North Korea has recently made enormous progress towards re-integration with the world economy on its own terms, and in particular security guarantees for its incumbent administration. Development of nuclear missile capability in 2017, followed by the willingness to discuss the destruction of this same capability only a year later does indeed highlight that Kim Jong-un may be, in Trump’s words, a very worthy and smart negotiator. Potentially, the prize is as large as a return to the world community of nations. The contrast with the disarray at the meeting of the traditional G7 allies days earlier was striking – and these trade disagreements are the greater risk for markets in our view.
Global markets had anticipated a non-confrontational outcome and were not disappointed. Geopolitical developments in North Korea are also not, in the short-term, especially relevant to global markets, unless there are increasing fears of military action. Intriguingly, Trump was quick to highlight the potentially interesting geographic location which North Korea occupies between South Korea and China – and the real estate development potential on the coast. These are ideas which look rather ahead of their time, for even the most adventurous of investors.
In any case, the document signed by the two leaders appears only to follow the process agreed between North and South Korea in the Panmunjom Declaration in April. What has however been given to North Korea in recent days is an enormous seal of approval from the current US administration together with a commitment to a process to ease US sanctions, while keeping the current regime in place. What the US received in return is less clear. Reportedly, Trump’s stated intention to stop “war games” during the press conference had not been discussed with allies; his claimed savings on US aviation fuel was an argument difficult to rationalise.
In our view, investors should instead be paying greater attention to the steady ratcheting of trade tensions between the US and China, members of NAFTA and the EU, or in effect the rest of the world. Prior to the G7 meeting in Canada expectations were modest but the belated rejection of the final communique by the US was a further disappointment. The release of photographs showing the US President appearing to sit defiantly surrounded by other Western leaders may not be wholly representative of the meeting dynamics, but serves to emphasise the risk that the post-WWII order may now be struggling.
Markets can also struggle to discount political events with potentially large but unquantifiable ramifications, especially where the impact on portfolios may only be over the very long-term. However, a world trading system based around the US and US dollar cannot function if the US wishes to withdraw from it. The “exorbitant privilege” the US enjoys through the use of its currency and financial institutions to facilitate world trade and direct global investment could also be called into question. Already, China and Russia are using energy contracts priced in local currency rather than US dollars. Should the US continue on an isolationist path, the status of the US dollar risks declining, to the benefit of precious metals and other currencies.
Furthermore, the position of the US appears to be at odds with 21st century industries which have fully utilised an open global trading system. US corporations have been a clear beneficiary of world trade, including for example the trillions of US dollar market value created in the US technology sector. This benefit would appear to far exceed any conceivable gain from introducing tariffs on traditional industrial goods or commodities.
Should the US continue to present historic allies with tariffs, the desirability of the continued world dominance of the US technology sector could easily be called into question. The only region which has developed a domestic digital economy ecosystem which has matched the US is China, which at times curbed the activities of foreign digital players, to the benefit of its domestic competitors.
In Europe, there may be no Cadillacs on the streets of Berlin – but there are effectively only Apple iPhones and Google-powered Android smartphones in every pocket. Economically, we suspect Europe would be better off with smartphones rather than low-margin and capital intensive autos. A change in specialisation between the US and the rest of the world is perhaps a thought experiment but if trade barriers are erected which stymie traditional exports it would be natural to expect European governments to at least attempt to promote stronger domestic competitors in future industries.
Defence spending has long been an additional bone of contention between Trump and NATO allies. But the undeniable US military dominance over many decades has been essential to delivering political and economic benefits to the US. These gains to military expenditure naturally accrue only to the dominant power which exercises control and projects influence; it is much more difficult to justify the same level of defence spending for any other player who does not have this offsetting benefit.
However, a breakdown in traditional US/European alliances may engender an increased budget for defence in Europe and be supportive for the domestic defence sector, over the medium-term. Geopolitical risk is in our view increasing as nations such as Russia, China or even North Korea may be eager to exploit the new fissures in traditional Western alliances.
In terms of the recent bout of US tariffs, the use of what appear to be stretched notions of US national security look unusually combative. The current US administration does not therefore look likely to back down in the near term especially as politically, trade wars may be perceived to attract voters in key US districts in the November elections. We therefore expect the rhetoric to endure at least until then, and cannot exclude the possibility of further retaliatory tariffs being applied by all sides together with increased uncertainty impacting business investment.
While current momentum in the US economy is very strong, it is unfortunately becoming evident that from an investment perspective profits momentum is one of the few factors keeping markets buoyant. While initially we were prepared to look through some of the more off-beat rhetoric from President Trump it appears following the G7 meeting he may be motivated to create significant actual disruption among historical allies in order to achieve his domestic political objectives.
Many global equity markets still appear richly valued and monetary policy in the US and Europe is becoming less accommodative. Our base (highest probability) case is that markets are likely to trade sideways at best through a period of rising bond yields, assuming the Fed maintains its current course. The risk of continued trade frictions add weight to our cautious positioning on equities.