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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 Investment Management Biweekly Geopolitical Report for October 21, 2024. I'm Phil Adler. National security agendas might never be the same after pagers and walkie talkies mysteriously exploded in the hands of Hezbollah militants about a month ago, and as we hear in this week's report, investment strategies may face a reckoning as well. Our guests today are Confluence Advisory Director Bill O'Grady and Chief Market Strategist Patrick Fearon Hernandez. Patrick, I'll direct the first question to you acknowledging your background in the CIA and NATO.
Phil Adler:Are you convinced that Israel was responsible?
Patrick Fearon-Hernandez:Oh, hi, Phil, and thanks for having us on the program. And to answer your question in very simple terms, yes. I feel pretty certain that these attacks on Hezbollah were carried out by Israel's intelligence agency, the Mossad. Big sophisticated operations like this are way beyond amateurs or second tier agencies. Mossad is one of the few agencies that could pull this off.
Patrick Fearon-Hernandez:And given the Mossad's intimate knowledge of Hezbollah and the other existential threats in Israel's own neighborhood, Mossad may have been the only agency that could do it. And for what it's worth, I was at an event with dozens of former intelligence officers just days after the attacks, and not one of them expressed any doubt that Israel and Mossad were responsible.
Phil Adler:Well, explain to us how this sabotage was accomplished.
Patrick Fearon-Hernandez:Many aspects of the operation are still not understood publicly, and in fact, they may never be revealed. Nevertheless, we can see the broad outlines of the operation from press reports. Basically, Hezbollah's leader directed his fighters in Lebanon to swap out their cell phones for old fashioned pagers last April, apparently in concern that the Israelis had compromised the cell phones. Hezbollah ordered the pagers from a company in Taiwan, but that company subcontracted their production out to a firm in Hungary. Well, it turns out that the Hungarian company was apparently just a front company for Mossad.
Patrick Fearon-Hernandez:It looks like Mossad acquired the pagers and sabotaged them with a special explosive that wouldn't be detected by Hezbollah's security review. Mossad also modified the pagers to detonate when they received a certain electronic signal. That signal was sent to all 5,000 pagers simultaneously, causing them to explode and killing and maiming 100. The next day, a series of walkie talkies also exploded.
Phil Adler:This requires sophistication in ways that we would not have thought possible in previous generations. First, the agent, which we assume to be Israel, was able to interrupt the supply chain with a successful disguise. I'm assuming that other countries are capable of doing the same thing?
Patrick Fearon-Hernandez:Again, we don't know all the details about how this was pulled off, but you can be sure that CIA, MI6, MSS, and other sophisticated agencies are already studying it and figuring out how they could do it. Without doubt, even criminal gangs or even lone wolf attackers are probably also thinking about it. I feel confident that at least some of these groups or people will soon be able to replicate the operation.
Phil Adler:This also requires technical expertise, but it doesn't seem to be extraordinary technical skill. How how difficult was it really in today's world with today's technology to alter the pagers and then detonate them.
Patrick Fearon-Hernandez:Oh, I highly doubt that sabotaging the pagers and walkie talkies was all that hard. I think the real innovation here was Mossad figuring out how to insert itself in the supply chain for these items. It would have been necessary for Mossad to monitor the order flow, have its front company be accepted as the supplier, produce and or modify the goods without being detected, and find a way to detonate them remotely. The scary thing, which prompted us to write our report, is that no one can unsee this now. Governments and companies around the world now have to be cognizant that any supply chain can be compromised.
Patrick Fearon-Hernandez:And in particular, any connected product that has a microchip and the capability to connect with the Internet or telecommunication network could be sabotaged in this way. Refrigerators, vacuum cleaners, electric toothbrushes, cars, factory equipment, etcetera, especially if they're imported from abroad. We think that'll prompt governments and companies to further shorten their supply chains by bringing production home or at least to friendly countries and otherwise prioritizing supply chain security.
Phil Adler:Bill, I'll turn to you as we discuss implications for the global economy. I think we can assume that the trend toward globalization was built in part on trust that free trade would be good for every country. What happened?
Bill O'Grady:Well, Phil, this issue gets into the underlying assumptions that are part of the trade theory and economics. When most students are taught international trade theory, they start with Adam Smith and David Ricardo. Smith based his trade theory as an outgrowth of his views on specialization. He argued in the Wealth of Nations that workers specializing in one element of production can far out produce a worker that had to fabricate the entire manufactured product alone. In a similar fashion, he noted that a nation that can make something cheaper than another nation to specialize in that good.
Bill O'Grady:Ricardo argued that even if a nation were better at everything compared to another, it should still specialize in what it did best and have other items produced abroad. But for any of this to work, nations have to believe that the act of specialization won't leave them at a geopolitical disadvantage. Alexander Hamilton and Frederick List argued that for some goods and services, nations should implement tariffs to protect these key industries so that if war were to break out, they would have the capacity to build the products of war. In other words, if we feared no war, then we should adopt the trade policies of Smith and Ricardo. If we face geopolitical risk, it would behoove us to protect certain industries or trade barriers.
Bill O'Grady:Now during the Cold War, the US is generally open to trade, but only with those nations in the free world. Tariffs steadily declined in the Cold War period, and our defense budget was large enough that we could fund a broad defense industry without resorting to terror protection. In addition, there were various programs designed to create strategic stockpiles of key commodities, which affect trade. But after the cold war ended, our defense budget declined, strategic stockpiles were mostly sold off. And for the most part, the US adopted a trading system inspired by Smith and Ricardo, which included numerous free trade agreements and tariff restrictions.
Bill O'Grady:We created a globalization situation that was consistent with the world lacking enemies.
Phil Adler:Which brings us to today, where we're clearly heading in the other direction, toward protectionist policies. So today's question is will exploding pagers greatly accelerate the transition?
Bill O'Grady:Well, I think there's a good chance this event will accelerate this process. Now whenever historians mark an event that triggers a new era, one can observe a path toward that watershed of events that were pointing to that change. In this case, the failure of free trade agreements in Europe and Asia, mainly the TTIP and the TPP of 2014, was a harbinger of change. In fact, the elections of Barack Obama and Donald Trump probably suggested a switch as well. So did the revelations of Edward Snowden, who showed the goods we buy have the potential to surveil us.
Bill O'Grady:The pandemic revealed the key medical goods were unavailable in the US because we no longer produce them. What the pager caper shows is that these goods with technology can perhaps cause bodily harm. This is a step change risk that we didn't seem to have before. But it isn't hard to imagine corrupted technologies in our cars, our food supply, our medical devices tainted in such a way to harm us. Once we can no longer trust where goods come from, the allure of free trade is undermined.
Phil Adler:So, Bill, should we accept as fact that we are now in a new era where supply chains, the kind that we've been accustomed to, come with an elevated degree of geopolitical risk?
Bill O'Grady:We have believed this for a while, but events such as these make the potential abundantly clear. We live in a world of connected items. The so called Internet of Things means that mundane products, such as cars or home appliances are connected to the Internet. These connections make updates to software easy and make diagnostic changes less costly. But as this event shows, these goods could be weaponized.
Bill O'Grady:Thus, knowing where all the components are sourced will become increasingly critical.
Phil Adler:Has Confluence in any way altered its investment outlook because of this event?
Bill O'Grady:Not directly, but the protections against inflation that are undermining global supply chains have been in place for a while. In fixed income, we have established bond ladders and have generally avoided long duration exposure. We have positions in gold and commodity sensitive equity sectors. Essentially, we were not planning for this event per se, but we expected supply chain disruptions.
Phil Adler:And who are the investment winners and who are the investment losers in this more dangerous environment?
Bill O'Grady:Well, broadly speaking, the winners are those investments that perform well in inflationary environments, gold, commodities, and equities, especially those with pricing power. Losers are assets that are hurt by inflation, especially long duration bonds. But this event may have specific winners. Companies that have suffered from foreign competition may find themselves with free trade protection that will boost their prospects.
Patrick Fearon-Hernandez:And the only thing I would add there, Phil, is that some specific types of firms could also benefit. For example, this may help spur an industry focused on supply chain security much as widespread computer hacking has helped spur the development of cybersecurity software companies.
Phil Adler:Thank you, Bill and Patrick. 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. This information does not constitute a solicitation or an offer to buy or sell any security. Our audio engineer is Dane Stoll.
Phil Adler:I'm Phil Adler.