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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 think most of our regular listeners would agree that Confluence is known for devoting significant resources to geopolitics. Leaving that by developing a strong sense of where the world is going, the firm is able to identify and act on trends that others may not see. In its 2025 geopolitical outlook report, Confluence identifies 6 big picture trends that are guideposts for its investment recommendations. The entire Confluence macro analysis group contributed to this report, and joining us today to discuss the 2025 geopolitical outlook are Confluence advisory director Bill O'Grady, chief market strategist Patrick Ferron Hernandez, and associate market strategist Daniel Ortworth and Thomas Wash.
Phil Adler:Bill, I'll start with you to discuss issue number 1, which is the next evolution of American Hegemony. You've included in the written report a clear detailed and I think insightful timeline of America's history as a global Hedgeman concentrating on events since the conclusion of World War 2 and the economic ramifications of policy decisions since then. Now if I may sum it up this way, America's devotion to achieving hegemony over the years eventually caused great stress to America's working class. The resentment this created helped lead in large part to today's more isolationist foreign policy, which demands a fresh look at investment strategy. Now you say in the 2025 outlook that you believe the US has now reached a critical point where some sort of resolution to the breakdown of the post war order is accelerating, which brings us to my first question.
Phil Adler:Why now and why critical?
Bill O'Grady:Well, Phil, since 2008, we have seen an angry electorate. Under earlier circumstances, figures like Barack Obama or Donald Trump would have never been elected president. The electorate wanted change, and they keep voting for outsider candidates to get it. The return of Donald Trump and the depolarization seen in US politics is a pretty clear signal that the inability of the political elites to fashion a workable solution to hegemonic policy that is also workable for the domestic economy has reached a critical point. What we don't know is what follows.
Bill O'Grady:We speculate on that outcome regularly. It could be anything from complete isolation to a more extractive model of hegemony where US effectively forces the cost of hegemony on its allies.
Phil Adler:Well, how will our more isolationist stance change, do you think, the behavior and policies of our allies and our adversaries?
Bill O'Grady:Well, yes. One reason the greatest generation took over the security of Europe and Japan is that they feared if if they defended themselves, it would lead to conflict. This generation saw 2 world wars because Germany and Japan couldn't feel safe. We're about to foster an experiment to see if our elders were right or overreacted. We could also see a world where globalization unwinds because it rests on the US, providing easy access to the dollar and treasuries.
Bill O'Grady:If restrictions are put in place, it will create frictions for trade. Think of it this way. Do you wanna trade with someone in local currencies? Russia has discovered the problem that taking Indian rupees for oil is that they have rupees they can only use to buy Indian goods, and they aren't finding anything to their liking. If this sort of situation spreads, trade will almost certainly decline.
Phil Adler:What are the main economic and market ramifications of this new world?
Bill O'Grady:Well, less trade, more inflation, higher interest rates, greater economic and market dispersion. The latter point is potentially a big issue. We've seen a world since the 19 eighties that has increasingly evolved into a single market. Benchmark prices for a plethora of goods developed, and local differences were usually a function of transportation costs. That world is at risk.
Phil Adler:How big a win will this be for America's working class?
Bill O'Grady:Well, to quote Thomas Sowell, there are no solutions, only trade offs. The American working class should see higher employment and better wages. But if the trade deficit narrows, the prices of goods and services will almost certainly rise. Relatively speaking, they will do better, but not all around better.
Phil Adler:Let's move on to issue number 2, which is less cohesion in the US bloc, more cohesion in the China bloc. Patrick, turning to you, this sounds alarming. Are democracies, which make up a major portion of the US world bloc simply less able to act forcefully on the world stage and risk falling behind?
Patrick Fearon-Hernandez:Well, yeah, Phil. I I think that's it. Although, that's only half the story. It's important to remember that many of the dynamics laid out by Bill in his section can also be seen in the other major democracies of the US geopolitical block. Even in places like Canada, the UK, and Germany, the Cold War imposed costs on the working class, and then a whole new set of costs were imposed by the post Cold War globalization.
Patrick Fearon-Hernandez:The resulting political dynamics are probably a key reason why our allies have resisted spending more for defense and emphasized selling more to the US in recent decades. Now if Bill is right that the incoming Trump administration will pound on them to pay for more of their own defense and clamp down on access to the US market, the resulting defense and trade disputes could well weaken the cohesion of the entire US alliance system and the broader US bloc. But remember, this would be happening just as the major countries of the China block are starting to show signs of greater cooperation, collaboration, and coordination. We've seen this in instances such as Iran's provision of missiles and drones to Russia for its war against Ukraine. This increased cohesion among China, Russia, Iran, and North Korea is likely to make them an even stronger competitor against the US and its block, especially since the US and its block are becoming less cohesive.
Patrick Fearon-Hernandez:The resulting worsening of the balance of power is likely to spur even more international tensions.
Phil Adler:And what are investment winners and losers in this scenario?
Patrick Fearon-Hernandez:Well, we think this trend will reinforce, some of the dynamics we've been discussing for some time now. The further worsening of tensions between the US and China blocks will likely lead to more global fracturing, more supply chain disruptions, added upward pressure on inflation and interest rates, and more pressure for increased defense spending, especially outside the US. That should be good for stocks in the industrial basic materials and energy sectors, and especially for non US defense firms and the producers of goods and services with dual civilian or military uses.
Phil Adler:Moving on to issue number 3, which is China's economic growth slows further, but not its military. Well, China certainly seems to have a hard time stimulating its economy. Does this make it a more dangerous military competitor?
Patrick Fearon-Hernandez:Yes. Probably. At the very least, the key message here is that China's slowing economic growth isn't forcing Beijing to slow down its military buildup. Even with its weaker economy, China still has plenty of resources to pour into its armed forces, and its ongoing investments in defense suggest that's exactly what the leadership intends to keep doing. Now in the longer run, if the weakening economy starts to threaten China's military buildup, it could conceivably prompt the leadership to attack Taiwan, the Philippines, or other adversaries before it's too late.
Patrick Fearon-Hernandez:But even if that doesn't happen, the key message here is that China's slowing economic growth probably won't cause it to ease tensions with the West.
Phil Adler:But do you see a time perhaps when the US might bargain to loosen trade restrictions in a deal to contain China's military buildup?
Patrick Fearon-Hernandez:Well, we don't directly address that possibility in the report, but it is something we think about. Given that president-elect Trump is so transactional, it's conceivable that he could strike such a deal. On the other hand, there are plenty of people who know Trump who would suggest that he focuses on winning economically in his deals. That makes me think he wouldn't be inclined to give up US economic interests in return for a slower Chinese military build up.
Phil Adler:China has lately placed trade restrictions on rare earth minerals. How much short term pain might this cause?
Patrick Fearon-Hernandez:Well, in theory, the restrictions on selling the US minerals such as gallium, germanium, antimony, and tungsten should be disruptive since China has a near monopoly on such supplies. However, don't be surprised if the pain takes a while to unfold. Users in the US have had at least a year to prepare for these restrictions, so I suspect there was some stockpiling going on. And remember that there are also workarounds to such trade restrictions, such as buying supplies through a third party country. Now these restrictions, therefore, could become nothing but a distraction.
Patrick Fearon-Hernandez:All the same, they do present disruption and higher costs at the very least. So the Chinese move will likely spur even greater US efforts to find its own supplies of these minerals.
Phil Adler:Is it fair to say before we leave this issue that this policy also causes some pain within China?
Patrick Fearon-Hernandez:It probably does. Although we haven't tried to scope out exactly how much pain that would cause for the Chinese miners. All the same, general secretary Xi has made it clear that he sees national security as a higher priority than economic growth or industrial profits. If he sees this as an important way to strike back against the US for its efforts to constrict China's military development, I think he'll move forward. Full steam ahead.
Phil Adler:Issue number 4 is Europe's politics shift further to the right. France is the latest example, but, Bill, you're particularly interested in the outcome of the election in Germany on February 23rd. What's at stake here?
Bill O'Grady:Well, the situation in France reminds me of an early 19 eighties song titled desperate but not serious. I expect the situation in France to continue to muck along until Macron has to leave office in 2027. With the German elections in February, the fractured nature of German's political situation will be revealed. As our report showed, the AfD, which is a far right party in Germany, represent about 20% of the electorate. Given the nature of the other parties, it doesn't seem possible to put a working coalition together without including the AfD.
Bill O'Grady:But the AfD's platform is anti euro, anti EU, and anti immigration. It's hard to see how having the AfD in government doesn't lead to some degree of withdrawal from the EU or the eurozone. So either we have political instability or the potential for Brexit.
Phil Adler:What will the impact be on markets if there is a political crisis in Germany?
Bill O'Grady:Well, we aren't exactly revealing anything here that informed investors don't already know. So for now, what I've described should already be discounted in the markets. Now if we end up with either another round of elections or a political arrangement where the AFD is in government, European assets broadly would be at risk.
Phil Adler:Issue number 5 is the Middle East struggles to regain peace. Turning to Daniel for comments on on this issue. How does the recent government takeover in Syria complicate what seems to already be a chaotic situation?
Daniel Ortwerth:Fill the sudden and unexpected ouster of the Assad regime and its apparent replacement by a rebel group puts Syria into play from a perspective of alignments. The Assad regime belonged to the Alawite sect of Islam, which aligns with the Shia tradition. This made Syria a natural partner of Iran, the Middle Eastern standard bearer of Shia Islam, and it also made Syria a vital geographic link in Iran's arc of influence that stretched through Iraq, Syria, and Lebanon all the way to the Mediterranean Sea. The rebel group that has just assumed control of Syria is from the Sunni tradition of Islam and no friend of Iran. In fact, those rebels have mostly relied on Turkey to the north for assistance.
Daniel Ortwerth:Even though Turkey is a largely Sunni country with a pro Sunni government, this potential expansion of their influence will not necessarily gain support among other Sunni regional powers. Saudi Arabia and Turkey are ancient rivals who may both hail from the Sunni tradition, but are of different ethnicities that have striven with each other for centuries. With centrally located Syria suddenly in a state of flux, we expect the regional powers, Turkey, Saudi Arabia, and Israel to try to gain from Iran's loss, while at the same time, the global powers with a stake in the region, the US, China, and Russia will inevitably play a role as they actively seek to protect their Middle Eastern positions.
Phil Adler:What are the chances of peace this year in the Middle East? Do you think there is a possibility of progress?
Daniel Ortwerth:Peace is a dubious word to use in the context of the Middle East since it occurs so rarely, but we might be able to speak in terms of stability. Ever since the attack on Israel by Hamas militants on October 7, 2023, the region has been extremely unstable with several different active conflicts. Syria aside, the last several months have witnessed nearly every major player in the region taken concrete steps to develop understandings with their rivals and restore stable relations. For example, Saudi Arabia has stepped up its diplomatic initiatives with Iran, and Iran for its part unilaterally suspended its uranium enrichment activities as a sign of goodwill with its nuclear program. Meanwhile, the outgoing Biden administration brokered a truce between Israel and Hezbollah in Lebanon, and the incoming Trump administration has emphasized its support for a quick end to the Gaza conflict.
Daniel Ortwerth:Riven as it is by so many ancient fault lines, several of which I've mentioned here, the Middle East is always at risk of instability and open conflict often with little tender notice. However, the region currently finds itself at a point where most of its influential players have a strong interest in a restoration of stability. So 2025 could be a year marked by, as you put it, Phil, progress.
Phil Adler:Daniel, how worried should we be that oil prices may skyrocket due to Middle East unrest?
Daniel Ortwerth:Phil, it is always a risk. With so much of the world's petroleum supply coming from this region and traveling through it, Middle Eastern conflict has a way of interrupting the flow of oil and wreaking havoc with prices. However, developments in other parts of the world have been keeping a lid on oil prices even amidst these conflicts and disruptions, and we expect those developments to continue in the new year. On the supply side, US oil production has become the highest in the world, and we expect it to remain roughly at current levels. Meanwhile, OPEC has been striving to reverse a production cut that it had implemented earlier to support prices, and we think they will continue to seek that opportunity in an effort to regain lost market share.
Daniel Ortwerth:On the demand side, disappointing economic performance and a strong transition to electric vehicles has suppressed Chinese oil consumption. We expect that to continue, and this will weigh on global demand for oil. Put it all together, and we think that volatility rather than a sustained rise in price will be the more likely effective Middle Eastern affairs on the price of oil.
Phil Adler:Issue number 6 is Canada and Mexico adjust to Trump 2 point o. The president-elect is demanding a curb on drug trafficking and illegal immigration in exchange for favorable trade status with our two neighbors. Thomas, you've written on this issue. Do you think that Canada and Mexico will comply?
Thomas Wash:Well, Phil, we're already seeing signs of cooperation between both countries and the incoming administration to address these concerns. However, I believe the president's threats was intended to facilitate a greater policy coordination. You see, administration officials recognized that stemming the flow of drugs, especially, necessitates dismantling the intricate networks exploited by traffickers. This approach would involve collaborative efforts with Mexico to dismantle cartels and Canada to curtail the use of its banking system for money laundering. We believe this collaboration will not only impact migration and drug flows but could also extend to trade flows as the US seeks to prevent China from circumventing tariffs.
Phil Adler:Well, you point out that Canada and Mexico already enjoy widening trade surpluses with the United States. The US does benefit from strong Canadian and Mexican economies. How might the US crack down on imports from these two countries?
Thomas Wash:So I doubt the overall goal is to crackdown on imports from Canada and Mexico as this could trigger a trade war detrimental to all parties involved. That said, any potential tariffs would likely face legal challenges from companies as a free trade agreement provides limited flexibility for broad based tariffs. A more likely interpretation of the tariff threat is a signal that the administration may not be willing to extend the agreement beyond its July 2026 review period. This could open the door for the US to demand changes to the agreement, potentially leading to increased supply chain uncertainty. While the Trump administration may be concerned about the size of its deficit with other countries, we believe its primary objective is to contain China.
Thomas Wash:Therefore, we anticipate the US MCA agreement will be updated to align all 3 countries on a unified stance against Chinese imports.
Phil Adler:Well, we've covered in part at least the 6 major issues presented in this year's geopolitical report. To sum up, the trends in this report, I don't think are a surprise to regular listeners and readers of Confluence analysis. These trends, many of them inflationary, do seem to send a cautionary message. But Confluence was also quite cautious in last year's report and and look how stocks have performed. The American stock market, at the time of our recording, has been surging and remains by far the best performing investment destination throughout the world.
Phil Adler:So my final question to you gentlemen is, what are the chances of this continuing for a while longer?
Patrick Fearon-Hernandez:Well, I'll take a stab at that one, Phil. I I think there are 2 issues here. 1st, many of the developments we discuss are playing out over time, and their impacts will become visible over time as well. For example, the evolution of US hegemony and global fracturing will gradually lead to more inflation, higher and more volatile interest rates, and challenges for fixed income investments over time. I guess you could say that we're giving people plenty of warning about what's to come.
Patrick Fearon-Hernandez:Secondly, however, we're also describing lots of risks that could suddenly explode into a geopolitical crisis that shakes the global economy and financial markets. In this sense, you could say we're like seismologists identifying deep underground fault lines that could produce a devastating earthquake if the forces build up and the tectonic plates ever slip. We hope that describing these fault lines will help explain some of the precautionary positions we advocate, such as having positions in gold and other precious metals even as the stock market performs well.
Phil Adler:Thank you everybody. I'm looking forward to following these trends throughout the year, and I do anticipate your updates and also deeper dives into these issues in our regular conversations to come. For our listeners to choose from the full slate of Confluence written reports, including the report that we discussed today, access confluenceim.com. Today's discussion 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: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.