Clash of Empires: Currencies and Power in a Multipolar World

I recently read the book Clash of Empires: Currencies and Power in a Multipolar World written by Charles Gave & Louis-Vincent Gave. It is a great read. No fluff. Quite short with many charts backing up the concepts & on point analysis.

Here are a few of the key themes & notes I took from the book, combined with some of the related themes I have sort of read online.

Their book is at least directionally bullish China (along with nearby emerging markets that will likely benefit from a halo effect if their China thesis holds true), extremely bearish Europe & perhaps at best neutral to the US in the short term with more of a bearish take in the longer run on the US (due largely to the relative rise of China).

Perhaps the directionally opposite take would be Kyle Bass as expressed in multiple interviews on Real Vision.

Europe

European Debts & Investments

Europe is largely uninvestable in its current incarnation – particularly bonds & banks. Some of their exporters might be ok, provided they export globally & their production isn’t in a category that is increasingly being competed with by Chinese producers.

The common currency has prevented interest rates & exchange rate changes from being able to adjust to bring the economic system toward equilibrium. While Germany appears financially healthy relative to other European economies, the common currency has meant Germany has had to play shell games to subsidize increasing levels of debt at the periphery.

Non-Euro denominated European equities have recently started to outperform Euro denominated assets.

Illusory Safety

The strength of the German economy has pulled down rates for other countries across the European region, which has made debt servicing costs lower than they were before integration.

Integration has been financial, but there has been no political integration. Any major recession risks collapsing the European Union.

Should the German Deutschmark return, other countries will choose not to pay their debts or to pay debts in a currency of their choosing. With that in mind, Germany might have made more malinvestments than China has.

Should there be a break up of the Euro it would not only be deflationary, but many of those debts German firms are sitting on could be worth approximately zero – the equivalent of taking some of their past production and dumping it directly into the ocean for no gains.

The waves of immigration will only stoke national differences & ultimately can not offset the aging demographics impacting the area which further slow economic growth.

European Innovation

Ricardian innovation – standardized integration & building of infrastructure – has ended as a source of growth across Europe with the Greek debt crisis, Brexit, Russia annexing the Crimea, & Turkey being a proverbial thorn in the side. Africa & the Middle East remain unstable. If the European empire can’t expand geographically then the low hanging fruit has already been picked.

Their Schumpeterian innovation is also more than a bit suspect given increasing regulations over the online economy which are hurting domestic European startups & acting as a subsidy toward the largest multinational players like Google & Facebook. EU venture capital deals have fallen off a cliff after GDPR & that is before the impacts of Article 11 & Article 13 kick in.

Negative interest rates further act as a kick in the face of innovation by keeping zombie firms alive & promoting financial speculation over fixed capital investment.

United States

Debt & Demographics

The United States is also facing an aging demographic profile. Elevated debt levels further constrain growth & high deficits crowd out other investments.

Recent promotions of modern monetary theory are a symptom of wanting to keep high defense spending with a broad-based welfare state without the associated required level of taxation.

Foreign central banks have stopped building reserves over the last 7 years & are no longer funding United States deficits. Foreign firms which took on Dollar denominated debts may be paying back debts. The global monetary base fell over 7% in 2018, which is part of why almost all asset classes performed poorly.

When global reserves fail to grow typically riskier assets underperform lower risk assets, while foreign assets also underperform US assets. When central banks reserves rise again US assets may underperform foreign assets. If central bank reserves grow rapidly the Dollar should fall significantly, with US commodity producers and other exporters being the beneficiaries of the shift.

Growth vs Value in an Age of Central Bank Manipulation of Markets

Pension obligations make some high cashflow businesses have no ongoing value if they are not able to either find new growth markets or aggressively pay down debts while interest rates are still relatively low. Heavy stock buybacks amplify earnings per share while the economy is healthy, but will also amplify losses per share when the economy turns.

Debt saturation makes the economy less dynamic and makes debt-larded companies less able to cope with dynamic changing markets as debt is the opposite of optionality. Some private equity plays like Toys R’ Us are a good example of how private equity driven debt can drive an otherwise solvent firm into insolvency.

Debt saturation makes the entire economy less dynamic. And if investors make more by speculating in existing assets (financial engineering) then there is less funding available for genuine innovation.

Quantitive Easing, ZIRP & even NIRP have lowered the discount rate on investments where returns are highest in the far out future. This in turn has shifted investor preference away from income toward growth by reducing the risk premium placed on growth. It also shifts the economic pie away from wage earners toward asset owners who see the value of their financial assets increase due to central bank intervention putting a bid under the market.

They describe 3 examples of innovative approaches & suggest the third is the path which remains available after elevated regulatory attention to the impacts of tech companies.

  • Apple: make a killer device driving a key platform (though what if there is no next device?)
  • Facebook: use richly priced stock to acquire their would be disruptors like Instagram & WhatsApp (though would any other major acquisitions be allowed at this point?)
  • Amazon: let a thousand flowers bloom with aggressive internal investments in many experiments

The U.S. stock market hosting many intellectual property rich growth businesses that have appreciated dramatically since the Great Recession have pulled in a lot of foreign capital.

High cashflow but slow growth businesses have been to a large degree deemed as having low residual value while businesses engaged in creative destruction of adjacent markets re seen as having high residual values.

If & when markets are allowed to normalize, the high value ascribed to money-losing growth businesses may come back to Earth while value stocks may outperform. They argue the sell off in Q4 of 2018 was the end of this valuation dichotomy. The flood of IPOs in 2019 may further prove them correct as investors now have a glut of supply of new growth stories to invest in at perhaps multiple hundred of billions of Dollars in valuation between entities soon headed to market including: Zoom, Pinterest, Uber, Airbnb, Slack, Postmates, PagerDuty, Cloudflare, Bumble, Crowdstrike, Palantir, Peloton, WeWork & many others which add to the selection of FANG, BAT, and many others that have listed over the past year or so including Spotify, Snap, Twilio, Zendesk, Match & other existing tech plays.

Dollar Reserve Currency Status

It is unlikely the Dollar would lose reserve currency status anytime soon. The title of the book does however hint at how the world could become multipolar. The rise of any legitimate competitor to the Dollar would ultimately be a negative for demand for the Dollar, even as the Dollar retains reserve currency status.

The ability to price trade in other currencies enables countries to ensure they have adequate reserves to buy vital commodities like oil without needing as much Dollars on hand to pay for those commodities.

Weaponizing the Dollar by fining foreign firms could hasten the decline of the Dollar’s reserve currency status, or at least encourage other foreign parties to denominate deals in other currencies.

Implications of the Chinese Trade War

President Trump is trying to reduce the trade deficit with China by adding uncertainty to global supply chains in order to try to drive production onshore.

If the United States works out a trade deal with China it could shift winners & losers across investment classes, with emerging markets outperforming U.S. equities & value stocks performing better than growth stocks within the United States.

If the trade war is improved through purchase commitments that would help rustbelt states by boosting commodity purchases. If the trade war is settled through a revaluation higher in the Yuan global asset prices should increase.

China

Trade Balance

China stopped recycling trade surpluses into U.S. treasuries after the Federal Reserve commenced their second round of Quantitative Easing & instead promoted their Belt and Road program while opening up the Chinese bond market to foreign investors.

In light of the 1989 Tiananmen Square massacre, China has a similar fear of stoking inflation that Germans with a memory of WWII have. They also recall how the Plaza Accord caused the Japanese economy to pop, so should China strike a deal with the United States to revalue the Yuan they would ensure any currency appreciation happened far more slowly.

Building a Reserve Currency

China is trying to build a parallel to the Dollar by promoting the pricing of gold, oil & other key commodities in Renminbi. To offset the US naval strength China is trying to build a land-based alternative integrated trading zone using their Belt and Road program.

Historically Germany has promoted outsized returns to rentiers & bondholders while the United States has promoted outsized returns to entrepreneurs & equity holders.

Like Germany, China views their currency value & bond markets as far more important than their equity markets. China closing their equity markets during the 2015 summer sell off eroded foreigner trust in the ability to invest inside China. To this day many Chinese companies (including Baidu, Alibaba & Tencent) still list their stock in New York vs Shanghai. Many new Chinese tech companies also prefer listing in Hong Kong (like Xiaomi) or New York (like Pinduoduo) over Shanghai.

As China views their currency & bond markets as critical, they are likely to try to keep adding stability to those markets to push down rates, which in turn will pull down rates in other emerging Asian markets, making some of their relatively high yielding bonds a compelling bet when compared to low-yielding fixed-income investments in developed western markets.

Other Key Countries

Inept politicians inside the United States have also drawn Russia closer to China, as ire that might be more appropriately focused on China was placed on Russia because the U.S. does not have highly integrated supply chains running through Russia.

If Germany should choose to have close relationships with Russia the US would likely promote military guarantees to Eastern European countries which would be discouraged by a strengthened Russia.

As Germany leads the EU, if China can improve ties with Germany & can get Saudi Arabia to start pricing oil in Yuan then the US Dollar would face major headwinds.

Implications for Regional Stocks & Bonds

As Chinese growth has slowed & their economy has underperformed they have in successive waves liberalized markets: labor, real estate, & commodities. As they liberalized markets people who speculated on the newly liberalized category performed well.

Their next market to liberalize would be capital.

If China is able to succeed in their efforts they will need to keep opening up access to their financial markets while improving the stability of the Yuan. Should success in creating a parallel reserve currency to the U.S. Dollar look imminent they will likely see falling bond yields & other economies in the Asian theater will also see declining bond yields anchored off the lower yields in China in a way that parallels the impact Germany has had across Europe. That in turn would make current longer dated bonds in these areas a compelling investment, along with many of the region’s equities

The Modern Day Container Ship at the Speed of Light

China is still heavily reliant on the United States & Taiwan for semiconductors. China has invested aggressively, engaged in aggressive IP theft, used antitrust to block mergers while forcing foreign firms to invest in China to try to close the gap.

Semiconductor firms may face margin pressures as they eventually lose access to the Chinese market & then end up increasingly competing against heavily subsidized semiconductors manufactured in China.

In future semiconductors, fiber optic cables & other internet infrastructure will become far more important than container ships are today. Portions of the book were also described in a blog post on the Evergreen Gavekal site named This Century’s Suez Crisis

“what was Xi thinking in laying out an imperial vision which, by any measure, could be seen as a direct challenge to the world’s existing empire, the US? Did he really imagine that he could paint a picture of a world in which “all roads lead to Beijing”, and that there would be no backlash? …

it can easily be argued that the last 60 years were above all the era of the container-ship (with container-ships getting ever bigger). But will the coming decades still be the age of the container-ship? Possibly not, for the simple reason that things that have value increasingly no longer travel by ship, but instead by fiberoptic cables! …

you could almost argue that ZTE and Huawei have been the “East India Company” of the current imperial cycle. Unsurprisingly, it is these very companies, charged with laying out the “new roads” along which “tomorrow’s value” will flow, that find themselves at the center of the US backlash. … if the symbol of British domination was the steamship, and the symbol of American strength was the Boeing 747, it seems increasingly clear that the question of the future will be whether tomorrow’s telecom switches and routers are produced by Huawei or Cisco. …

US attempts to take down Huawei and ZTE can be seen as the existing empire’s attempt to prevent the ascent of a new imperial power. With this in mind, I could go a step further and suggest that perhaps the Huawei crisis is this century’s version of Suez crisis. No wonder markets have been falling ever since the arrest of the Huawei CFO. In time, the Suez Crisis was brought to a halt by US threats to destroy the value of sterling. Could we now witness the same for the US dollar?”

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