In a multipolar world countries will have to navigate multiple relationships, some will be difficult to classify as either alliances or rivalries.

I am not entirely sure as to the origin of the term ‘frenemy’ – the wikipedia entry for the word suggests it comes from the TV show Sex and the City – but it is perfect for today’s geopolitical context. Multipolarity is defined as a global system where more than one or two states are capable of pursuing a significant, and independent foreign policy. Great (and significant) powers have multiple foreign policy goals, some regional, some global, and some calibrated for the domestic arena. Out of this necessity to pursue multiple, often competing, strategies simultaneously arises a new type of a relationship between countries, one that is best captured by the pop-culture term frenemy.

Take the following two articles from Reuters:

In the first, a senior Iranian official told the newswire agency that the U.S. had informed Tehran in advance of its intention to attack the Islamic State (IS) militants in Syria and “assured Tehran that it would not target the forces of Syrian President Bashar al-Assad,” an Iranian ally. Another Iranian official, commenting on the U.S.-Iran cooperation against IS, tried their best to dance around the issue of an informal alliance, “This is an intelligence matter and I can assure you geopolitical and intelligence matters will not be shared with Americans… but military and security issues are being shared to fight against IS.” In other words, the U.S. and Iran are cooperating on geopolitical and intelligence matters!

In the second article, Reuters reported that the U.S. is looking to sell Vietnam P-3 Orion surveillance aircraft. The U.S. is upgrading its surveillance fleet with the new P-8 Poseidon aircraft and thus is looking to off-load the older, but still highly capable, P-3 to countries in East Asia that are concerned about China’s rise. To sell Vietnam the aircraft, Washington has to lift its arms embargo on Vietnam and ignore the human rights violations that it had repeatedly criticized Hanoi for in the past. But in the context of a more assertive China, which recently provoked Vietnam by floating a massive oil rig in waters that Hanoi claims as part of its exclusive economic zone, Vietnam and the U.S. are coming closer together.

Clients often ask me why American foreign policy so incoherent, particularly in the Middle East. It comes back to what Henry Kissinger said in the 1980s: “America has no permanent friends or enemies, only interests.” Perhaps the phrase should instead end with, “only frenemies.”

East Asia Blues: South China Sea Is Not Going Away Folks

A poll of BCA Research Investment Conference attendees suggested that most investors are worried about Russia and the Islamic State, but investment-relevant risk remains in East and Southeast Asia.

I just got back to our Montreal HQ after two days at the BCA Research Investment Conference in New York. It is always great to catch up with old friends and make new ones at our annual event. It is also always an honor to share the same stage as our invited guests and my colleagues.

It is a tradition at our conference to ask the audience a few questions before we begin each panel. I began my Geopolitical Update presentation with two simple questions: which geographical region do you expect to produce the most investment-relevant risk in 2015; and do you think geopolitical risk will increase, decrease, or stay the same in 2015?

Unsurprisingly, a majority of the audience expected geopolitical risk to increase in 2015. No arguments there. But when it came to selecting the source of that risk, most of our clients and invitees expected it to come from Russia (first choice) or the Middle East (second choice). Only 14% respondents thought that East Asia would produce market-relevant geopolitical risk next year.

Here I respectfully – and considerably – disagree with our clients. While the probability of more tensions and noise from Russia and the Middle East remains high, the market impact of the two regional crises will likely remain muted. Meanwhile, East Asian geopolitical tensions continue to mount. The more investors ignore this region, the greater the likelihood that the market will be blindsided by a crisis.

Take this New York Times article from September 13 which reported that Malaysia had offered the U.S. a base from which to fly surveillance aircraft over South China Sea. The claim remains unconfirmed by Kuala Lumpur, but fits the pattern we have come to expect in the region where China’s neighbors are increasing military cooperation with the U.S.

The airplane in question, the P-8 Poseidon, is currently flown out of the American Kadena Air Base in Okinawa, Japan. A P-8 was recently ‘buzzed’ by a Chinese Shenyang J-11B Flanker B air-superiority fighter, causing a minor incident. Chinese officials went on the offensive soon after, publically warning the U.S. national security adviser Susan E. Rice, while she was visiting Beijing, that the Obama Administration should stop the “close-in” surveillance flights. The warning is unlikely to alter American planes to deploy (a lot) more P-8s to the region, with Boeing set to produce approximately another 100 planes for the U.S. Navy.

The U.S. uses the P-8 Poseidon aircraft to spy on China, and its submarine fleet in particular, from international waters. Washington’s claim is that its aircraft can operate within international waters beyond the immediate 12-mile territorial line. China, on the other hand, claims that foreign aircraft are not allowed to fly within the 200-mile exclusive economic zone without permission. The difference in views is further accentuated by China’s claim to nearly all of South China Sea.

The reason I am highlighting this news item is because Malaysia is not an obvious candidate to join America’s containment of China. Kuala Lumpur does have a territorial dispute with China – James Shoal, only 22 miles off the coast of Malaysian state of Sarawak (Borneo) – but the issue has not soured relations between Beijing and Kuala Lumpur thus far. Malaysian public also has the most unfavorable views of the U.S. out of the major East Asian countries (Chart 1), suggesting that there could be a domestic political constraint to closer military relations with Washington.


Malaysia: Not An Obvious U.S. Ally


Malaysia is a ‘litmus test’ for our Geopolitical Strategy theme that East Asia geopolitical tensions are rising. In other words, if even Malaysia is joining the anti-China coalition that America is building in East Asia, then our view that things will get worse in the region is probably right. Russia and Iraq are certain to continue to make noise in 2015, but it is difficult to see how either produces major, and global, market-moving risks other than in a few unlikely scenarios. East Asia, on the other hand, could blindside investors precisely because nobody is paying attention to it.

We Read (And Liked)… China Goes Global: The Partial Power

Investors are faced with disparate conclusions about whether China is a truly global power.

According to David Shambaugh’s comprehensive look at Chinese power and its current role in the international system,* China remains a partial power that will continue to struggle advancing its foreign policy preferences within the existing global order.** Shambaugh uses the term partial power to explain that while China’s importance in areas such as global commerce and energy markets is very large, it remains a limited power in terms of its diplomatic reach, cultural influence, role in global governance, and security presence on the global stage. We agree with this nuanced take on the rise of China.

Shambaugh’s most important finding is that Chinese policymakers are being forced to advance the country’s domestic and foreign policy priorities within a global system that is based on liberal rules and norms designed by America in the post-Cold War era. This is a problem because Chinese cultural and political beliefs are opposed to many of the current rules and norms of the game. China is also suspicious of today’s architecture because it was designed by Western powers when China was weak and incapable of influencing outcomes. The stage is therefore set for a revanchist power to take on the declining hegemon.

As a result, China will continue to engage with other states and international organizations only if the result of their engagement directly impacts their strategic interests. As China grows more powerful, it could become more resistant to the institutions and practices that have underpinned the global economy for the past few decades – such as the World Trade Organization or the IMF. In fact, Beijing is likely to attempt to erode those institutions actively whenever the opportunity is at hand. This will create more uncertainty for global investors, as well as opportunities to profit from changes in geopolitical landscape.

Some analyses contend that Chinese power is understated and that the international system will be increasingly shaped by Beijing in the near future. Others argue the opposite, that China is years away from seriously influencing global affairs. Which view is correct? Does it matter?

The second source of uncertainty investors will need to grapple with comes from within China itself. Shambaugh does a good job describing the inconsistencies and opaqueness of the Chinese foreign policymaking process. For instance, after explaining the various actors and bureaucracies that influence Chinese foreign policy, Shambaugh contends that China’s national security decision-making process is “unclear, uninstitutionalized, and unregulated.” This is concerning.

The growing presence of the U.S. military in the region, along with the multitude of calls coming from China’s neighbors for a more assertive American footprint in Asia, will increase the importance of understanding if, how, and when China will react. Unfortunately an opaque policymaking process makes that exercise very difficult. The result is, as we have been arguing at the Geopolitical Strategy for some time, a growing probability that investors are caught off-guard by Chinese response to American strategy of containment.

* Shambaugh, David (2013). China Goes Global: A Partial Power. New York: Oxford University Press.
** David Shambaugh is an international authority on Chinese domestic politics, foreign policy, and international relations in Asia. He is currently the Director of the China Policy Program at George Washington University.

We Read (And Liked)… War! What Is It Good For?

War is not only inevitable, but it is also very good for humankind.

This is the message that Stanford historian and archaeologist Ian Morris argues in his provocative War! What Is It Good For?* Apparently it is good for a lot! Morris contends that violent contests between human societies foster in-group cooperation, technological innovation, and eventually human progress itself.

In a sweeping survey of history – surprisingly readable considering the scope – Morris shows that war, and eventually conquest, led to the decline in violent deaths from 20% to just around 3-4% by the first century AD – to even lower levels today. Although war is perhaps negative in the short term, in the long term it forces societies to organize on an ever larger scale that ultimately suppresses violence in the broader human population.

Underpinning Morris’ argument is a thoroughly Darwinian mechanism. Just as with biological evolution, human societies get bigger and more sophisticated, or they become extinct. The lesson from history for humans is therefore to get bigger, meaner, better organized, and thus more proficient at killing other societies on a mass scale. In the process, societies eliminate internal conflict and discord, replacing countless micro-conflicts with the ability to wage a few macro ones. In this way, Morris can claim that the 20th century, which produced some of the most extraordinary organized killing campaigns known to man, was actually far more peaceful than any major time period that preceded it.

Morris is not the first to make the argument that war makes states. Charles Tilly, one of the most famous sociologists and political scientists of the 20th century, famously compared the state to an organized crime syndicate. The state organizes itself and collects taxes in order to fund what is essentially a protection racket. States that do not to perform this function efficiently ultimately fail.

What can investors take from these pro-war arguments? Morris’ book is a great read for the late-summer, full of fascinating anecdotes from history; but is all this emphasis on the evolutionary quality of war in any way applicable to today’s world?

I would say yes. As the world enters a multipolar era where no one state is in charge, it is likely that geopolitical tensions and wars will increase in frequency. If as Morris and Tilly argue, war has an organizing quality, perhaps then internal discord will dissipate in the face of increasing geopolitical conflict. Take American political polarization. It was at its nadir during the early days of the Cold War (Chart 1). Perhaps what American policymakers need to overcome their ideological differences is a clear external threat. Similarly, perhaps what Chinese policymakers need to pursue painful structural reforms, or Europeans to strengthen their integration, is the clarity of purpose that comes with geopolitical competition.

Chart 1: Could Cold War Lite Assuage Polarization?

GPS Cold War Chart

The problem with this view is that we have no evidence that economic and financial globalization is sustainable between geopolitical rivals. The late 19th century saw a considerable increase in globalization, and it was multipolar, but European countries also coordinated their relations via the Concert System established by the Congress of Vienna following the Napoleonic Wars. If today’s multipolar system goes down the path of competition and tension, it is likely that it will erode globalization along with it.

*Morris, Ian (2014). War! What Is It Good For?: Conflict And The Progress Of Civilization From Primates To Robots. London: Profile Books.

Low Potential?

One of the raging debates among economists and investors these days concerns the size of output gaps in the major developed economies. If output gaps are smaller than widely believed, central banks will need to tighten monetary policy earlier than expected, which could trigger a selloff in equity and bond markets.

The IMF estimates that the output gap will reach 2.2% of potential GDP in advanced economies in 2014, down from a high of 4.9% in 2009.

What is often overlooked is that output gaps would be much larger today had it not been for a significant decline in potential GDP growth. Chart 1 shows the growth of real potential GDP in a variety of countries and regions since 2008. Each panel contains two series: one drawn from the IMF’s April 2008 World Economic Outlook database; the other from the most recent projections released in April 2014. (The IMF did not make output gap projections back in 2008, so I assumed that whatever output gap the IMF estimated for 2008 would eventually converge to zero in 2014; this allowed me to back out projected potential GDP growth).

Low Potential? - Chart 1

The numbers are striking. For advanced economies as a whole, the IMF estimates that real potential GDP will be 7% lower in 2014 than what it projected in 2008. For some countries, the drop in potential GDP growth is immense: for example, the IMF estimates that real potential GDP in Spain will be 21% lower in 2014 than what it had projected in 2008. In the case of the U.K., potential GDP is likely to be 10% lower.

Are these estimates correct? To be sure, potential growth must have slowed over the past six years relative to what the IMF had expected before the crisis. The Great Recession led to a steep drop in capital spending, which sapped productivity. It also undoubtedly caused many people to flee the labor market, some of whom are unlikely to return.

Yet, the sheer magnitude of the downward revisions to potential GDP strikes me as excessive. The weakness in capital spending has likely pushed up the rate of return on capital (this is one reason why profit margins are so high), which should give a nice cyclical boost to capital spending going forward. In addition, a large share of youth who dropped out of the labor market will eventually return (quite a few decided to stay in college, which is not necessarily a bad thing). And perhaps most importantly, many workers who remained in the labor force have ended up in substandard jobs that do not fully utilize their skillsets. Stronger labor demand over the next few years should allow them to transition to jobs where they are more productive, helping to boost potential GDP.

Back in the 1930s, many commentators argued that the economy had suffered a permanent loss of capacity. Yet, as Chart 2 shows, real per capita GDP eventually returned to its pre-Great Depression trend by the 1950s. If this happens again, it would imply that today’s estimates of potential GDP are too low, which is another way of saying that the output gap may be bigger than widely estimated. In that case, tightening too early because of a fear of diminished spare capacity would be a huge mistake (just as it was in 1937).

Low Potential? - Chart 2

I suspect that Janet Yellen is quite sympathetic to this line of thinking, and as such, she will want to see a meaningful burst of inflation before she starts to hike rates. But if the output gap is bigger than commonly believed, as I think is the case, that burst of inflation may not occur for several more years at least. This calls into question the widely-shared view that the Fed will start raising rates next year.