Ulysses, Opium and Electric Vehicles

Trade wars can have long-running, unintended consequences. The Smoot-Hawley Act of 1930, widely regarded as a catalyst to the Great Depression, contained a clause (section 305) that permitted the banning of obscene materials, a classification that (in the US) covered James Joyce’s Ulysses. Joyce’s publisher, keen to sell the book in the US, brought a test case under the Smoot Hawley Act (United States vs. One Book Called ‘Ulysses’), and the resulting verdict that the book was not ‘obscene’ made Joyce’s text a bestseller in the US and changed American obscenity laws.

A more serious case was the consequence of the Opium Wars, which ended with Hong Kong ceded to Britain, and began what China recalls as its ‘century of humiliation’, a perspective that still colours Beijing’s view of the West. In 1997, Chris Patten presided over the handover of Hong Kong to China, and in 2020 the introduction of the national security law drew Hong Kong legally, institutionally and politically back to China, with little protest from the West, and in my view, this is the defining event that marks the end of globalization as we knew it.

A key institution in the process of globalization was the World Trade Organisation (WTO), which in its early incarnation as GATT (General Agreement on Trade and Tariffs) enjoyed strong leadership under Peter Sutherand and later Pascal Lamy, but is now defunct.

Beyond its trade agreement rounds, the most consequential event for the WTO was the decision to admit China in 2001. The move was approved by President Bill Clinton at a time when there was an uneven power balance between the US and China and, at the time, Clinton described China’s economic relationship with the USA as ‘the equivalent of a one-way street’ (arguing that it was a highly attractive opportunity).

The trade, manufacturing and financial relationship between China and the West formed the basis of globalization, and it is the evolution of China from a provider of cheap labour into an economic powerhouse, together with the failure of the West to hold it to the terms of WTO, that has led to the breakdown of globalization. Indeed, many expected that the second Trump presidency would pick up where the first one left off, with a hostile trade stance on China (in 2018 Marco Rubio released a very hawkish report on China ‘The World that China Made’).

Now, Europe rather than the US, may be the one to pick a trade fight with China.

China’s growing prowess in technology, intense domestic industrial competition, coupled with large quantities of state aid for ‘champion’ firms, and the need to replace a deflating real estate sector with a manufacturing boom, have created a surplus in/of manufactured goods, which China has opportunistically dumped on the European market (known as the China shock 2.0), to the consternation of auto manufacturers, chemical producers and pharmaceutical firms in the EU.

Until very recently, the EU has permitted this to continue, for at least two reasons. The first is that EU trade policy is very product-focused in terms of its corrective measures, and the second is that there has been no strong consensus amongst the large European countries on how to deal with China. For example, in his 946 page memoir “La diplomatie n’est pas un dîner de gala’ (a play on Mao’s line that a revolution is not a dinner party) the former French ambassador to China, Claude Martin states that the lack of a coherent, watertight view on China by the EU (with policy measures to support), meant that China could divide and conquer across European capitals.

That is apparently changing. In recent weeks, commentators and industry bodies in the major countries, notably France and Germany, have been striking a bold and hawkish note on China, and this much was reflected in a major development with the issue of a letter by French and German presidents to the EC president, where they call for a much tougher stance on China.

In my view, there are three mistaken elements in the French/German stance, a lamentable view of Europe as the victim, a lack of urgency to get European industry to reform and become more competitive (notably few of the Draghi recommendations are in place), and third, the lack of an even more aggressive view on China in the sense that its economy may be even weaker than many think.

Diplomatically, the move is being presented as a ‘conversion’ by the two governments, each led by intensely unpopular figures (Macron’s ratings are at an all-time low and Merz’ is not far behind).

There are two elements to note in the letter, which aims to protect key European industries such as chemicals, pharmaceuticals and autos in particular. The first is a diversification instrument that will safeguard supply chains from over-reliance on Chinese goods and inputs, and the second powerful measure aims to exclude Chinese companies (China is not mentioned in the document but the sense is that it is very much the target) from the EU market where trade dumping produces severe and systematic distortions. The implementation of such a measure could be rapid and would need a majority of EU states to block it.

EU trade commissioner, Maros Sefcovic spent last week in China, trying to extract a commitment from Beijing to limit the flow of Chinese goods to Europe. My sense is that the polite apathy that greeted him (as I write there is talk of an agreement on are earths) means that China has little intention of striking a reliable deal, and that a trade confrontation between Europe and China in early 2027 is something European businesses need to prepare for.

Have a great week ahead, Mike

Reincarnation

In the coming weeks we will likely hear James Carville’s name more often. Carville earned his fame as political adviser to the Democrats (his wife Mary Matalin was an equally famous Republican adviser), and is known for his pithy advice, having told the Clinton Democrats that ‘It’s the economy, stupid!’, and recently counselled them to ‘play dead’, whilst the Trump Republicans continue to make mistakes.

It might be expected that Carville will become sought after for his views on the forthcoming mid-terms, but it is more likely we will hear him quoted in relation to the bond market. In the context of mostly dull economists, journalists in need of a good bond market quote turn to Carville who stated that ‘’I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”

He said it in 1994, when US bond yields had pushed out to 8%, forcing Treasury Secretary Robert Rubin into a four-year deficit reduction programme – built on a rare moment of constructive bipartisanship – that halved bond yields and eventually produced a budget surplus. That kind of policy foresight, bipartisanship and political leadership is rare today; what endures is the bond market’s reputation as a powerful, intimidating beast.

Today, the bond market is back, and it is intimidating investors, governments and soon, the public. For all too long, bond buying by central banks had a soporific effect on bond prices, dulling them to the rising fiscal risks that have now enveloped most of the major economies. A couple of years ago we compared the effect of central bank liquidity to the storyline in the Danish film ‘Druk’ (which I recommend) where a group of teachers experiment with a permanent state of tipsiness. Central banks are now withdrawing liquidity, bond markets are sober and alive to the world and are pointing out various truths.

The first of these is that the ‘debt purgatory’ has commenced, precisely when the US Treasury Secretary made a series of failed interventions in currency and bond markets, demonstrating – in the spirit of Carville’s quote – that the bond market is more powerful than the government. In that respect, a threshold has been crossed where finance ministers may no longer be able to run near record deficits (in the context of economic expansion) and gargantuan debt levels. Scott Bessent, who has displayed a fetish for controlling market prices, may soon need either to start trimming spending, or to raise taxes (unlikely).

In France, the debate on the budget starts in earnest next week, in the context of the highest spread between French and German bond yields since 2012, and the woeful performance of the CAC 40 (in the past three years the Spanish and Italian stock markets have outperformed it by close to 90% and 75% respectively). To that end, debt, deficits and bond markets will dominate politics. For example, a recent Institute of International Finance (IIF) shows that the US spends more on interest payments (4% of GDP) than at any point in the last thirty years. In that context, it is likely that bond markets may only be calmed when governments make a serious effort to mend their finances, and when central banks enact further rate increases. This will prove to be a tough run into and beyond Christmas.

The second germane element of the rise in bond yields (which are only returning to their 150 year averages), is reflexivity, a word coined by George Soros to describe the ways in which moves in asset prices can cause effects in the real economy (and in other asset prices).

Higher bond yields should curb risk appetite and slow the economy. In previous economic cycles the thinking was that higher bond yields led to higher mortgage rates and thus a sluggish property market. The difference today is that many of the ‘Baby-Boomer’ generation have paid off their mortgages, or locked in mortgage rates at low levels, and the US middle-class has never been wealthier, and less rate sensitive (for example a new book ‘The Everywhere Millionaire’ by Owen Zidar and Eric Zwick traces the origins of the wealth of the 3 million Americans with over USD 25 million in wealth each and this effect is evident through the rest of the US wealth pyramid).

In other areas, the reflexive effect of bond yields may just be beginning and is already manifesting itself in the very riskier reaches of the corporate bond market (high yield/CCC rated bond yields are rising) and may soon take its toll on cyclical commodity prices (copper and oil).

The puzzle, optically at least, is that US equities have not registered the rise on bond yields. However, within the equity market, the many stocks have been weak over the past month (for example household ‘names’ Goldman Sachs and Boeing have fallen close to 20% since mid July) but headline indices have been kept higher by the small number of mega-cap AI related stocks (Intel, NVIDIA). Unlike US households who have in general been deleveraging, the AI complex is busy piling on debt. A sign of this is that UBS recently initiated a new publication, the ‘AI Debt Financing Monitor’. Experience tells me that the initiation of publications that herald the arrival of new asset classes is always a warning sign. To that end, the time to buy bonds is when yields rise to levels that brings hyperscaler debt raises to a halt.

Have a great week ahead, Mike

Spies Like Us

Ursula von der Leyen, the European Commission president, once led a mysterious life. Owing to death threats by the Red Army Faction against her father Ernst Albrecht, a prominent Christian Democrat, and suspicions that she might be kidnapped, she was sent to study in London, under the alias ‘Rose Ladson’. As such, von der Leyen is unfortunately acquainted with the types of security threats that are live across Europe.

In her State of the Union speech last Wednesday, geopolitics and security had top billing. In particular, Russia’s hybrid war in Europe (from sabotage to manipulation of elections, as we highlighted in a recent note, Russia Risks Rising) is enunciated as the main risk, and institutionalized measures are being put in place to counteract this. A full European Security Strategy will be unveiled this autumn, part of which is a NATO style Article 4 measure, where one European nation (likely including Norway, the UK and Canada) can draw upon the support of others. Indeed, the sense is of a Europe broadly preparing to assume the structures and processes of NATO, in the event that the US disengages from it.

It is likely that a component part of the new European Security Strategy will be a European Security Council, whose role may be to run crisis management, cross country procurement and to liaise with close EU partners such as the UK and Canada. In keeping with Jean Monnet’s dictum that Europe only moves forward in a crisis, it has required a war in Ukraine, conflagration across the Middle East, not to mention a very unexpected shift in foreign policy by the White House, to get Europe to this point. Given that its EU level diplomatic service has effectively failed, partly because of national level competences and rivalries, the EC needs to take care that the same does not happen in the realm of security.

One concern, that is so far registering behind the scenes, is a growing rivalry and even antagonism between the French and Germans in the areas of innovation, battle readiness and funding. Another more profound concern is that different EU countries have very disparate levels of competence when it comes to intelligence gathering and operations.

European nation states have been spying professionally for centuries, and Christopher Andrew’s excellent book ‘The Secret World’ makes this very clear. Some have allowed these skills to wither, and others have had to pivot to meet new challenges. Spain’s intelligence effort was almost entirely focused on domestic threats (separatists) up until the lethal Madrid bombings in March 2004, and thereafter it had to quickly build up an external facing capability. Other nations, from Sweden to Japan, are now augmenting their external-facing intelligence services.

In this context, the French magazine L’Express has, based on interviews with sixty former spies (including some agency chiefs), scored and ranked Europe’s intelligence agencies, and there is a very good discussion of the process in the Collimateur podcast. The runaway winner is MI6, on 261 points, followed by France’s DGSE on 169 points (judges apparently gave them high marks for their field operations), followed by the Netherlands on 97 points (renowned for their discretion and cyber capabilities). Then, maybe unsurprisingly in fourth is Ukraine’s secret service, given the extent of the challenges it has faced. Germany comes some way behind in fifth, followed mostly by the Nordic countries, Poland and Estonia.

A number of large countries are well down the list, such as Spain and notably Italy (Estonia gets 27 points as compared to Italy’s 9 points), as are wealthier countries Switzerland and Belgium. Austria and Portugal prop up the end of the list, and the likes of Hungary and Slovakia get zero scores, and according to the authors of the research report, are largely untrusted. Ireland did not feature. There are broadly two axes of strength, London/Paris and Den Haag, and the other to the north (Nordics/Baltics down to Poland). The south of Europe is weak, as are a number of EU members to the east.

Today, the majority of the intelligence agencies in Europe are united by the challenge presented by Russia, not to mention hybrid actors (gangs and cyber-attack groups) as well as some powerful corporate intelligence teams. There remains insufficient trust between many of them, and the opportunity for hostile actors to target weaker states is significant. Lurking behind the ranking is an ongoing reliance on US intelligence.

By that mark, Europe’s spies have a long way to go.

Have a great week ahead, Mike

The Rotten Heart of Europe

One of the first books I read that helped to explain how Brussels worked was Bernard Connolly’s ‘The Rotten Heart of Europe’, published in 1995. It was a massive hit (in the UK) and hugely controversial. Indeed, a second edition came with a cover recommendation from the then editor of the Spectator Boris Johnson (‘one wanted to stand on the desk and cheer’).

The book did much to propagate Euroscepticism in British politics, and we might trace some of the roots of Brexit to it. With some irony, Brexit showed that the Commission can function in a forceful way when a crisis befalls it. However, as is well documented the challenge for the EC is to now step up a level and reinforce itself for a multipolar world where it will compete more acutely with China and the US, with at the same time Russia snapping at its heels.

Connolly’s book came to mind a week ago when speaking at an investment conference. I was joined on a panel by economists and policy makers from Italy, Spain and Portugal, so that together we made up a representative group of the euro-zone periphery countries hit hardest (though Greece suffered the most) by the euro-zone debt crisis.

Each of the periphery economies has had a remarkable turnaround – Italy is a bastion of political stability, Spain is the fastest growing of the large economies and Greece, Portugal and Ireland are arguably ‘too hot’ in terms of the rate of growth and price inflation they experience. What is telling is the signal from bond markets – yields for Italy, Spain and Greece for example, are below those of France and the UK, and Ireland is nearly on a par with Germany.

In that respect, the tables have been turned. It is not forgotten how Angela Merkel and Nicola Sarkozy upbraided the lazy Mediterraneans in the 2010’s. Now, the three large countries at the heart of European history – the UK, France and Germany, are struggling, and to unkindly borrow Bernard Connolly’s title, constitute the ‘rotten heart of Europe’

They share common problems – sluggish, low growth, an inability to foster sustained private investment, political instability in the face of electorates who are in thrall to the easy solutions of populist parties. The reaction to last week’s triumph of the AfD (Alternative fur Deutschland) in Saxony-Anhalt is an example, and it may mean that Frederich Merz suffers the fate of Keir Starmer should his coalition collapse or his party cast him aside in favour of a younger leader.

Though the tempo of growth is picking up in Germany, the UK and France, it will not rescue the leaders of the large economies. An additional complexity is that trading partners and allies are turning against them – China is exporting its manufacturing over-capacity to the German consumer and the special relationship that characterized US-UK diplomacy has all but withered away. The prospect that the White House might favour Argentina’s case for sovereignty over the Falkland Islands is a stunning case in point.

Unlike France, the British and German economies suffer from a similar failure to upgrade their ‘production capital’ – investment in research, skills, new technologies and to an extent, manufacturing capacity. Both are behind France in terms of military power, but France is a leader in over-regulation. The fate of these three great nations has already inspired an endless flow of analyses, ideas and suggestions – the best of which from Mario Draghi, seems to be ignored.

The sole thought I have to add, is that incumbent, centrist politicians in all three countries appear to ignore the increasingly obvious lesson that the rules of the geopolitical game have changed, and as we have referenced before in this note, we live in an ‘age of predators’, and consequently prey (Starmer). In this regard, new ideas are not the solution, but a change of method is. That method is more singular, less consensus led and aggressive. Edouard Philippe in France and Andy Burnham are its test cases, we will know by next May if they learn this lesson, and if not, Europe is in dire straits.

Have a great week ahead, Mike

Debt Purgatory

Roland Garros is one of the more stylish and elegant parts of Paris, and not a bad location to discuss finance and economics. Unfortunately, France’s political elite did not rise to the occasion. At the end of last week, (MEDEF), the large French business network gathered the principal candidates for the 2027 presidential campaign to listen to their views on the economy, and in particular their policies to pare back France’s gargantuan fiscal deficit and debt load. With a few exceptions, they disappointed. 

The candidates for the far-left (Jean-Luc Melenchon of La France Insoumise) and far-right, Marine Le Pen of the Rassemblement Nationale, appeared to treat the event as a light-hearted post-holiday chat show, and not a forum to debate the faultline that could pitch the euro-zone into another debt crisis. 

Though France’s presidential election is far off (the first round is on 18 April 2027), international investors need to pay close attention to it, both as a specific risk factor for bonds, foreign exchange and equities, and as a harbinger of what might befall most of the other major economies. 

In this respect, France has at least two things in common with the US. First, its weak finances. The budget deficit has been stuck at 5%, a level historically associated with a recession, and debt to GDP is on course to hit 120% according to the OECD. Second, there is no appetite to tackle this dire fiscal situation. In the US, there is little prospect of corrective tax hikes or spending cuts, and the Trump administration appears to have a fetish for intervening in markets.  

In France, three governments have been consumed by the process of setting a budget, and there is no political nor popular will to set France’s finances on a sustainable track. What is worse is that wild, populist suggestions that France could cancel the debt that the Banque de France holds (as a result of quantitative easing) are being aired in the media. France’s political class and populace are not known for their financial literacy, and the belief in some quarters that debt can be magicked away is dangerous and sets the economy up for a sharp reality check. 

Having witnessed the brutal effect of a debt crisis and the subsequent austerity on the Irish economy from 2010 onwards, French policymakers and its public are badly unprepared for what may come. Government spending at 57% of GDP is comparatively huge, and much of this goes on social welfare (healthcare and pensions). 

Unlike the US, France is not enjoying an AI capital expenditure fuelled wealth effect, and the notion that it might act to structurally boost economic growth is anathema to nearly all of its politicians. In a demonstration of moral hazard, France has accumulated debt at a pace and amount more than any other euro-zone country, without much protest from the ECB.

Markets however, are reacting. French ten-year bond yields have just passed Italy’s. While long-bond yields in Japan, the US and UK have all broken higher to multi-decade highs, the re-rating of France is troubling. For international investors, France’s changing status, from a core, safe haven, to a periphery market is one of several signals of a coming debt purgatory – a long period where indebtedness dominates markets, government politics and geopolitics. 

For European policy makers, the fact that France is the indispensable nation on geopolitics, defence and military innovation complicates matters because it means that politically, in the context of German underperformance, France is harder to corral into a fiscal straightjacket in the same way the European Commission did with Greece, Ireland and Spain. On the European political stage, there is no-one fiscally credible politician who might stand up to France and avert the potential for contagion across the euro-zone. 

If for instance, both Melenchon and Le Pen make it through to the second round of the presidential election, bond investors will desert France, French bank share will collapse, luxury goods firms will become bargains, and the euro will likely fall. Bond investors will likely rush to the few safe havens the euro-zone offers – Germany, the Netherlands and Ireland as well as assets in ‘old’ periphery countries like Norway and Switzerland. 

More broadly, a continued rise in French yields, in the face of policy inaction (a draft budget is to be presented to parliament at the end of September), will for the first time in over a decade sensitize international investors to the credit risk inherent in government balance sheets. What is intimidating is that here France is in good company, most of the major economies, China, Japan, the UK and the US are as indebted as it is. 

Everything is Fine

On September 16, 1992, the British pound was ejected from the rigid European Exchange Rate Mechanism (ERM) system that it had joined in 1990. In the ERM, the pound was linked to the Deutsche Mark but effectively at too high a valuation, making it uncompetitive. A few days later, Chancellor Norman Lamont tried to sound upbeat, telling journalists that ‘My wife said she had never heard me sing in my bath before,”, suggesting that he was happy to be rid of the ERM. This characteristic gaffe by Lamont was badly received at a time when British industry and households faced a sharp rise in interest rates.

The pound’s exit from the ERM came after painful interest rate hikes (from 10% to 15% in one day) and massive intervention from the Bank of England on one side of the foreign exchange market. On the other side, famously, was the speculator George Soros, who ‘broke the pound’ by selling billions of pounds in the expectation of a devaluation. At the time, a youngish Scott Bessent worked in Soros’ Quantum Fund. Today, as US Treasury Secretary, Bessent is having his ‘singing in the bath moment’.

Bessent has made two interventions in markets in the past month. The first, a historic joint move (the last one was in 1998) with the Japanese authorities to boost the yen. The involvement of the Treasury ensured that Japan was able to buy yen without selling Treasuries, which would have pushed US yields up. In that context, Bessent’s second intervention was a promise to effectively sell short duration bonds, and with the proceeds buy long duration ones, the intention being to push down long-term yields.

Bessent’s moves were greeted with puzzlement and some disdain in markets. Interventions in markets are rare, normally occuring when something is broken or about to break. When they do occur, they need to be large (almost unlimited) to have credibility. Mario Draghi’s announcement that the ECB ‘would do what it takes…and believe me it will be enough’ is the best example. Thus, the Treasury Secretary’s interventions give the impression that something is not quite right, and in this regard, at least three problematic issues are raised.

The first is that Bessent has announced the arrival of a debt crisis, or rather a debt purgatory, a long period where indebtedness weighs on government policy, markets, and geopolitics. The bond market intervention coincided with America’s debt burden topping the USD 40 trillion mark, and the Treasury Secretary has simply succeeded in drawing greater attention to this.

Markets registered this in May when long dated (30-year) bond yields on US, UK and Japanese debt hit levels not seen since before the global financial crisis. Bessent’s intervention shows that governments are now feeling the financial pain associated with this rise in yields and are starting to worry about how to curb it. A particular problem for the US, is that a mixture of geopolitics and AI driven debt issuance, mean that there are fewer natural or passive buyers of its debt.

The second element of note in Bessent’s actions is that they betray a philosophy across the Trump administration that is intensely focused on asset prices to the detriment of economic policy. The president’s active stock trading and public promotion of stock trades, billion-dollar forays into cryptocurrencies, and attempts to shepherd the oil price through social media are all part of this. At the same time, the US has a historically enormous budget deficit, which the rating agency Fitch expects to surpass 7%. In the past a deficit of such magnitude would only occur during a deep recession or financial crisis.

Today, in the context of a record high stock market, and an AI boom, it is a dangerous anomaly. Should something go wrong to pitch the US into a recession, there is no fiscal cushion. Bessent has done nothing to reduce the deficit and his tinkering in the bond market shows that the deficit is not his priority.

Thirdly, the bond market intervention is ill timed because the other ‘wing’ of American financial policy, the Federal Reserve, has a new chief, Kevin Warsh, also a former hedge fund manager. Warsh has a preference for a Fed that communicates less to markets, but he has so far not communicated well. Markets are unsure of his stance on inflation. The added complication is that Warsh prefers a more spartan Fed, one that is less active in bond markets, so the Treasury intervention is a contradiction of this. The other concern is that the Fed begins to suffer from fiscal dominance, which in simple terms means that in making policy, it is looking over its shoulder at the actions of the Treasury, and the sentiment in a wobbly bond market.

With markets still focused on AI, Bessent has unwittingly opened up a macro ‘battle’, which the bond market will surely win.

Have a great week ahead, Mike

Friends

An important sign that globalization is over and that America’s role as the keystone of the world order is crumbling is the flux in strategic alliances between countries, across multiple regions. Arguably there has not been a period of such furtive strategic alliance formation since before the Cold War. Globalization was a geopolitical anomaly in the sense that there were no major wars, international norms, rules of geopolitical behaviour and institutions were respected. This is certainly not the case today, and the idea of ‘fracturing’ we wrote about in 2020 is accelerating.

Sweden and Finland reacted to the invasion of Ukraine by joining NATO. Next week (29^th) Iceland will vote to recommence membership negotiations with the EU and potentially join Moldova and Ukraine in the accession queue. Iceland had toyed with membership in the aftermath of the global financial crisis and the consensus in the small country is once again turning to Europe, because of ‘geopolitics’, by which Icelanders mean the presence of Russia in the Arctic and greater Nordic region, and American threats to ‘take’ Greeenland.

The Iran War will eventually provoke a re-alignment of alliances across the region, where the crucial variable is the relationship between the UAE and Saudi Arabia. Two weeks ago, Saudi Arabia, Pakistan and Turkey signed a joint defense pact in Mecca, an accord that has strategic implications for Iran, Israel and notably, India. During the period of globalization, Turkish foreign policy was conditioned by the maxim ‘no trouble with neighbours’. Now, Turkey is involved in some form, in every skirmish in the region – from Libya, to Syria, to Azerbaijan to Iraq.

Then in Asia, relatively new ‘clubs’ have been forming; AUKUS (effectively a US – Australia alliance), the Quad (Japan, the US, India and Australia) and the Shanghai Cooperation Organisation (China, Russia and Pakistan are the main members). For their part, South Korea, Japan and Taiwan, all formal allies of the US, will be worried by the gradual strategic distance that the White House is putting between its Asian allies, the most recent is the curtailing of joint military training exercises between American and South Korean forces.

Most of these alliances are motivated by a common factor; an America that is more singular, and less willing to be the world’s policeman. This change is complicated by the fact that the White House appears to have a fascination for autocrats (for example, Steve Witkoff, President Trump’s peace emissary has not visited Ukraine, but is a frequent visitor to Moscow). Indeed, some of the critics of the White House’s foreign policy stance, such as Harvard academic Stephen Walt, go a step further and have referred to the US as a ‘predatory hegemon’.

The net effect is that many countries will now experience the loss of the ‘policeman premium’ they enjoyed when America underwrote their defence, and instead will have to pay a ‘predator premium’; the higher security and defence costs associated with a more adversarial geopolitical climate. Germany is the case in point, where military spending and combat readiness had dwindled during the period of globalizations, but where it has now lifted its debt brake and will spend up to Eur 1 trillion on defence in the coming ten years. Corporates are also facing this defence friction – either through supply chain disruption, cyber-attacks or the theft of corporate secrets to the extent that corporate intelligence is a fast-growing field (Lewis Sage-Passant’s book ‘Beyond States and Spies’ is a very good text here).

The kaleidoscopic shift in alliances will likely continue, and a cautionary tale is the manner in which the tangled web of alliances that sprung up during the first wave of globalization (1870-1913) tripped itself up. Then Europe was split between the Triple Alliance (Germany, Italy and Austria/Hungary) and the Triple Entente (Britain, France and Russia). Margaret MacMillan’s books on the First World War (for example ‘The War That Ended Peace’) are worth a read and the parallel in the arms race between Britain and Germany then, and China and the US now, is striking.

Alarmists might worry that a ‘great power’ war is close, but the only saving grace from the wars in Iran and Ukraine, is that the great military powers struggle to achieve their aims in the face of new technologies and tactics. Let’s hope they learn these lessons.

Have a great week ahead, Mike

Is China OK?

China's economy grows at one of lowest rates in decades

For much of the last decade or so, Chinese friends and acquaintances, as well as many people I know in Singapore and Hong Kong, have remarked that their view of Europeans is a lazy and decadent people, too tolerant of the problems that beset their societies. This view is in part gentle mockery, and part sincere. Europeans, not used to being mocked, will look up from their Aperol spritz and ask what they are doing wrong?

Indeed, according to the latest (and fourth) University of Alberta ‘How China sees the World’ survey, it seems that most Chinese don’t rate the EU as a major geopolitical player, though a significant economic partner and more importantly, a tourism destination.

The survey highlights that the Chinese have a strong view of their country’s importance on the international stage, pitting it ahead of the USA in a bi-polar world order. The interesting elements in the survey are the casting of Russia as an indispensable, trusted partner on the international stage for China, and the confidence with which participants gauge a war with Japan as a likely geopolitical event.

To an extent, it is welcome to consider Chinese views on the rest of the world, granted the irony that for such an important economic and geopolitical player, there are relatively so few Western experts on China, and in Western public discourse there is not a well-developed conversation on Chinese culture and politics. Consider that there are very few Irish public figures who know China well, and the evolution of China’s economy does not get enough detailed attention in the Irish media, despite China’s enormous role in the world economy.

This might be because China makes it increasingly difficult for outsiders to understand it. In the past seven years, Western investment in China has dropped significantly, and the flow of Westerners to work in China has also fallen. A further illustration is that there are now fewer than 2000 Americans studying in China according to the Straits Times (down from 11,000 in 2019) while there are still some 250,000 Chinese studying in the US (down from 354,000 in 2019), and a further 150,000 Chinese studying in the UK (and close to 4,000 in Ireland).

The reduced social, political and commercial connection between China and the West makes it harder to read what is happening to the Chinese economy, with the additional concern that official Chinese data is not helpful either. Granted that China last week printed one of its lowest official GDP growth readings, this is a significant hurdle. Indeed, there is a sense amongst many Western economists that only an amalgam of very detailed, micro indicators (e.g. electricity usage) can help build a picture of what is really happening in the Chinese economy.

For example, In the USA, the Conference Board has reconstructed China’s economic data, and has concluded that not only has the performance of the Chinese economy overestimated, but it has been driven by the flow of huge amounts of capital into the economy that has steadily become less productive (in the sense that one dollar of capital leads to a decreasingly small return). It may be that the Conference Board team has gotten it wrong, but there is simply neither the forum nor the spirit for an open debate on Chinese data. Also, a prominent Chinese economist Gao Shanwen, who died of cancer last month, had stated publicly that the trend rate of growth in China is far lower than official figures suggest.

Despite that, the most interesting element is that the Chinese authorities have managed their economy better than most have thought, and to use a headline from the New York Times, China’s economy ‘has failed to fail’ in the sense that it has not had an obvious cyclical recession in decades.

If there is a strategy behind this, it looks from afar, as the state pushing activity from one economic engine to another. The Chinese property market has steadily deflated over the past six years, and the financial consequences of this have in my view not fully registered with banks and households. At the same time, through a mixture of state guidance and ruthless industrial competition, China has shifted the locus of activity to manufacturing (and the last Plenum, policy making forum, has ordained deep tech as the spearhead of the Chinese economic effort).

One consequence has been the creation of over-capacity, but in goods of sufficient quality and low production cost, that they displace European markets. Last week, exports of Chinese cars to Europe have just topped a monthly tally of 1 million, while European manufacturers (even Porsche) are struggling in China. The result is a crisis of confidence in German manufacturing, and a policy debate on how to curb the flow of Chinese exports into Europe.

In the past year, China has pursued an ‘involution’ policy, of reducing spare capacity across a range of industries, but this does not yet appear to have borne fruit and raises the risk that there is still a lot of operational leverage in the economy. Two other risks loom. One consequence of the funding of real estate and manufacturing through the banking sector is that in terms of assets, China’s banks are amongst the largest in the world, a systematic risk in the event of a downturn, and its public (including local and regional authority) debt, is dangerously high.

With trading partners, such as Germany, beginning to react to China’s export boom, the policy options for Beijing are increasingly limited as they try to maintain economic momentum. Another bad GDP print and investors will start to fear the worst.

Have a great week ahead, Mike

You’re in the army now

At a recent dinner event three people, myself included, referenced Valery Gerasimov, chief of the general staff of the Russian army, and famous in geopolitical circles for a 2013 essay where he outlined the concept of ‘total war’ as seen through Russian eyes. It is a view of conflict that covers many strategies such as cyber, border testing, propaganda, intensive social media and covert attacks, for example. This approach has been very much on display across Eastern Europe and the Baltics – the encouragement of discord in Bosnia, the hollowing out of Hungarian politics and in particular the harnessing of Belarus as a form of geopolitical attack dog. Indeed, the fact that General Gerasimov has entered our minds is a sign that the doctrine is succeeding.

An excellent steer as to the tactics of ‘total war’ is David Kilcullen’s book ‘The Dragons and Snakes’ where he examines the new, unconventional forms of conflict pursued by the likes of Russia and China. One striking example Kilcullen describes is Russia’s efforts to drive immigrants and asylum seekers through the border with Norway, the aim being to test Norway’s reaction, its border security and to generally aggravate NATO.

Total war is highly effective. The ongoing destabilisation of adversaries through unconventional means is relatively cheap and effective, especially so when many governments in the West refuse to publicly acknowledge the manipulation of the infrastructure of democracy and public life. Other efforts, such as assassinations and the incursion of drones and jets into European airspace, with the added spice of cyber-attacks, are harder to ignore. They likely amount to signs of Russia stressing and probing European defences, and most importantly, testing the commitment of the US to NATO.

In this respect, NATO should be highly focused and motivated, but in the context of its gathering in Ankara, consistent with the view that all of the institutions of the post WW2 era are unravelling, dangerously on the brink of irrelevance. The danger is that it ceases to be an alliance, and instead serves as a mere organisation.

The reasons for this are well known. Whilst military level ties between the likes of France and America are very strong, Europeans (and Canadians) fear that Europe and the US no longer share the same enemy and worry that even in a post Trump 2.0 world, the stance of the US will not revert to an embrace of NATO.

In short, if NATO’s Article 5 was to be invoked, Europeans are still (despite comments from the summit) not convinced that the US would pick up the phone. Indeed, the only person to have triggered Article 5, Ambassador Nick Burns (former US ambassador to NATO who triggered Article 5 on 9/11) has said that Donald Trump’s repeated view that he wants to ‘take’ Greenland, is ‘breaking the bonds of trust’.

To that end, many officers in European armies increasingly regard the NATO command structure as an organisational framework through which European armies can coordinate, plan and organise, and to that end it still has value. Europe is re-arming, and as Germany showed this week, balance sheets are swelling with the issue of new debt to finance defence spending. This re-armament is urgent, in view of warnings from intelligence agencies of a clash with Russia within the next five years. One nod to this risk is the upgrading at the NATO summit of the Baltic Air Policing mission to an air defence one.

By their nature, democracies are vulnerable to the tactics of ‘total war’ and the rise of social media has made populism an easy and attractive strategy, and thoughtful rebuttal a near impossible one. Two important reminders of this came last week.

Nigel Farage, who according to some is Britain’s prime minister in waiting appears to have made a tactical error in resigning his Westminster seat, so as to recontest it. Farage did so in order to head off an inquiry into donations he has received (note that the former head of Reform in Wales is serving a lengthy jail sentence for pro-Russia bribery). With the exception of the satirical independent candidate Count Binface, no other parties will contest the seat, undermining Farage, with potentially enormous consequences for British politics given the rise in popularity of Reform.

Across the Channel, where on repeated occasions the French authorities have warned of foreign influence in French elections, the French judiciary have confirmed Marine Le Pen’s culpability in a finance scandal, but effectively opened the way for her to stand in the 2027 presidential election. The court battle is not yet over, and Le Pen will face several constraints (possible house arrest or electronic bracelet). Most voters should feel disdain in voting for a politician convicted of corruption, though Nicolas Sarkozy stills enjoys an allure in France.

But, Le Pen, whom Emmanuel Macron has accused of being funded by Russia, will likely play the martyr card, that the elitist French system is set against her. She has a hard-core support approaching 30% of the electorate, and the only person who can stop her is Edouard Philippe, the former prime minister, who has been far too mild mannered. He needs to take note from the evisceration of Keir Starmer, otherwise the next NATO summit in Tirana in 2027, may be marked by Marine Le Pen leading France out of NATO’s command structure.

Have a great week ahead, Mike

Modern Times

On May 15, 1932, there was an attempted coup d’etat in Japan, led by a militant, nationalistic faction in the Imperial Army. The principal victim was the Japanese Prime Minister, Inukai Tsuyoshi. The perpetrators of the coup were given relatively light prison sentences, a pointer to the less democratic and belligerent Japan that would soon follow.

The bizarre element of the coup, which fortunately did not succeed, was a plan to murder the actor Charlie Chaplin. The thinking was that such a deed would incite popular fury in the US, and thus lead to war, in which Japan would prevail. At the time of the coup, Chaplin was watching a sumo wrestling match with the Prime Minister’s son, and thereby escaped the assassins.

This was more than lucky and in many ways Chaplin’s film The Great Dictator is a fine riposte to the destructive nationalism and totalitarianism that took hold across the world from the mid 1930’s. It is a film that still resonates today in our world of ‘predators’.

While our view of Japan today is of a placid, highly civilized country, its history in the past two centuries is a reminder of the pitfalls of isolationism, nationalism and war – concerns that are now echoing louder across the international political economy debate. It should be said at the same time that the post second world war relationship between the US and Japan is a good example of how two feuding countries can come together (Al Alletzhauser’s ‘House of Nomura’ is good on this topic).

Yet, such was Japan’s economic rebound after the second world war that America feared the rise of Japan as it now does China, and fans of economic history may know that during the 1980’s and 1990’s Donald Trump was an eminent Japan-trade basher. For instance, the April 13 1987 cover of Time magazine carried an image of Uncle Sam pitted against a sumo wrestler under the banner ‘Trade Wars – the US gets tough with Japan’ (the stock market crashed five months later).

Now, following decades lost to the after-effects of its economic crisis, Japan is undergoing an awakening, spearheaded by the historic election of the first female prime minister of Japan, Sanae Takaichi. This awakening takes different forms, a more assertive diplomatic stance on China, a ramping up of defence spending amidst greater public comfort with the idea of Japan as a budding military power. Also, Japan’s government is ambitious for its economy and has announced a record state budget of 122 trillion yen (over Eur 600 bn), and Japanese firms like Softbank are in the vanguard of the AI boom.

There are two other financial aspects of this awakening. In an attempt to revitalize the Japanese economy, the Bank of Japan had kept interest rates at or below zero for some time. It has abandoned that policy recently and with both growth and inflation picking up, bond yields have surged. For much of the last fifteen years, the ten-year bond yield in Japan has been well below 1%, but in 2024-25 normalised toward the 1.5-2% range, and is now 2.7%, whilst the longer term 30-year bond yield is 3.95%.

As one of the world’s most indebted countries (Japan’s headline public debt to GDP ratio is well over 200% according to the IMF), the effect of this is that fiscal policy is increasingly smothered by the effect of interest payments on that debt, and policy is trapped between trying to grow the economy, control inflation and not upset the bond market.

Equally the yen is grabbing attention, falling to a forty-year low this week. Indeed, it might well be lower, but traders are wary of a market intervention by the Japanese authorities. There are several factors driving this, the hedging of foreign exchange risk by investors buying Japanese assets, real interest rate differentials, and worries over the effects of expansionary fiscal policy. A costly bout of yen intervention might be close.

As Japan’s asset prices hit records for largely the wrong reasons, it serves as a reminder that many large indebted economies exist on a financial tightrope between growth and calamity. Britain is the most prominent example, but Japan is a more systematic case and over the summer could be the source of a market wobble, if not outright crisis as bond market sell-offs become more common in our ‘age of debt’.

It’s all enough to make me think of Charlie Chaplin’s depression era film Modern Times.

Have a great week ahead, Mike