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Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, as well as two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays).
Welcome to the Confluence of Ideas from Confluence Investment Management focusing on major geopolitical and economic trends and their investment implications. I'm Phil Adler. In this midyear twenty twenty five report subtitled Searching or the Endgames, Confluence analysts join us to take a fresh look at key geopolitical trends and identify potential opportunities for investors. Our guests are Confluence advisory director, Bill O'Grady, chief market strategist, Patrick Fearon Hernandez, and Associate Market Strategists, Daniel Ortwerth and Thomas Wash. The group has identified six key trends with issue number one, not surprisingly, being US China tensions.
Phil Adler:And among these tensions, trade has easily gotten the most attention in the first half of the year. Patrick Fearon Hernandez has written about this issue, so my first question is directed to Patrick. What have events in the 2025 taught us about a possible endgame to the battle between The US and China over trade?
Patrick Fearon-Hernandez:Well, hi, Phil. Thanks for having us all on the program. To answer your question, we generally expect Washington and Beijing to eventually strike some kind of a deal on trade issues, but it won't necessarily be a happy solution. It's likely to have characteristics of an agree to disagree deal, and trade tensions could then easily flare up again in the not too distant future. This just reflects how strongly the two countries' economic imperatives differ and how much they're at odds with each other.
Phil Adler:Now you make the point in the report that the attention devoted to trade may divert attention to serious divisions between the two countries in other areas. What should investors focus on?
Patrick Fearon-Hernandez:Well, you're right. We think that even if The US and China each reach an agreement on tariffs that reduces or ends trade tensions at least temporarily, there will still be growing tensions in other areas of the relationship. It looks like China will continue exerting military pressure on its neighbors in the Western Pacific. And as the Trump administration looks to shore up the defense capabilities of US allies in the region, China will have even more incentive to act. So military tensions will likely keep worsening.
Patrick Fearon-Hernandez:And, of course, then there's the great technological rivalry between The US and China. The Trump administration, like the Biden administration before it, recognizes the need to keep a technology edge over China. So it will keep restricting Chinese access to key US technologies. And China will keep trying to gain those technologies by any way it can and even to surpass The US in key technologies. This also ensures that US China relations are more likely to worsen over time even if trade tensions cool.
Phil Adler:Issue number two is the Russia Ukraine war. Patrick, is Russia closer now to an end game victory than it was six months ago?
Patrick Fearon-Hernandez:Well, compared with six months ago, I would say yes. That doesn't necessarily mean that Russia is on the verge of a final win in Ukraine. It doesn't look like Russia can generate the offensive momentum for that to happen soon. All the same, the Kremlin has been able to regain some momentum recently. And during the spring and early summer, it had started to take more meaningful chunks of Ukrainian territory again.
Patrick Fearon-Hernandez:That's probably a key reason why president Putin hasn't heeded president Trump's demand that he stop the war. A key question is what happens now that Trump has evidently soured on Putin and is starting to rearm the Ukrainians again.
Phil Adler:Confluence, Patrick, has identified opportunities in foreign markets, particularly in defense stocks for many months now. Would you say wartime events in the first half of this year have accelerated those opportunities and that investors might be well advised not to wait?
Patrick Fearon-Hernandez:Yes. It does look like that. But to reiterate our recent fuse, it's still not clear to us how the Trump administration's effort at fiscal consolidation will affect US defense contractors and their suppliers. What is clear is that European defense firms and Asian firms to some extent are probably better placed to take advantage of the global drive to rearm. We continue to favor foreign defense firms over their US counterparts, especially given that the weakening dollar also gives an advantage to foreign stocks generally right now.
Phil Adler:Daniel Ortwerth has been keeping a close eye on The Middle East, which is issue number three as that region experienced significant upheaval in the past several months. Daniel, how has conflict in the region changed the balance of power there?
Daniel Ortwerth:Phil, The Middle East has four geopolitical heavyweights, countries whose population, resources, and economy give them the ability to pursue their interests, exert their influence, and divide for regional dominance unlike the smaller, less powerful countries in the region. Those four countries are Turkey, Iran, Saudi Arabia, and Israel. Only two short years ago before the Gaza conflict began, Iran seemed to be succeeding in its efforts to build its strength and its position throughout the region. Its oil production and exports had nearly recovered to previous highs. It was profiting from an expanding arms trade with Russia, and its proxies in Iraq, Syria, Lebanon, Gaza, and Yemen were gaining strength and exerting pressure throughout the region.
Daniel Ortwerth:Since the Gaza conflict began, Iran has suffered several severe setbacks. The Israeli offensive in Gaza has crippled Hamas. US and Israeli strikes on the Houthis in Yemen have drastically reduced their activity. A rebel group closely allied with Turkey toppled the Assad regime in Syria. Each of these were Iranian proxies.
Daniel Ortwerth:The Trump administration resumed the maximum pressure sanctions regime against Iran. And finally, the Israeli war against Iran in June, assisted by The US, has destroyed or degraded key military assets, especially its air defense network, its ballistic missile force, and its nuclear program, although the extent of the damage to the nuclear sites remains uncertain. Taken together, these setbacks have crippled Iran's ability to project power in the region. Predictably, the other powers are all finding ways to fill the void. As examples, Turkey has solidified its tight relationship with the new government in Syria.
Daniel Ortwerth:Not to be outdone, Saudi Arabia has pledged abundant financial aid to Syrian reconstruction, and Israel has expanded its security buffer on its northern and southern borders.
Phil Adler:Daniel, it seems like searching for an endgame to these Middle East conflicts might be fruitless. Less. But in the near term, what is the likeliest course for Iran?
Daniel Ortwerth:Iranian leadership must strike a balancing act between preventing any further hostile activity against itself from foreign powers and projecting an image of power and resolution to its domestic audience, meaning the population and key political constituencies. To do this, we expect Iran to abide by the ceasefire that ended the June war with Israel and to refrain from any confrontational acts either on its own or through its proxies. They are severely wounded. Their defenses are down, and they know it. To preserve their legitimacy at home, we expect the Iranian government to maintain a campaign of harsh rhetoric, especially against Israel and The US.
Daniel Ortwerth:Also, we expect Iran to return to the negotiating table with The US, but to drag out the process with all manner of debating and demands about what is even being negotiated. On the bottom line, we expect a tenuous peace combined with a rancorous political environment.
Phil Adler:One more question on the Middle East, and it has to do with oil prices, which have remained relatively stable in spite of all these conflicts. Do you see that situation continuing?
Daniel Ortwerth:Probably, Phil. There is always the possibility of an extreme event such as an attempt by Iran to close the Strait Of Hormuz to shipping. 20% of global oil consumption flows through that Strait, so a real threat of its closure would likely roil markets. However, absent something on this order of magnitude, the oil market has demonstrated a newfound ability to take Middle Eastern turmoil in the stride. We attribute this change to an expansion and diversification of supply from non OPEC sources such as The US and Guyana and technological advances in the management and visibility of the global oil market to give its participants a better ability to see just what is happening and to adjust their operations.
Phil Adler:Issue number four is The US mulls capital controls. This would be a way to reduce the trade deficit. Turning now to Bill O'Grady. Isn't reducing the trade deficit the goal of the Trump tariffs?
Bill O'Grady:Well, it is one of the goals. The administration has tended to suggest there are other goals from tariffs as well. For example, there have been statements suggesting that fiscal revenue is a goal. But I do think the overarching goal of tariff implementation is to change the global financial system in order to expand US manufacturing and reduce the impact of the financial system on The US economy.
Phil Adler:Well, as we look for a possible endgame, what have we learned in the first six months of the year about whether tariffs will be successful in reducing the trade deficit as well as improving The US debt situation and stimulating domestic manufacturing?
Bill O'Grady:Well, it's a it's a bit early to tell, but one trend that has been emerging is that the incidence of tariffs has been broader than expected, at least so far. Incidence is a term from public finance that attempts to answer the question, who pays the tax? Initially, it was widely believed that consumers pay the tariff through either higher import prices or through higher overall prices. For example, if the price of a foreign good rises, a domestic supplier would have an incentive to raise the cost to equalize the cost of the import, expanding the domestic suppliers' margins. So far, the results have been more mixed than expected.
Bill O'Grady:In some cases, the foreign exporter has lowered the price of the export to The US to maintain market share. In some cases, it would appear that firms have accepted reduced margins likely on fears that the price increase would lead to a proportionally larger drop in demand. It's too early to know if the trade deficit will fall much, but there is clear evidence that the inflation yet hasn't increased. It's also too early to tell if the debt situation will be aided by tariffs, and the same can be said for lifting domestic manufacturing. Both of those would be longer term effects.
Phil Adler:So what do you think? Do you think the Trump administration will begin emphasizing capital controls now, seeing them as a more powerful solution to achieve its goals?
Bill O'Grady:It's something I think that could emerge. Tariff implementation can be difficult. There are a multitude of goods to tax. Firms have incentives to engage in transshipments to lower tariff revenues. Smuggling and tariff avoidance fraud has a long history.
Bill O'Grady:Capital controls, on the other hand, are simpler to implement. Essentially, when foreign nations run a trade surplus with The US, they need to park their excess dollars through the purchase of US assets. Given the widespread use of the dollar in global transactions, holding US assets is attractive. It's also worth noting that The US has deep and liquid financial markets and a large supply of treasuries, which have been seen as the world's safe asset. So putting a fee on dollar investment would raise revenue.
Bill O'Grady:Controlling these flows would dramatically reduce the incentive of running a trade surplus with The US in the first place. If tariffs don't meet the goals of the administration, it would not be a great leap to see capital controls implemented.
Phil Adler:And what are the likeliest outcomes, do you think, for inflation and the dollar?
Bill O'Grady:Well, if The US is actively trying to discourage foreigners from running a trade surplus with The US and holding US financial assets, the dollar would certainly be subject to reduced demand and likely a weakening exchange rate. Given that the dollar by most valuation measures is expensive, we think a weaker dollar is likely. This outcome would tend to raise price levels. However, we note that inflation is complicated. We have noted the degree of income inequality affects inflation as does demographics and labor power.
Bill O'Grady:Our current expectation is that inflation will be elevated relative to the recent past, but probably not trigger a 1970 style condition.
Phil Adler:Issue number five is the prospect for lasting economic change in Europe. I'll turn back to Daniel Ortwerth to address this issue. Are you impressed by Europe's response to the apparent need to increase its defense spending?
Daniel Ortwerth:Yes, Phil. I am. Since the end of the Cold War more than thirty years ago, Europe has cut its devotion of resources to defense by more than half, and it has resisted calls by The US to increase its share of the defense burden. However, the combination of Russia's invasion of Ukraine and the Trump administration's threats to reduce The US's commitment to European defense have inspired a drastic and, we think, lasting change in European motivations. Germany is leading the way with a commitment to raise its defense spending by 70% by the end of the decade, but we are witnessing similar commitments in most European countries.
Daniel Ortwerth:Perhaps the clearest and most impressive sign of the new commitment, however, is an agreement among North Atlantic Treaty Organization members to increase their defense spending to 5% of GDP, which is more than double the NATO average of recent years.
Phil Adler:Daniel, in what ways could this increased defense spending perhaps spill over to the broader European economy?
Daniel Ortwerth:Phil, I wanna make clear that the European drive to rejuvenate its economy is more than just a defense story. More broadly, the countries of Europe are awakening to ways that their economy is falling behind to the other major economies such as The US and China. We are seeing a raft of initiatives such as increased government borrowing for economic investment and business friendly reductions in regulation and tax changes to spur investment. Still, to your question, the renewed focus on defense arguably is the most prominent part of the effort at rejuvenation, and we do envision it spilling over into the broader economy. For instance, the commitment to a 5% of GDP on defense includes a provision for up to 1.5% of that number to go toward essential societal investments, such as infrastructure and cybersecurity.
Daniel Ortwerth:Cybersecurity. This is reminiscent of how The US interstate highway system was initially justified as a defense investment to facilitate the rapid movement of troops and military equipment as well as the evacuation of urban areas in the event of an attack.
Phil Adler:Daniel, how soon might we see tangible economic impacts?
Daniel Ortwerth:Generally, Phil, these are long term projects and initiatives whose effects are felt over time. In the main, we should think of the effects of these things as materializing over the course of the rest of this decade with lasting effects beyond that. However, the speed and sense of urgency with which they are being approved and implement suggests that the initial signs of new vigor might start to show themselves before the end of the year.
Phil Adler:Let's turn now to issue number six, which is a second wind for AI investing. Thomas Wash has written about this issue. Thomas, just how powerful and potentially long lasting is this second wind?
Thomas Wash:Well, the Trump administration wants The US to double down on AI supremacy by aggressively cementing its leadership while actively countering China's advancement. In fact, tech driven investments were the cornerstone of q one's economic growth, and this momentum is probably going to accelerate given the passage of the new tax bill. As AI becomes further entrenched across industries, we're seeing a parallel push to restore critical supply chains, solidifying this as a sustained priority rather than a fleeting trend.
Phil Adler:The race for AI, Thomas, is a key geopolitical battlefront. Who is winning the current sprint between The US and China for technological superiority?
Thomas Wash:While The US currently maintains a narrow lead in cutting edge technology, China is rapidly closing the gap. This trend became evident earlier this year with the release of DeepSeek's latest model, a language learning system that demonstrated capabilities comparable to US developed counterparts like OpenAI's ChatGPT. What made this achievement particularly noteworthy was China's claim to have developed it using less sophisticated chips, though this assertion has been met with some skepticism in the tech community.
Phil Adler:Well, what are likely end games, and how can investors prepare?
Thomas Wash:So China possesses distinct advantages in the AI race, including a political system that enables rapid infrastructure deployment and control over critical mineral resources. These factors could position China to overtake The US technological leadership within the next decade. Should China surpass American AI capabilities, The US would likely mobilize its allies to restrict integration of Chinese technology into the global system. Nevertheless, this intensified competition may ultimately benefit the tech sectors in both countries by accelerating innovations and investment.
Phil Adler:I'll direct my final question to Patrick. Clearly, nobody can accurately predict the timing of certain geopolitical events, and I'm thinking mostly here about what's happened in The Middle East during the first half of the year. But I'm not sure that overall trends in the first six months of the year have been particularly surprising to the confluence panel. Am I correct?
Patrick Fearon-Hernandez:Yes. At a high level, the kinds of geopolitical and economic tensions we've seen in the 2025 are completely consistent with the general trends we've tracked and written about for several years now. In other words, The US pulling back from its role as the global hedgeman, rising US China tensions, the fracturing of the world into relatively separate geopolitical and economic blocks, greater aggressiveness by the authoritarian countries in the Chinese block, etcetera. All the same, it's hard to predict the details with any precision. We still have to keep a close eye on the day to day news flow to understand the near term trends and to predict near term market impacts.
Patrick Fearon-Hernandez:That's especially hard these days given the big policy changes being pushed by president Trump. Those changes have the potential to shift both the longer term trajectory of the world and the short term trajectory as well. But I can assure you that we're doing our level best to understand today's trends and the potential shifts in the global investment environment along with any investment strategy adjustments that might entail.
Phil Adler:Thank you, everybody. We've been reviewing today the Confluence mid year geopolitical outlook, subtitled searching for the endgame. You can find the written version on the front page of the Confluence website, confluenceinvestment.com. Our discussion today is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice.
Phil Adler:Also, this information does not constitute a solicitation or an offer to buy or sell any security. Our audio engineer is Dane Stole. I'm Phil Adler.