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Co-authored with Philip Mause.
The New Cold War, And Its Economic Consequences
Increased tensions growing out of the war in Ukraine, stress over Chinese claims to Taiwan, and other issues have begun to hint at the likelihood of a new Cold War. One likely “team” would be the U.S. plus its NATO allies, Pacific allies, and other global partners. On the other side would be Russia and the People’s Republic of China (‘PRC’), as well as various states hostile to the U.S. (Iran, Cuba, Venezuela). Because economic sanctions are popular, this is likely to lead to the emergence of trading blocks and possibly even “currency zones” as the “teams” restrict trade with the opposition and focus on trading within the team itself.
Investors should be aware that they have benefitted from a period of “globalization” and “neoliberalism” characterized by less government intervention in markets and reduced restrictions on international transactions involving trade, investment, technology exchange, and labor migration.
The new Cold War could change all of that. This Cold War will likely be different from the last. The PRC is a much more substantial economic player than the USSR was. Neither Russia nor the PRC is really trying to get the entire world to adopt a rigid ideological system like communism. As with the first Cold War, there will be a hesitancy to escalate conflicts because of the presence of nuclear weapons. There will also be a number of “neutral” nations who just want to be left alone but, in some cases, will try to play the two teams off against one another.
In any event, the Cold War – if it emerges – will curtail and possibly end what has been an era of free trade, globalization, openness to foreign investment, and easing of restrictions on travel and immigration. The so-called Age of Globalization will recede, and a new era will begin.
The new Cold War will likely feature national security concerns leading to enhanced export controls, restrictions on the exchange of technology, efforts to avoid dependence on foreign (or non-team) sources for critical supplies, efforts to attract neutrals with promises of trade benefits and preferences, increased defense spending, and constant comparison to determine whether in some way we are “falling behind.” There may also be restrictions on incoming and outgoing investment as well as tighter controls on immigration. The Cold War will also become a “solution in search of a problem” and will be used as an argument for a variety of public policies that already have advocates.
Investors should become aware of this situation, monitor its progress, and understand the likely consequences. There is a considerable amount of uncertainty, but certain broad outlines of this future can be discerned.
Defense Spending
One almost inevitable consequence of a new Cold War will be increased defense spending. Some of this will be directly absorbed by our own military, but there will also be expenditures directed at assistance to allies with the U.S. functioning in its traditional “Arsenal of Democracy” role. This will create some opportunities for the industrial and tech sectors and, of course, major opportunities for defense contractors.
It should be noted that some economists believe that defense spending has a particularly strong tendency to increase inflation. This is because – unlike other spending (for example, on education or infrastructure), it does not have the effect of ultimately increasing domestic production. It is unclear whether this argument has merit in the long term; there are certainly numerous examples of technologies that were developed under defense-related government contracts that had major civilian applications.
Inflation
To the extent that a new Cold War causes a sharp step back from the trend toward globalization, it will almost inevitably be inflationary. Globalization allows businesses to choose the least expensive and most economically efficient means of making a product or providing a service. With the entire world to choose from, a businessman has lots of options and can find cheap sources of materials and labor anywhere on the planet.
A new Cold War will likely (it actually has already) lead to government intervention in the market to restrict globalization. Some economically attractive options will be taken off the table. Businessmen will have to move up the cost curve to find alternatives to what had been the economically optimal solution. We are seeing this already with sanctions against Russia and restrictions on dealings with China. Certainly, the Europeans are paying higher prices for natural gas, petroleum, and, ultimately, electricity than they would if the international market were completely unrestricted.
Businesses may also respond by taking measures that are not mandated but are viewed as prudent. For example, even if the cheapest alternative is to use a single source for manufacturing a key component, prudence may dictate the benefits of using multiple sources even if that policy results in higher costs.
It is possible that the inflationary effect will be a one-time ratchet upward followed by stability. It is also true that resourceful businessmen are likely to find new sources of labor and materials in the large part of the world that will be unaffected (at least initially) by the chill of a new Cold War. However, at least at the outset, there is very likely to be (and probably already has been) an inflationary impact.
Autarky
Autarky is a term used sometimes to describe a nation’s effort to become completely self-sufficient and avoid (in extreme cases) any imports or, more commonly, to avoid dependence on imports for essential or strategic items. There is no way that the United States would be able to or would want to make a drastic move in this direction. However, we are already seeing efforts for us to move certain key industries (e.g., semiconductor manufacturing) “on shore.” We also see frequent media articles referencing our dependence on China for key minerals, components, parts, etc., especially in the area of “green” energy.
It is very likely that we will continue to see public policy – in the form of mandates, tariffs, and subsidies – aim at on-shoring semiconductor production, rare earth mineral production and refining, and other “strategic” industries. This will likely result in higher costs for those items. It will also create investment opportunities for domestic businesses that can produce the critical items subject to government policy. Investors should be aware of the opportunities and risks that this situation will create.
Smaller Markets
It can be seen in a number of markets – but especially in markets characterized by “network economics” – that one (or possibly two or three) major player dominates the market and, in recent years, has been able to turn local dominance into global dominance. In terms of dealing with foreign countries, this phenomenon was often reciprocal – U.S. companies dominated certain markets even in China, and TikTok gained a big market share in the U.S. An entrepreneur seeking to gain a first-mover advantage and then ride the dynamics of network economics could look forward to a potential marketplace of 8 billion people. Those days may be coming to an end.
Some of the market limitations will be due to more stringent export controls. During the Cold War, we had a complex system of export controls restricting exports in support of a variety of public policy objectives. Most important was an effort to prevent U.S. technology from falling into the hands of our opponents. In some cases, exports to neutral countries were restricted to prevent the trans-shipment of the products to the wrong destination. Since export controls are associated with protected technological innovation, the imposition of stricter controls will likely tend to reduce markets for such products.
This may not be as bad as it sounds. Even in a new Cold War, they may continue drinking Coca-Cola in Shanghai. And, in a world in which tech firms lose some market if China is closed off, there is likely to be a surge of activity in India due to U.S. firms moving manufacturing in that direction, thereby generating a stronger economy and a stronger market for the latest tech innovations.
Currency Zones
In a new Cold War, we may see the parties try to develop economic zones of influence and even go so far as to structure currency zones. These would be areas in which the currency of one party to the Cold War would be used exclusively in international trade leading to the interdependence between a neutral country and one of the parties to the Cold War. Thus, if China developed a strong trade relationship with a coffee-producing country and that trade was exclusively in yuan, China might get to the point where it would not need to generate dollars in order to buy coffee.
There might even be a challenge to the dollar’s supremacy in international trade and finance. More loans might be denominated in yuan, leading to a greater demand for that currency. These developments might lead to lower exchange rates (“a decline in the dollar”) which would be inflationary but would also help U.S. businesses that export or compete against imports. It could also make things more complex for the financial sector.
More Government
Many of the changes described above have the net result of more government spending and more government regulation. Spending would be largely in the defense area, but advocates of other spending programs could use the new Cold War as an argument. One of our authors attended college partially supported by a “National Defense Loan.” The Interstate Highway system had a defense rationale. Anxiety about the Soviet Union was used to justify expenditures on scientific research, physical education, and foreign aid. Some of these government programs turned out to be very beneficial and contributed to technological advances. But in the short term, they expanded the government’s share of the economy.
On the regulatory side, export controls would expand and complicate things, especially for tech companies. The desire to have key industries on-shored would lead to a kind of national industrial policy. All of this means greater government involvement in business and higher government spending, which likely means higher taxes.
Investor Implications
First of all, it is not inevitable that we will slide into a new Cold War. And even if we do, it may not last 45 years like the previous one. Both Putin and Xi are now entering their 70s, and in neither case does the country have a systemic bias toward conflict with us the way that traditional Communist regimes tended to. Investors have to watch this development, however. Lots of investors complained when Chairman Bernanke took steps that favored certain investment strategies and undermined others. The answer has always been that policy and politics are part of the background against which investment strategy has to be developed and analyzed.
A new Cold War would generally be negative for investors for some of the reasons noted above. It is not an accident that one of the greatest Bull markets in history developed in the 1990s when the first Cold War came to an end. On the other hand, certain companies would likely benefit, and there were some periods of strong market upturns during the last Cold War.
A recent IMF paper has estimated that what it calls “geo-economics fragmentation” could reduce global GDP by percentages in the low double digits and pose a major risk to investors.
On the other hand, U.S. companies that produce materials or items of strategic significance which are now being imported may benefit substantially from international developments. Investors seeking to minimize risk may want to stick to U.S.-centered businesses like REITs and BDCs, as well as the U.S. healthcare sector (although Pharma relies significantly on exports). Some attractive names are Ares Capital (ARCC) yields 10%, a leading BDC focused on established US companies, and Healthcare Realty Trust Inc. (HR) yields 6.2%, a solid medical office REIT.