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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 July 22, 2024. I'm Phil Antler. China's effort to control the South China Sea and push back against the Philippines is at the top of the Confluence list of potentially game changing geopolitical events for the rest of the year. Confluence Associate Market Strategist Daniel Ortworth makes the case in this week's report that understanding the motivations of Philippines President Ferdinand Marcos Jr. May help investors prepare for a range of outcomes.
Phil Adler:Daniel, bring us up to date. What's the latest as we record this conversation in mid July in this ongoing confrontation in the South China Sea?
Daniel Ortwerth:Phil, it certainly has been a busy summer in the area. Let me highlight 3 telling developments. 1st, in mid June, the Chinese stepped up their level of attacks on Philippine resupply missions to the second Thomas Shole using axes and knives to puncture Philippine vessels. In the altercation, 1 Filipino service member lost his thumb. 2nd, in early July, about 2 weeks later, the two sides held a special meeting in Manila to discuss the dispute expressing a clear intent to prevent further escalation of the crisis.
Daniel Ortwerth:Then just 1 week after that, the Philippines and Japan signed a defense pact called a mutual access agreement which opens the door to increased joint training exercises and the exchange of defense equipment and technology. This latest move is generally viewed as a way for the Philippines to broaden their deterrence of China beyond just relying on the US. Taken together, we view the Philippines as conducting a balancing act, trying to reinforce its own position without provoking further escalation of an already dangerous dispute with its much larger neighbor.
Phil Adler:Before, Daniel, we focus on Philippines president Marcos, can you help us understand how the Philippines' economic ties with China add complexity to the relationship between the two countries?
Daniel Ortwerth:Sure, Phil. By now, I'm sure most of our listeners are familiar with China's famous Belt and Road Initiative started in 2013 under Xi Jinping when he first came to power. This is a massive infrastructure development program led by China, which China partners with the other typically underdeveloped nations on projects such as ports and railroads in the partner nations. In 2016, the Philippines newly elected president Rodrigo Duterte embarked on a policy to distance the Philippines from the US under the contention that his country was not adequately benefiting from the relationship and instead to develop closer ties with China. Although the foundation of this switch was a set of belt and road initiative projects, it more broadly led to rising two way trade between the countries.
Daniel Ortwerth:Well, Phil, two things happened along the way. 1st, China did become the Philippines' largest trade partner eclipsing the US. However, secondly, as many countries around the world have experienced, Chinese investments in the Philippine Belt and Road projects have been well below the levels promised. Questions about the value of this new Chinese economic relationship began to arise well before Duterte left office in 20 2022.
Phil Adler:But turning to to president Marcos, Marcos, after one of the latest confrontations, said his country will not back down but does not want war with China and has no plans to invoke the country's mutual defense treaty with the United States. As you mentioned this does sound like a balancing act that demands an experienced and skilled leader. Perhaps by looking at the man's history we can draw some conclusions. First, we know he was educated in the west. He comes from a political family.
Phil Adler:How did these beginnings shape the path he has taken?
Daniel Ortwerth:Well, Phil, it goes back to his father. Ferdinand Marcos junior's father was already an elected official in the Philippines when Marcos junior was born in 1957. And from the beginning, father cultivated son in the political ways of the Philippines. This means that from his earliest years, Marcos junior was steeped in an understanding of the formal and informal power structures that govern Philippine affairs. This involves certain powerful families with entrenched interests in their home areas and that have strong influence on national politics, the Marcos family being just one of those.
Daniel Ortwerth:He even had the opportunity to serve as an elected official himself during his father's presidency. So on the bottom line, by the end of his father's time in power in 1986, Marcos junior had learned the balancing act that is domestic Philippine politics.
Phil Adler:We might think it may have been relatively easy for a man with such a well known name to make a political comeback after his father was driven from power in 1986. What can we learn about Marcos junior about the way he built his political career?
Daniel Ortwerth:Phil, we can learn that Marcos junior is persistent and able to bounce back. Being exiled along with the rest of his family in 1986 might have spelled the end for most people's careers. Not so with Marcos junior at his first chance to return in 1991. He went back to the Philippines, reconnected with his power base, and got elected back into office by 1992. This man does not easily give up.
Phil Adler:Do you think his success navigating his political drive to the top may cause him to overestimate his ability to deal with China now?
Daniel Ortwerth:Phil, this kind of thing is always a risk with any political leader that he or she might overplay his or her hand. However, based on what we are seeing so far with Marcos junior, we do not think he will make that mistake. With statements such as the one you mentioned earlier about not intending to invoke the mutual defense treaty and his quick move to engage in cooling off negotiations with the Chinese after the most recent second Thomas Scholl incident, it looks as though Marcos junior will employ the same balancing act skills in foreign affairs that he uses in domestic politics.
Phil Adler:You mentioned, Daniel, the Philippines under former president Duterte flirted with engaging with China on a much friendlier basis. Again, go into it a little bit more. How did this end?
Daniel Ortwerth:Not well for the Philippines, Phil. As I mentioned earlier, China did not live up to its promises on its Philippine Belt and Road Initiative Investments, but perhaps the bigger issue is that the Chinese used Duterte's friendly overtures toward Beijing as political cover to ramp up its efforts to establish its sovereignty claims in the Philippine portion of the South China Sea. To be sure, those efforts predated the Duterte administration, but they were not so aggressive before 2016. The inflection point that has led to the current crisis began during Duterte's time in office as a telltale sign of how the flirtation you mentioned ended. Even Duterte became disillusioned with his Chinese relationship and began to pivot back to the US as early as 2018.
Phil Adler:Does the Philippine population now stand firmly behind their president as he stands up now to China?
Daniel Ortwerth:Yes, Phil. It does. A recent survey revealed that 76% of Filipinos view China as their country's greatest national security threat. That same survey showed that on a 3 to 1 basis, Filipinos view China as having had a negative impact on their economy versus a positive one. It also showed that 61% of Filipinos agree with the Marcos administration's strong response to Chinese encroachment in the South China Sea.
Phil Adler:While Marcos has said he has no plan to invoke his country's defense treaty with the United States, are there ways short of that that he might attempt to leverage his relationship with the US?
Daniel Ortwerth:Certainly, Phil, and we are already seeing them. 1st, Marcos Junior has extended US basing rights in the Philippines. US troops and equipment are now allowed to operate from 9 different locations in the Philippines. Some of them remarkably close to the areas of dispute. Secondly, he can increase the size and tempo of joint training exercises and in fact, this year's annual Philippine US military exercise called Balikatan, which means shoulder to shoulder in Tagalog, which is the main Philippine language, was the largest since the Cold War.
Daniel Ortwerth:Thirdly, he can further develop relations with other US allies in the region making it easier for the US to lead a multinational coalition of sorts in the region. This is how we interpret recent developments between the Philippines and both Japan and Australia in particular.
Phil Adler:Daniel, what do you think is the most likely outcome?
Daniel Ortwerth:I should start by saying that we do not expect escalation to the level of open conflict or outright war. The risk of this happening has clearly risen and it could happen. However, the leaders of all involved parties have emphasized their desire to peacefully and diplomatically resolve the dispute, and they are exercising tight control over their forces. Now, accidents do happen. Wars do sometimes start when soldiers or sailors on the scene make a mistake that leads to a chain reaction, but most of the time that does not happen that is averted.
Daniel Ortwerth:Neither side shows any inclination of backing down. So we expect both sides to continue to reinforce their positions. And really, that means that for now, this dispute will remain a fixture in the region.
Phil Adler:But do you see any prospects at all for a resolution?
Daniel Ortwerth:Not in the near future, Phil. All conflicts eventually do get resolved in someday this one will too. However, as things stand now, the Philippine and Chinese positions are irreconcilable and they have both as it were dug in. We need to prepare ourselves for this to be a part of the news flow on a regular basis.
Phil Adler:And, Daniel, what are takeaways for investors?
Daniel Ortwerth:Our previous report on the China Philippines tensions emphasized that they could lead to rising transportation costs in the region, increasing military spending in key regional players and their allies, and further fracturing of the world into relatively separate geopolitical and economic blocks. The result would likely be higher inflation and interest rates, pressure on long term bonds, rising sales for defense companies, and emerging opportunities for companies that develop new technologies with defense applications. Additionally, the ongoing decoupling of the global economy into blocks should drive up commodity prices in general, but especially critical inputs to military production such as iron, copper, and uranium. The increasing duration the South China Sea tension and the China Philippines dispute that necessitated us writing a second report on the subject really just reinforces each of these themes.
Phil Adler:Daniel, one last question which involves China broadly. You write in your report and you mentioned earlier in our discussion that the Philippines were frustrated with their belt and road initiative experience with China because China over promised and under delivered. Now has this same experience been replicated throughout the world in a way that significantly damages China's influence?
Daniel Ortwerth:We have Phil, and it kinda follows a pattern. An increasing number of countries around the world have had a common disappointing experience. It involves big promises on the front end for help from China to develop key infrastructure, but it also involves big loans from the Chinese to the country in question. The participating country is expected to do a lot of work to develop the project, but with the expectation that Chinese help will be there the whole time to help them out along with ongoing funding. Over time, the burden is suddenly shifted to the host nation, and the investment flows from China fall increasingly behind schedule.
Daniel Ortwerth:Ultimately, the host nation finds itself behind on its work schedule, behind on the expected financial benefits of project that would help to pay for the thing, and behind on its debt payments to China. This has earned a moniker in global diplomatic circles of debt trap diplomacy. Now, the Philippines itself found themselves headed down this path when it pulled the plug on its belt in road projects and got out of the trap before it closed.
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 and 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.