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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. I'm Phil Adler. The race between The United States and China for military superiority will continue to have major implications for investors. Confluence associate market strategist, Daniel Ortworth, joins us today to give us an update on The US China military balance of power. Daniel, your last update was two years ago.
Phil Adler:Before we get to specifics, what is your overall impression? Should we be more worried today about China's military capabilities than we were two years ago?
Daniel Ortwerth:Yes, Phil. I think we should. The simple truth is that China continues to invest heavily in its armed forces, showering it with the resources necessary to continue on a path to becoming a world class military. Its defense budget is estimated to have grown nearly 6% from 2023 to 2024, and the Chinese government has announced plans to increase its 2025 defense budget by an additional 7.2%. I should emphasize that these numbers might actually understate the true pace of increases.
Daniel Ortwerth:The Chinese disguise their military spending in a number of ways that blend civilian and military development programs and make it hard to compare it with other defense budgets such as our own. The latest US Department of Defense report on Chinese military power estimates that Chinese military spending probably exceeds the published figures by 40 to 90%. Two things about that statement should grab our attention. First, it suggests that the true number could be almost double the official Chinese defense budget. Second, forty to 90 is a very wide range.
Daniel Ortwerth:If a study is thorough and diligent as the DOD study cannot narrow the range more than that, it tells us just how much we really don't know about the full extent of the Chinese military buildup.
Phil Adler:What do we know about China's main focus? Is it Taiwan, or does China have grander intentions?
Daniel Ortwerth:Chinese leadership has a vision that unfolds in stages. Initially, yes, Taiwan is the focal point of what we might call stage one of its strategic plan, which is the full unification of all Chinese territory. Now this stage is not all about Taiwan. It includes things such as the eradication of terrorism and separatism in its western provinces, namely Xinjiang and Tibet, and the establishment of full control and internationally recognized sovereignty over the South China Sea. Still, the so called reunification of Taiwan under the control of the government in Beijing is the clear number one on that list of stage one priorities.
Daniel Ortwerth:Ultimately, though, the Chinese government has a vision called the great rejuvenation of the Chinese nation. In this vision, China achieves what it considers a full restoration of itself as the world's premier state, exercising a leadership role in global affairs. To this end, general secretary Xi Jinping has set the goal for the People's Liberation Army to develop into a world class military by 2049. That phrase, world class military, means the capability to succeed in a confrontation with the best military forces in the world, and the clear implication in the documents articulating this vision is the ability to beat The United States. So, Phil, it's yes to both.
Daniel Ortwerth:Taiwan is number one on the agenda now, but that agenda has grander intentions stretching well into a future in which China is the global number one.
Phil Adler:Well, Daniel, let's focus on just a few of the key areas covered in your report this week. First, expenditures on military resources. Is China pouring more resources into its military than we are into ours?
Daniel Ortwerth:No, Phil. I don't think so. As discussed earlier, we cannot be absolutely sure due to the lack of clarity in Chinese reporting, but The US defense budget is nearly a trillion dollars, which is almost certainly larger than the Chinese budget by any measure. However, the key in this comparison is to understand it in the context of each country's scope of commitments. At this point in history, the Chinese military is still mainly focused on its own neighborhood, meaning East Asia and the seas adjacent to its own coastline.
Daniel Ortwerth:China does have expanding long term military ambitions, but for now, its focus and commitments are still close to home. Meanwhile, The US has a global network of bases, treaty commitments, and interests that it supports. With these global commitments in mind, 2024 US defense spending was equal to about $5,000 for every square mile of the Earth's surface, excluding Antarctica. If we assume China's current core interest extend only over the eastern half of the Northern Hemisphere, about one quarter of the Earth's surface, its total adjusted spending in 2024 equaled about 13,000 per square mile of its defense sphere.
Phil Adler:How about military technology? Does The US still have a technological edge?
Daniel Ortwerth:Mostly, but the gap is shrinking across the board. And in some places, the gap may have entirely closed. The US certainly does invest very heavily in technology and is doing so now with more urgency, but China has very effectively focused its technology investments in the areas most critical to likely near term conflict scenarios. By that, we mean Taiwan and the South China Sea. We will talk more about this later, but the one area that I would emphasize is missile technology.
Daniel Ortwerth:China has developed an entire range of missiles designed for just about any purpose, and this would prove a key advantage in a fight close to China's own coast.
Phil Adler:Well, before we get to missile technology, how has the Chinese navy grown in the past two years compared to The United States?
Daniel Ortwerth:Phil, this might be the area of greatest concern. China's shipbuilding capacity is the greatest in the world while The US' capability in this area has languished. This is a story of its own for another day, but the result has clearly manifested itself in the relative sizes of the two navies. While the ship count of the US battle force remains essentially the same as two years ago, China's battle force grew by at least 30 ships in that time, and that does not include 60 coastal patrol ships that the Chinese Navy transferred to its coast guard. Those ships are smaller and older, but they are also equipped with ominous missile capabilities that would certainly play a role in a conflict in China's neighborhood.
Daniel Ortwerth:To be fair, The US retains sizable advantages in the most capable platforms that are essential to global power projection, such as aircraft carriers and nuclear submarines. However, China has built some of its greatest advantages in the platforms most essential to an invasion of Taiwan, such as amphibious landing ships.
Phil Adler:Daniel, is it the same story for the air forces of the two countries? Is China making up ground?
Daniel Ortwerth:Although China is making up ground, I would not call it the same story. Whereas the gap shrinkage in naval assets is alarming, The US has done more to preserve its advantage in the air with the introduction and fielding of newer platforms such as the f 35, the f 15 e x, and the k c 46, the US has made appreciable strides to recapitalize its force and stay ahead. More recently, the announcements of the newest designs, the f 47 and the b 21, introduce a set of future platforms that no one else in the world can match. Still, China has made great strides even in just the last two years to upgrade its air forces. Historically, China relied heavily on older generation fighters, but it has largely replaced that legacy fleet with newer designs that can compete in the modern world.
Daniel Ortwerth:Even with the older designs, China has made difference making upgrades to key components such as engine upgrades.
Phil Adler:Well, let's talk about missiles now, both conventional and nuclear. What stands out to you about progress China is making in these areas?
Daniel Ortwerth:Phil, I wanna point out two things that really grab my attention here, breadth of types and sheer numbers. Whereas The US has historically focused on certain particular missile types, admittedly in part due to treaty compliance obligations, but also due to a choice to focus on prioritized capabilities, the Chinese have sought to flood the battle space with large volumes of many types of missiles. Here, we are talking about range, payload, intended target, and even launcher types such as fixed versus road mobile. The weight of effort in this area gives strong evidence of what China is trying to achieve. First, they are trying to make it as difficult and risky as possible for The US to enter the Taiwan or South China Sea battle spaces with its naval assets.
Daniel Ortwerth:For instance, if a US aircraft carrier got too close to Taiwan, it would face a hailstorm of missiles capable of sinking it. Second, they are trying to make the targeting problem for any enemy seeking to neutralize those missiles as difficult as possible. With so many of them of so many types located in so many places, a foe such as The US would have to expend a tremendous amount of effort and resources to get them all. Now I shouldn't end this thought without mentioning Chinese efforts to further develop its nuclear force. The last two years have witnessed intense activity in remote stretches of China in the form of new silos for intercontinental ballistic missiles.
Daniel Ortwerth:According to estimates, China now has 300 such silos, which they are filling with new technology ICBMs. At this rate, China's nuclear force is projected to achieve parity with The US sometime next decade.
Phil Adler:Daniel, there are so many aspects to this subject of military strength, including cyberspace, espionage, aerospace. You provide details in your report that we really don't have time to go into here, but my impression is that China is becoming a more formidable opponent in all of these areas. Areas. Am I correct?
Daniel Ortwerth:Yes, Phil. You are. I agree. We just don't have the time to go into detail, but I will take a moment to highlight one thing. It was only ten years ago that China established a new military organization called the strategic Support Force or SSF to house and direct all of these seemingly supplemental parts of their defense structure.
Daniel Ortwerth:Well, just last year, they disbanded the SSF and reassigned these functions to report directly to the highest command level of their military, the Central Military Commission headed by Xi Jinping himself. The message was clear. These are not just supplemental functions. They are core to how China expects to wage any future full spectrum war.
Phil Adler:Well, if we could do some summing up, in what areas does The United States still appear to hold a clear advantage militarily, and where does China have an edge?
Daniel Ortwerth:Phil, I'm gonna take this in perhaps an unexpected direction. The United States has 53 treaty allies around the world with which it has mutual defense agreements. These are countries with whom The US and the treaty ally are obligated to come to each other's aid if attacked. Now this might seem like a burden for The US with so many commitments. However, that list includes key East Asian countries such as Japan, South Korea, and The Philippines.
Daniel Ortwerth:These countries share our view of China as an increasing threat. They are increasingly aligning their policies on this threat with The US, including increased joint training exercises, China focused training exercises, and they are expanding their militaries largely with US made equipment. Meanwhile, China has one single mutual defense ally, North Korea. Follow the news flow, and you can see that while North Korea has proven to be a dilemma for China due to its erratic behavior, the recent statements of US allies show clear that if China initiated military aggression against US interests in the region, we very likely would not have to face that aggression alone.
Phil Adler:Well, you mentioned earlier in our discussion The US global military commitment, which might be seen as as a burden. Do you think The United States is shifting its major attention to China now and hopes to create a world where we can avoid major confrontations with more than one power at once? And that's why The US is withdrawing support from other parts of the world that have been traditionally important since the end of World War two.
Daniel Ortwerth:Phil, I think it has become clear that The US has made China its number one strategic military priority Across a range of actions from key appointments of China hawks and the Pentagon through sustained encouragements of our European allies to increase their share of the defense burden to these increasingly frequent and realistic joint training exercises in The Pacific, the shift in priority seems pretty clear.
Phil Adler:Let's turn, Daniel, finally to investment implications. If we can expect trade and military tensions to remain high or even get worse, what options are there for investors?
Daniel Ortwerth:Phil, I know we have been heavily emphasizing some of the same themes in recent reports, but The US China military face off might be the single strongest contributor to these themes. In particular, I'm talking about block formation and all of its effects such as the disruption of trade, technology, and capital flows between The US and China blocks. In this environment, Chinese stocks and the equities of countries allied with China are likely to be especially at risk. In contrast, if The US seeks to offer economic and security incentives to its allies and neutral countries to wean them away from China, those countries' stocks might benefit. With tensions boosting defense budgets all over the world, we continue to believe that defense industry stocks have bright prospects.
Daniel Ortwerth:This may be especially true for European defense companies as countries of the EU respond to the growing Russia threat and the perceived need to gain independence from The US. We expect all of this to exacerbate consumer price inflation and prompt higher interest rates. That outcome will likely be negative for bonds and positive for critical commodities, kind of across the range of those commodities, but especially uranium.
Phil Adler:Thank you, Daniel. The title of Daniel's report is update on The US China military balance of power, and you can find the written version, which includes a detailed graph with numbers measuring military assets of the two countries on the front page of the Confluence website, 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.
Phil Adler:Our audio engineer is Dane Stole. I'm Phil Adler.