Subscribe
Share
Share
Embed
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 June 3, 2024. I'm Phil Adler. The South China Sea is yet another geopolitical danger zone in a rapidly dividing world that demands investor attention. Confluence associate market strategist Daniel Ortworth joins us today to discuss the history of a territorial dispute that has the potential to erupt. Daniel, since this region can seem so geographically distant from the United States, I'm not sure some investors are aware how important the South China Sea is as a transportation route for trade.
Phil Adler:What is important to know?
Daniel Ortwerth:Phil, the South China Sea sits athwart some of the busiest, most important sea lanes in the world, connecting the countries of the region with some of their most important trading partners. By some estimates, as much as a third of all the world's seaborne trade passes through this body of water, and some of the countries such as Japan, South Korea, and Singapore rely on it for well more than half of their total trade. In a case such as Japan, this includes virtually all of the petroleum products it purchases from Middle Eastern countries without which their economy would grind to a halt. For us in the US, it is important to consider that most of these countries are our trading partners too.
Daniel Ortwerth:Even if their trade with us does not flow through the South China Sea, their suffering can spread to us if their economies are not functioning well.
Phil Adler:China claims most of this region as its own even though parts of it lie much closer to other countries like the Philippines, is there any legitimacy to China's claim?
Daniel Ortwerth:Not according to most countries and not according to an international judicial body called the Permanent Court of Arbitration in the Netherlands. China tries to claim that 286 bits of rock, reef, and other exposed land in the South China Sea are islands of theirs, sovereign territory in their eyes, which would make the sea around those bits of land theirs too. Some of those land features are very close to other countries surrounding the South China Sea. None of the other countries in the region recognize the Chinese claim, and the international court I mentioned officially ruled against the claim. China has its friends into lies just like we do.
Daniel Ortwerth:And surely, they support these Chinese claims on this issue and really any subject. But China kinda stands alone on this one.
Phil Adler:Daniel, how is China enforcing its claim?
Daniel Ortwerth:Very vigorously, Phil. For virtually this entire century, they have been busy turning dozens of these bits of land into man made islands. From north to south, they have built more than 3,000 acres of land, which they have developed for a range of purposes. Of particular concern, they have installed key military capabilities on these islands. Throughout the South China Sea, there are now artificial islands equipped with anti air and anti ship missiles, and 3 of these new islands have military airfields capable of supporting sustained combat operations.
Daniel Ortwerth:To defend these islands, the Chinese have built and deployed almost 250 so called fishing vessels, part of a paramilitary force called the Chinese Maritime Militia that are armed and capable of engaging in limited combat.
Phil Adler:And how are neighboring countries, chief among them the Philippines, responding?
Daniel Ortwerth:With alarm, Phil. And some of them are trying to stand up to the Chinese as much as they can. The Philippines in particular have been voicing strenuous objections and condemnations of Chinese actions, doing what they can to assert their own economic and territorial rights in the part of the South China Sea that both countries claim. The Philippines have been sending their fishing fleets and their naval vessels into those waters trying their best to demonstrate their sovereignty. More substantially, they have been very busy developing military ties with the US and key countries in the region.
Daniel Ortwerth:They have been actively working with Japan, Australia, and Vietnam along with the US to increase military cooperation and readiness, and this includes invitations to these countries to send new or more military presence to the Philippines to be based on Philippine soil.
Phil Adler:Still, Daniel, the Philippines in the very recent past have not been an entirely faithful ally of the United States. How would you describe the relationship right now?
Daniel Ortwerth:Phil, let's put that into a little bit of historical perspective. The US and the Philippines have a relationship dating back to 18/98. Over the course of the last 126 years, the only time US military forces have not been in the Philippines was during the Japanese occupation of World War 2. In fact, the Philippines are the oldest treaty ally of the US in East Asia having signed a mutual defense pact in 19 51. And throughout most of that time, the relationship has been positive.
Daniel Ortwerth:Okay. Now against that background, the Philippines had a president from 2016 to 2022 named Rodrigo Duterte who took an opposite course. He decided that the Philippines were not adequately benefiting from their relationship with the US. He distanced the Philippines from the US and developed a close relationship with China. Near the end of his term, he began to realize that this was a bad move and he started to realign with the US.
Daniel Ortwerth:Now under the new president, Ferdinand Marcos junior, the Philippines have firmly returned to the US camp.
Phil Adler:Daniel, what is the latest area of contention, the latest geographical area of contention between China and the Philippines?
Daniel Ortwerth:There is this little obscure reef in the South China Sea near the Philippine coast well within the Philippine exclusive economic zone called the second Thomas Shoal. In 1999, the Philippines deliberately grounded a World War 2 era ship on it and installed a detachment of marines on the ship. Even that long ago, they sensed that the Chinese desire to expand control in their waters was going to be a problem. And this was an attempt by the Philippines to assert their own sovereignty over the area. For 25 years, they have kept this ship called the Sierra Madre staffed and supplied.
Daniel Ortwerth:Now that things have turned sour between China and the Philippines, the Chinese have taken to harassing Philippine resupply missions and asserting that the second Thomas Shull is sovereign Chinese territory.
Phil Adler:And this has escalated recently. Am I right?
Daniel Ortwerth:Well, Phil, several things have happened. So I'll take just a moment to highlight the most important events in the area. In recent months, on three occasions, ships of the Chinese Maritime Militia and Coast Guard have surrounded Philippine resupply vessels, watercanned them causing extensive damage, and on one occasion causing a collision preventing their passage to the Sierra Madre. China has also claimed that it reached a so called gentleman's agreement with former president Duterte by which the Philippines acknowledged Chinese sovereignty in return for limited fishing rights in the area. Additionally, China has now released what it claims is a transcript of a phone call back in January between the Philippine naval commander for the area and the Chinese military attache in Manila in which the Philippines agreed to abide by a set of Chinese rules for their resupply missions to the Sierra Madre.
Daniel Ortwerth:The Philippines, of course, are completely denying these alleged agreements and the authenticity of that transcript.
Phil Adler:Daniel, I I just wanna make sure I understand. If China takes military action against the Philippines, the US is obligated to respond?
Daniel Ortwerth:Not only is the US obligated to come to the defense of the Philippines, but president Biden has officially stated that the US defense obligation, in fact, extends to any attacks against Philippine forces in and around the second Thomas Shull. Of course, the gray area in this dispute is just what constitutes an attack. The Chinese have been very careful to limit their actions against Philippine forces to the kinds of things that can be interpreted a variety of ways. There is considerable uncertainty in how any future act on either side will be interpreted.
Phil Adler:Well, neither China nor the Philippines seem to be backing down. How would you gauge the possibility that this dispute will widen into something broader?
Daniel Ortwerth:Phil, this is a point at which we should remind ourselves that great powers typically exercise great caution when it comes to anything that can lead to open conflict or outright war. The risks of great loss are extremely high and no one grasps that as keenly as a great power. We fully expect both the US and China to do everything they can to prevent escalation. However, the briefest of glances at history tells us that wars do happen. When they do, something always provides the initial spark.
Daniel Ortwerth:Could this dispute in the South China Sea be that spark? We sure hope not, but we are soberly aware of the risks.
Phil Adler:This dispute seems to add to evidence supporting previous Confluence investment recommendations. Am I correct?
Daniel Ortwerth:Yes, Phil. It squarely fits the pattern we have outlined of decoupling and the formation of competing geopolitical blocks Increasingly, the US and China seem to be economically pulling away from each other and taking opposing positions on global issues. As this trend deepens, we are seeing the countries of the world gradually taking sides in the emerging great power competition. Along with the US and the Philippines, both Japan and Australia have issued condemnations of Chinese actions at the 2nd Thomas Scholl, while other countries in the region are trying their best to say neutral and issue statements to keep themselves in China's good graces.
Phil Adler:Daniel, we've discussed in recent reports all of the reasons that inflation may stay elevated and even worsen, issues like rising transportation costs, deficit spending, trade barriers, rising demand for many commodities. Most of these issues are very much tied to worsening geopolitical divisions. But I wonder, do forces exist which legitimately might push prices in the opposite direction and ease these inflation worries?
Daniel Ortwerth:Well, if there is, it would be a side effect of lost trade. In Southeast Asia alone, there are nearly 20 countries whose economies would suffer greatly from closure of the South China Sea, experiencing recessions of varying degrees. There are also countries outside the region such as the oil exporting countries of the Middle East whose economies would shrink from an inability to ship their oil to Southeast Asian customers. If there were to be significant recessions in these countries, the overall reduction in demand could lead to declining prices for commodities and other traded goods.
Phil Adler:Daniel, finally, you suggest in your report that some of the countries neighboring the South China Sea along with South Korea and Japan might be driven to increase military spending because of Chinese provocation. Does this trend tend to increase or decrease the value of these countries as investment destinations?
Daniel Ortwerth:Phil, I think the investment opportunity there is not so much the countries themselves, but the stocks of the companies who are selling military equipment and essential technology to the armed forces of those countries. As we've previously highlighted, this opportunity is probably not limited to traditional defense companies, but will also likely include emerging technology companies whose leading edge products prove critical enablers for advanced war fighting techniques. We remain on the lookout for these opportunities, and we will pass them on as we discover them.
Phil Adler:Thank you, Daniel. 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.