CIO View: US & China

The Thucydides Trap

It’s clear that while it is not necessarily at the forefront of investors’ minds at the moment, the power struggle between the US and China has not gone away. Indeed, it is going to be a major geopolitical theme in the coming decades. So while the noise around this issue has quietened in the wake of more immediate market concerns, the signal remains.

Why is that? Because we are in a changeover period, where the rising power is challenging the leading power, and the leading power – if not declining – is certainly not surging ahead anymore. This situation carries significant risk. Professor Graham T. Allisson of Harvard describes this as the Thucydides Trap, whereby historically – more often than not – the conflict between an incumbent and a rising power leads to war.

Whether or not we see a major conflict arise, be it military, economic or even cyber, the rise of China as a global power has ramifications for investment markets. The drumbeat of demographics and long-term growth trends do point to Chinese relative share of global GDP potentially challenging the US in US dollar terms, if already the case against a broader of basket of currencies. This is clearly, a point of regime change, and China’s strategic patience is unquestionable. If you were to look at global GDP over the last 2000 years, China’s share – alongside India – was pretty dominant for a major proportion of that time. That changed only in the last 200 years or so, when the Industrial Revolution powered Europe and the West forwards, and the pace of change materially increased. Now, we are reaching a potential turning point again, and you don’t need to look far to see it. In both US and Chinese news, virtually every day you see coverage of brewing tensions, and not just in trade, but also in increasing military presence, and in technology.

What does this mean for markets and investors?

There are two major ways that this conflict can affect portfolios. The first is that, at the margin, it is not very positive for globalisation. This flourished after the Berlin wall came down and China joined the World Trade Organisation, but since 2009 it has started to track sideways, and perhaps even declined. This is evident anecdotally, but is backed up in the data; exports as a percentage of global GDP have steadily been shrinking. A multi polar world, rather than one that relies on a single power as the engine of global growth, is more likely to lead to lower growth and reduced trade, which of course has negative ramifications for a broad swathe of financial assets.

The second thing to think about is of course, geographical allocation. With a multi polar world you can see a splitting up not just of power centres, but also of things like technological standards. In terms of corporates, that could mean that you end up with large players in the US on the one side, large Chinese companies on the other, and Europe caught somewhere in between the two. And in that kind of set up, the winners – the kind of large global companies that we’re used to seeing dominate markets - won’t continue to capture all of the profits.

Investing in a multi polar world

The geopolitical situation is complex, but our approach is relatively straightforward; global indices and benchmarks are already heavily skewed the US, and the world is looking increasingly fragmented, so we are particularly interested in opportunities outside of the US, and in domestically focussed equities. In particular, we have been increasing our exposure to Chinese A shares through an active manager, to make the most of the wide dispersions between winners and losers in that market. In terms of regional allocation within fixed income, we think that both US government and Chinese bonds are likely to offer stability as safe havens in each power block, albeit with low yields at this point in time. Ultimately, we are positioning portfolios to capture the best opportunities all over the world, which also mitigates the geopolitical risk rather than try and put all of our eggs in one basket. We are operating in an increasingly regionalised world, and investors face not only increased risk, but also limited opportunity by focussing too heavily on any one economy to power the return of their portfolios.

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