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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 Bi-Weekly Geopolitical Report for January 27, 2025. I'm Phil Adler. American foreign policy and trade policy are likely to experience major changes under the new Trump administration. Confluence chief market strategist Patrick Fearon Hernandez joins us today to focus on the potential upsides and downsides of these changes and how they might impact investments. The title of this week's report is Trump and the Political Economy of Alliances.
Phil Adler:Patrick, clearly, the traditional way the US has created and maintained alliances is getting a serious second look. What exactly no longer seems to work in our favor, at least in the eyes of the new administration?
Patrick Fearon-Hernandez:Well, hi, Phil. Thanks for having me on the program. Well, to answer your question, I think the first thing to understand is that the traditional way that the US exercised hegemony and maintained its alliances was pretty radical. Even with all of our power, especially in the 1st decades after World War II, the US chose to act as a benevolent hedgeman. To curry favor and incentivize other countries to accept our leadership, we provided the world with important public goods, like defending some countries from aggression, protecting the sea lanes, and providing the reserve currency.
Patrick Fearon-Hernandez:This created a lot of goodwill toward the US. However, those policies also imposed a lot of costs on US citizens, especially after the China shock when the enormous low cost Chinese workforce entered into the world's trading system. In the eyes of president Trump and his administration, the costs borne by US citizens to maintain hegemony and the US alliance system are no longer tenable. In other words, Trump and his administration see the balance of the burden sharing between the US and other countries as the problem.
Phil Adler:Well, the system in place since the end of World War II has made the dollar the world's reserve currency. A strong dollar makes foreign products cheap to buy in our country, but it has at the same time caused the US manufacturing sector to weaken, considerably. Would forcing our allies to shoulder more of their defense costs helped to reverse these trends?
Patrick Fearon-Hernandez:Well, we tend to look at the dollar's value from a broader perspective than just defense spending. Essentially, you could say that foreigners are too eager to export to the US and then to recycle their earnings into US Treasury obligations, the result is to put upward pressure on the federal budget deficit and on the dollar's value. Shifting defense costs to allied countries might allow the US to have a smaller military budget, which could help contain the budget shortfall. However, you'd still have to address other issues such as the excessive foreign exports or investment into the US.
Phil Adler:Well, if the United States does withdraw some of our traditional support for allies, we may lose influence as they become less loyal to us. How can you measure loss of influence in economic terms?
Patrick Fearon-Hernandez:Well, yes. This, concept is an interesting and important underpinning of the political economy of alliances, the theory that I lay out in this article. There is undoubtedly a relationship between a country's influence in an alliance and how much it contributes to the overall resources or power of the group. The country that contributes most to the alliance is probably its most influential member. Another way to put it is that there's a trade off between influence within the alliance and the defense cost savings that a country gets from joining the group.
Patrick Fearon-Hernandez:If a country sees the alliance as a way to cut its military spending, that's fine. But if the country cuts its military spending so much that it no longer seems to be pulling its weight in the alliance, the country will lose influence. The problem is that influence can't easily be measured. You could probably do statistical studies comparing the policies adopted by an alliance with the preferences of its top donors, but even that wouldn't be very precise. I think you just need to accept the general idea that he who pays the piper calls the tune, and he who doesn't pay the piper has to put up with some pretty unpalatable music.
Phil Adler:I've read commentaries, Patrick, recently that raise concerns about defense challenges facing the United States including the evolving need to fight more than one war at one time. At a time when US defense industry capacity is shrinking, We seem to be falling behind our adversaries at a time when China, Russia, North Korea and Iran seem to be better coordinating their military policies to benefit from synergies. In light of this, would decreasing our military support to allies really help us cut defense spending?
Patrick Fearon-Hernandez:Well, that's one of the key questions facing US defense policy. President Trump has very clearly signaled that he wants and expects US allies to hike their defense spending dramatically, but he hasn't publicly clarified how that would affect the US military budget. If the US's allies do hike their defense spending a lot, there's reporting that Trump wants to use this as an opportunity to implement outright cuts in US defense spending, probably to help pay for extending his tax cuts and reduce the federal budget deficit. However, given all the defense needs that you mentioned, it might be that greater allied spending just allows the US defense budget to remain static or maybe rise more slowly. In any case, a key thrust of US defense spending going forward will probably be to shift outlays from big, super expensive platforms like submarines and bombers to cheap, innovative drones and smaller systems.
Phil Adler:Let's look further at how the new administration might reset the terms and conditions for US alliances. The new secretary of treasury, Bessent, has a 3 part plan to shift costs away from the US. One part is restructuring the reserve currency reserve asset system. How would this work exactly?
Patrick Fearon-Hernandez:When the media discuss Besson's 3 part plan, they usually describe this plank as his plan to cut the federal budget deficit roughly in half to 3% of gross domestic product or less. But he seems to be assuming a big international element for this part of the plan as well. As we read the plan, it looks like much of it turns on keeping other countries in the dollar system but reducing their financial income that they derive from it. Bessin seems to want to force foreign central banks to swap their enormous holdings of regular treasury securities for a new non tradable security that carries an ultra low interest rate. That would reduce the federal government's interest payments and probably disincentivize foreign purchases of US treasuries, potentially keeping the dollar from getting too strong and discouraging foreign exports to the US.
Patrick Fearon-Hernandez:If that helped boost US economic growth, federal tax receipts would probably go up, also helping the deficit.
Phil Adler:Well, this plan might cut our government's interest cost, but I wouldn't think our allies would be exactly eager to buy long duration treasuries with ultra low interest rates. What do you think?
Patrick Fearon-Hernandez:Well, it all comes down to who has the economic leverage. Given the vast size of the US economy and its markets, the US has a lot of leverage. And it looks like Besant would threaten big new import tariffs against any country that didn't play along with this plan. That's a key reason why we think the plan could potentially work.
Phil Adler:Well, a lot has been written and discussed about how tariffs will be a key part of of the new administration's plan. It does appear right now that tariffs might be phased in to keep inflation from rising too quickly. But just to emphasize the point you just made, it looks like you think our approach to tariffs might be built on a strategy of awarding lower tariffs for products of countries which agree to our demands.
Patrick Fearon-Hernandez:Exactly. I think it's that simple. The threat of import tariffs could largely be a negotiating tactic.
Phil Adler:While other parts of the Bessin plan include lower regulation and higher US energy production, which could theoretically lead to economic growth and more tax revenue. And if energy costs decline, lower inflation. I'm curious, Patrick, how energy companies might be encouraged to drill more at a time when the world economy is slowing and and more of the global power needs is met with alternative fuels. Not to mention perhaps some resistance to opening up more public lands for exploration. This just doesn't seem like a strategy with any major payoffs.
Phil Adler:At the same time though, the emerging AI industry does demand large amounts of energy. What do you think?
Patrick Fearon-Hernandez:Well, yes. This is indeed an issue, and we're eagerly awaiting more details on the energy plan in particular. You're exactly right that US energy production is already at a record high. And given the slowdown in economic growth abroad, any additional output could put downward pressure on prices. Nevertheless, we think Trump would be willing to accept that as a way to help the working class.
Patrick Fearon-Hernandez:It may be that energy firms benefit merely from lower regulatory costs rather than from a major expansion of their sales.
Phil Adler:Patrick, what are your conclusions at this point about how the new administration's major restructure of foreign relations might impact investment returns?
Patrick Fearon-Hernandez:Well, it's still early days, and the administration is still developing and releasing the detail on its foreign policies. So it's still not entirely clear how this will all play out. However, if this goal of shifting the costs of security and prosperity to other countries is successful, it could well pay massive benefits for the US politics, the US economy, and the well-being of US workers. The result then would be consistent with the strong equity returns that we saw in the weeks right after the election. The Trump program appears to have a lot more internal
Phil Adler:significant decreased in significant decreased loyalty from allies, maybe even causing some to lean toward China, how might investment strategy be affected?
Patrick Fearon-Hernandez:Well, as we note in the article, perhaps the biggest risk is Trump tries to push costs onto other countries is that they'll push back or move away from the US. They could try to go their own way, especially on defense, as they sense that the US is no longer a reliable, equitable partner. Some may decide to develop their own nuclear weapons. As you mentioned, some might decide to come to terms with China and ally with it. This world could be very chaotic and result in even worse geopolitical or economic tensions than today, and we think that would weigh on a wide range of asset classes, including most equities if it happened.
Patrick Fearon-Hernandez:However, it would probably help European and Asian defense sector firms and potentially commodities as well.
Phil Adler:Thank you, Patrick. Again, the title of this week's report is Trump and the Political Economy of Alliances, and you can find a link to the report on the front page of 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, and this information does not constitute a solicitation or an offer to buy or sell any security. Our audio engineer is Dane Stole.
Phil Adler:I'm Phil Adler.