a strange thing to announce in front of a visiting US President – especially The Donald.
Monsieur Macron’s oration prompted a tirade from Mr Trump, whose bromance with the French President is clearly over. But on 13th November Frau Merkel, in a speech to the European Parliament in Strasbourg, unequivocally spoke in support of President Macron in favour of the establishment of a European Army. She said that an EU army would counter unreliable allies. (By which French and German listeners would have understood America and Britain).
As if to underline the East-West split in Europe, the Poles were celebrating the 100th anniversary of the re-establishment of their nation. At an Independence Day event in Warsaw, Polish President Duda addressed the multitude. Polish soldiers stood side-by-side with members of a right-wing group (comparable, perhaps, to the English Defence League) which is vociferously opposed to Muslim immigration, as well as representatives of Forza Nuova, an Italian right-wing movement.
Monsieur Macron’s attempt to re-configure the Western security apparatus, supported by the out-going and increasingly enfeebled German Chancellor, makes him a much more dangerous figure than Mr Trump. It is now clear that the Franco-German alliance is trying to push Europe – and particularly the 18 Eurozone countries – in the direction of fiscal harmonisation (that means a common budget and identical taxes), and political union – all with a common defence identity.
As usual, the French and the Germans are out on a limb. Who will pay for this shiny new European Army? As President Trump is keen to remind Europeans, most NATO members do not even meet the alliance’s aspiration to spend just two percent of their GDP on defence. Most Eurozone states have debt-to-GDP levels at record highs. Their welfare states are expanding and the cost of healthcare is rising. Where is the money for this new defence arrangement going to come from?
Moreover, not all Eurozone states are NATO members even now. The Republic of Ireland, Sweden, Austria and Finland were resolutely neutral states during the Cold War (the first two by choice, the latter two by virtue of treaties). They benefitted from the collapse of the Soviet Union – but contributed nothing towards the defence of Europe from (what Ronald Reagan called) the evil empire. It is funny that the EU negotiating team has taken such a supportive stance to the Irish on the matter of the UK-Ireland border when Ireland, unlike Britain, contributed nothing to their current freedom.
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But the real point is that Monsieur Macron’s proposal has fundamentally shifted US opinion in the direction of Mr Trump’s outlook. Not only does the US subsidise European defence costs – to the extent that the Germans can run a massive trade surplus with the USA – but now Macron & Co. are potentially going to point France’s force de frappe missiles at Washington. That would be a very big mistake.
I now think that Mr Trump will campaign in the 2020 presidential election on a platform of the US leaving NATO altogether. Europe is actually a distraction for the US from its main focus – which is, of course, the containment of China. Most Americans are now tiring of Europe’s combination of penny-pinching and arrogance. If Mr Putin were to decide to quash Estonia as he quashed Georgia in 2008, I suspect that most Americans would conclude that Monsieur Macron and Frau Merkel (if she is still around) should sort it out with their own threadbare army.
So President Obama’s pivot towards Asia will actually accelerate under Mr Trump. Europe is making a huge mistake in its liberalist-globalist contempt for Mr Trump. And its peoples may very well live to regret it.
Conclusion & Action
What should investors make of this re-configuration of the global geopolitical landscape?
We are living at a time of rapid technological change – which offers huge opportunities – but also of a revolution of the states-system that has obtained for nearly 75 years. The peace of 1815 which was sealed at the Congress of Vienna, and which drew a line under the era that we now call the Napoleonic Wars, lasted 99 years until 1914. Will the period of peace between great powers which began in 1945 last that long?
Investors can’t really prepare for a major shock that will most probably occur at an indeterminate time over the medium to long term. But they can position themselves for fundamental shifts that are likely to occur over the short term.
One prospective outcome of a US-China Cold War (even more than a hot war) is that the countries that have most invested in the internet (the world wide web) may start to want to fragment that web into mutually impenetrable silos. The day of reckoning for the internet giants is coming – especially for the titans of social media, Facebook (NASDAQ:FB) and Twitter (NASDAQ:TWTR) – as Europe and the USA begin to regulate that sector more pro-actively.
Chinese influence now stretches well beyond South and Central Asia as far as central Europe and even Greece, and the Chinese media giants are a part of the Chinese power-play; just as Chinese construction companies are instrumental in the roll-out of the New Silk Road. In my opinion, the second phase of Mr Trump’s cold war against China will be that, as well as tariffs, the administration will take measures to staunch the flow of American capital into China. That will inevitably impact the Chinese stock market, but especially its tech sector which is widely held outside China. China’s social media giants – Baidu (NASDAQ:BIDU) andAlibaba (NYSE:BABA), in particular – will suffer a similar fall from grace as their US analogues.
There will be other consequences which I would like to explore in 2019. In Europe, the risk of a major crisis has thus far been underestimated by the markets. The Eurozone economy is already slowing down at a time of increasing risk of economic shock – whether from an Italian default or from a major recession which would reveal the huge economic imbalances on which the single currency is sustained. I’ll be shining a laser-beam into that dark pit very soon.
[i]Speaking to Bridget Kendall in The death of the post-war settlement. Available at: https://www.bbc.co.uk/search?filter=programmes&q=The%20Death%20of%20the%20Postwar%20Settlement&suggid=urn%3Abbc%3Aprogrammes%3Am0000t68
[ii]See: https://www.zerohedge.com/news/2018-11-18/apec-summit-ends-unprecedented-chaos-after-dramatic-collapse-us-china-relations?fbclid=IwAR3Fuojvfgt8IFCAGljEl8USRuDpfprvcWroUIL_XRGhd-mAIR5Gp5otN3I
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