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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 mid year outlook from Confluence Investment Management. I'm Phil Adler. Several Confluence analysts will be joining us for this report dated June 17th 2024. They are advisory director Bill O'Grady, chief market strategist Patrick Fearon Hernandez, and associate market strategists Thomas Wash and Daniel Ortwirth. Some of the themes we'll discuss today will be familiar to those of you who regularly listen to our biweekly geopolitical reports, but mid year does seem to be a good time to sharpen our geopolitical focus as a key part of our framework for investment strategy.
Phil Adler:Our review of big picture conditions may be particularly important this year because of the multitude of international challenges created by competition between the world's great powers. In fact, the title of this year's mid year outlook available in written form on the confluence webpage is uncertainty reigns. Well, number 1 on our list of important issues is China's effort to control the South China Sea and exert control over the Philippines. Daniel Ortwirth wrote and spoke recently on this, so we'll begin with Daniel. Daniel, what has happened since January to elevate this particular issue in our list?
Daniel Ortwerth:Well, Phil, quite a lot has happened since the beginning of the year on the parts of China, the Philippines, and the United States. The focal point of this issue is a small submerged reef in the South China Sea called the Second Thomas Shoal. It is in the internationally recognized exclusive economic zone of the Philippines. But remember, China lays claim to the entire South China Sea as its sovereign territory. Over the years, the Philippines have tried to assert their own sovereignty over the area, especially by keeping a small detachment of marines on a grounded ship in the 2nd Thomas Shoal.
Daniel Ortwerth:Since January, the Chinese have made a practice of harassing Philippine ships attempting to resupply those marines. Chinese coast guard and maritime militia ships have been intercepting the resupply missions surrounding water canoning and occasionally colliding with them. The Philippines have responded with raising the frequency of the resupply attempts, issuing strong public accusations against China, and inviting the US and other countries to work together militarily to include increased basing of allied troops on Philippine soil. The US has responded not only by accepting those invitations, but by reaffirming its commitment to the US Philippine Mutual Defense Treaty. President Biden publicly confirmed that the treaty includes attacks against Philippine forces at the second Thomas Shole.
Phil Adler:And what are the the near term and long term implications for investors?
Daniel Ortwerth:Phil, I should be clear that we do not expect outright military conflict in the near term. The risks have risen. The chances are higher than before, and it could happen, but we do not think the risks have reached the tipping point. That means the implications for investors follow along the lines of a world preparing for the possibility of armed conflict in the South China Sea and hedging against those risks. In the near term, we expect an uptick in the buying of safe haven assets such as gold and treasuries.
Daniel Ortwerth:We also expect rising costs for critical commodities such as copper and uranium. Longer term, however, we are very cautious about long term bonds, even treasuries. The broader trend of decoupling and block formation to which the South China Sea tensions contribute leads to higher inflation and interest rates, and both of these developments would hurt long term bonds.
Phil Adler:Going to, the second item on our list of big picture items that are very important for investors to address, It's Russia's war with Ukraine and growing alarm among NATO countries, and that makes our big picture list at number 2. And Patrick Fearon Hernandez, I'll turn to you to address this question. Reports have emphasized recently Russia's territorial gains since the beginning of the year. Now is there another side to this military story?
Patrick Fearon-Hernandez:Well, yes. One little notice development recently is that Russia's offensive in the northeast has lost a lot of momentum. The Russians are still making some tactical advances, especially near the city of Kharkiv, and they're also now getting a lot more of their missiles and drones through to their targets throughout Ukraine. But as of right now, there's probably less risk of a Ukrainian collapse than we saw earlier in the year. And now that US and other Western aid is coming in again, it looks like the Ukrainians should be able to hold the line for the time being.
Patrick Fearon-Hernandez:More broadly, it looks like the Russian military has stalled in large part because of relatively limited resources and the Ukrainian military's ability to strengthen its defensive lines. A lot of observers think Russia will try to launch a big offensive over the summer, but the evidence right now suggests they may not be able to build much momentum. As we've said before, we think this war will continue for some time until ultimately each side is exhausted enough to enter into negotiations.
Phil Adler:Well, we're aware that NATO countries are boosting their defense spending. I guess one question to ask right now is that they have the capacity to raise spending by substantially more.
Patrick Fearon-Hernandez:Well, you're right that the US and other NATO countries are continuing to boost their defense spending as they face that prospect of Russian aggression against Western Europe. In theory, they could boost their defense spending by another 2 x, 3 x, or even 4 x their current levels before reaching the point where the defense burden weighs on economic growth. The problem is that any such effort would require painful changes in fiscal policy, such as hiking taxes, cutting civilian budget accounts, or letting their budget deficits widen. It remains to be seen how they'll deal with this problem, but because of the reluctance to hike taxes and cut social security or health care spending, we see a significant chance that the Europeans will simply let their budget deficits widen, at least in the near term.
Phil Adler:And as for how investors should address this, do you recommend increased investment in a broad range of European defense companies?
Patrick Fearon-Hernandez:Well, obviously, every investor is different. So we can't make one blanket recommendation for everyone. Every investor should work with his or her adviser to determine the best way forward. Nevertheless, I think we would see the current defense spending boom in Europe as just getting started. That means European defense companies may well have plenty of runway for even more revenue and profit military applications could also do well.
Phil Adler:The fighting between Israel and Hamas and the involvement of Iran is number 3 on our list. Daniel, you've, been writing about this issue as well. Looking at the way this has evolved since January, should investors feel at least slightly more confident that this won't erupt into a major war drawing in outside nations?
Daniel Ortwerth:Slightly is a good word to use, Phil. We are still talking about a shooting war taking place in a region of the world riven with volatile fault lines, The enmities and disagreements among Middle Eastern countries, nationalities, and religious traditions run very deep, and many of them have a stake in the outcome of the Gaza conflict. We do not yet see a ceasefire or broader negotiated resolution taking shape, and each of the major players seems intent on jockeying for position in that outcome when it eventually does emerge. Still, we recognize a pattern in the behavior of the major players, a pattern that I would call restraint, whether it is Israel responding to US pressure by reducing the scale of its most recent operation in Rafa, Egypt refraining from retaliation when one of its soldiers was killed by Israeli gunfire, or Iran choosing to not respond and to end the cycle of attacks between itself and Israel after an Israeli strike on targets conspicuously close to Iranian nuclear assets across the region, we observe what we view as a choice to keep the conflict contained, at least for now.
Phil Adler:With the risk though remaining high, what are the implications for gold and oil prices?
Daniel Ortwerth:We view the impact on gold from the Israel Gaza conflict the same way as we view the impact on gold of the South China Sea tensions. In both cases, we are talking about rising risks and the increasing chances of those risks reaching a tipping point. Again, gold is one of the most commonly chosen safe haven assets that investors buy in response to rising risks, especially geopolitical risks. Now oil presents us a much more complex picture. Historically, oil prices have risen in response to conflict in the Middle East.
Daniel Ortwerth:We are not seeing that this time, at least not yet. Some reasons for the relative stability in oil prices have emerged such as record setting US production, and this trend could continue. Oil prices may remain range bound. However, we caution investors to remain on their guard. These are somewhat uncharted waters, and the historical pattern of rising, perhaps even spiking.
Daniel Ortwerth:Oil prices over the course of this Middle Eastern conflict could rear its head with little to no warning.
Phil Adler:The US election is number 4 on our list. And to address this issue, we turn to advisory director Bill O'Grady. Bill, much has been written about an erosion of trust in in the US government, which could be manifested in dangerous ways if the election is very close as appears to be the case. Bill, how does less faith in the US government impact investment strategy?
Bill O'Grady:Well, this is a multifaceted question, Phil. The first issue is this lack of trust is driven by deep political polarization in the US. In the past, losing an election was disappointing. Now it is seen as catastrophic and existential. Essentially, Americans seem to believe that the other side winning will end life as we know it.
Bill O'Grady:In the reality, it isn't that stark. I generally believe that trends, not men, really drive politics. Politicians are faced with constraints and restraints, and thus their ability to act independently is is somewhat limited. For example, Trump's tariffs were decried by Democrats, but once they gained control, they left him in place. That's because the underlying trend against globalization is in place regardless of who is in power.
Bill O'Grady:But because of this perception of existential threat, the parties are willing to take extraordinary measures to win elections. These actions undermine trust. Government policy is seen as designed to harm the party out of power even when that may not be the case. This willingness to take aggressive actions undermines the investing climate. A key trend that's been evolving is that businesses do face different investing climates depending on the party in power.
Bill O'Grady:That makes long term investing difficult. For example, should a utility build coal fired capacity? Under the GOP, this might make sense only to see regulations change when Democrats retake power. Finally, this lack of trust gives our adversaries fertile ground for election manipulation. If one believes the other side is evil, one is prone to believe the worst about your opponent.
Bill O'Grady:Thus, misinformation that suggests bad behavior, even if it isn't true, is likely to be believed. So far, the financial market seem to be ignoring the potential for political uncertainty. We could see increasing market volatility as November approaches. For now, we are mostly using precious metals as our hedge against this outcome.
Phil Adler:Bill, before you mentioned tariffs and how Democrats fell in line with President Trump's policy on increased tariffs. But going forward, policy on tariffs seems to me to be one key difference between the candidates. How might investors prepare for the possibility of increased tariffs?
Bill O'Grady:Well, one of the points we made in this section is that president Trump's first term was a learning on the fly situation. One thing he missed in the first term is that under conditions of floating exchange rates, tariffs are less effective because applying them on a nation will simply lead that nation to depreciate its currency. We note that candidate Trump has learned from this outcome and is calling not just for tariffs, but a weaker dollar as well. A weaker dollar plus tariffs will likely trigger higher inflation. Thus, precious metals and skewing fixed income to short duration should offer some opportunities, So might foreign investments.
Phil Adler:Let's move fairly quickly through the remaining big picture issues now. Number 5 is US defense rebuilding. US defense stocks, Patrick, have taken a back seat to technology recently. Is this an opportunity here for investors?
Patrick Fearon-Hernandez:Well, it very well could be. We suspect that part of the problem for US defense companies is that our nasty budget politics in this country have really unnerved investors. US budget spending on both civilian and military programs has been subject to great uncertainty in recent years, even though it's clear that defense spending would need to rise for the country to face down China, Russia, and the other authoritarian rivals. But if the threat comes to be more widely accepted and if we can overcome some of the political polarization, the floodgates could open for not just the US' prime defense contractors, but also for companies making dual use goods and services such as cybersecurity and other defense related technologies.
Phil Adler:Issue number 6 is global monetary policy. And, to address this issue, we'll hear from associate market strategist Thomas Wash. Thomas, there have been some key decisions by central banks since the beginning of the year. What should investors pay most attention to?
Thomas Wash:Yes. This has been the year of the central bank pivot. You know, the Bank of Canada, the Swiss National Bank, and the European Central Bank have all made decisions to cut their benchmark policy rates by 25 basis points, while the Bank of Japan went in the opposite direction and ended its era of negative interest rates. Although market participants expect central banks in the west to make more rate cuts throughout the year, their decision may come down to whether the Federal Reserve will follow through on its plan to cut rates. As of the time of the recording of this podcast, FOMC members have signaled that they are open to cutting rates twice in the latter half of the year.
Thomas Wash:However, signs of sticky inflation and a persistently tight labor market have led policymakers to rethink whether cuts are appropriate at all. And we suspect that there are some on the committee that believe that the bank should at least be open to another rate hike if inflationary conditions worsen.
Phil Adler:Will foreign economies, Thomas, be weakened if the Fed continues to delay rate cuts?
Thomas Wash:You see, the reduction of interest rates are a double edged sword as it could stimulate growth, but also lead to higher inflation. Think about it this way. Many countries depend on imports priced in US dollars, particularly commodities like food and fuel. When the US dollar strengthened due to rising interest rate differentials, those imports become more expensive for major importers. This is why the Fed's decision to delay rate cuts is important to foreign markets.
Thomas Wash:If US policymakers decide to follow through with their plan to cut rates this year, it will pave the way for other central banks to do the same. Conversely, a potential hawkish reversal such as not cutting rates or another hike may lead other central bank to hold off, and in extreme case, even make a u-turn on the recent rate reductions to prevent a reacceleration of inflation.
Phil Adler:As we move to the second half of the year, Patrick, what other issues do you have an eye on that have the potential to be geopolitical disruptors or at least set into motion important new trends? Well, Phil, I think
Patrick Fearon-Hernandez:that the main one that I'm starting to think about much more closely is the possibility that the various global frictions today could make the Olympic Games in Paris an enticing target for terrorism or sabotage. If there's a major attack, there would be great pressure on France and its western allies to respond, and that could potentially lead to even more destabilizing frictions that could hurt economic activity and or financial markets. And I would remind you that the Paris Olympic Games start in late July and run into early August.
Phil Adler:Well, you've outlined in this report many risks for investors to manage. Has the broad outlook from Confluence changed in the past 6 months?
Patrick Fearon-Hernandez:Well, for myself at least, Phil, I don't think we've seen any major surprises that point to a change in the overall trend. The 30 year period of optimism and globalization after the end of the Cold War is still getting smaller in the rear view mirror, and the world is increasingly seeing the contours of the new period of great power competition. The risk of the great powers running into outright conflict is growing, so the world is still fracturing into relatively separate geopolitical and economic blocks. The US and its liberal democratic allies are in one camp, and China and its authoritarian fellow travelers are in another camp, and there are several leaning or neutral camps as well. In any case, the economic results are fractured supply chains and reindustrialization in the US bloc, which still seems to us to produce a likelihood of higher and more volatile inflation and interest rates going forward.
Phil Adler:Last question of our session and and we'll turn back to Bill O'Grady for this one. And it's about the dollar and gold and and the relationship recently. It it seems to me that a strong dollar and strong gold prices don't usually coexist the way they seem to be doing right now. Bill, should investors recalibrate strategy based on a new reality?
Bill O'Grady:Well, it's really important to understand why this condition has occurred. We believe that foreign central bank accumulation of gold has led to this situation. Washington's aggressive use of financial sanctions has spooked foreign central banks to diversify their reserve holdings. As long as this condition remains in place, we can see the dollar and gold behave in this fashion. We note that gold equities and gold have also not behaved normally.
Bill O'Grady:This is because Western investors tend to view gold and gold shares as substitutes, but a central bank will not.
Phil Adler:With that, it is time now to say thank you to our panel today, and it's also time to remind our listeners that our 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. This information does not constitute a solicitation or an offer to buy or sell any security. Our audio engineer is Dane Stoll. I'm Phil Adler.