The 2013 Mid-Year Geopolitical Update

(We will take a break for Independence Day; our next report will be published July 15th)

At mid-year, we customarily publish our geopolitical outlook for the second half of the year. This list is not designed to be exhaustive. As is often the case, a myriad of potential problems in the world could become issues in the second half of the year. The lineup listed below details, in our opinion, the issues most likely to have the greatest impact on the world. However, we do recognize the potential for surprises which we will discuss throughout the year in upcoming weekly reports.

Issue #1: The Lame Duck Problem

In our 2013 market outlook, we discussed the problems second term presidents usually face. Scandals often erupt as problems that were festering in the first term become revealed in the second. In the first term, a president usually has his pick of advisors and cabinet secretaries. In the second term, the first group is usually exhausted and replaced with, to put it bluntly, the second team. The quality of advice and guidance tends to diminish. In addition, the president tends to fall victim to hubris. Because he now has experience, he tends to rely less on the counsel of others and thus becomes vulnerable to mistakes. And finally, as the mid-term elections approach, the political class begins to focus on the next presidential election, reducing the influence of the current president.

Historically, this tends to become an issue after Labor Day in the middle of the second term. Most voters only begin to pay attention to upcoming elections after this holiday and so a president typically gets about a year and three quarters before his power begins to wane.

Second term presidents usually counteract these issues by following a number of strategies. Sometimes, they become more bipartisan. President Reagan was able to pass tax reform by working closely with Senator Bill Bradley, a moderate Democrat. President Clinton engaged in triangulation, pitting himself against his own party and against the GOP. He was able to pass the State Children’s Health Insurance program in this manner (of course, he also faced impeachment). Nearly all presidents begin to focus on foreign policy, an area where they have relative freedom to operate. Still, for the most part, second terms tend to be disappointments.

What is becoming a concern for President Obama’s second term is that he seems to be reaching lame duck status in an unexpectedly rapid fashion. A series of scandals, including the administration’s actions in the Benghazi terrorist attack, the IRS’s targeting of conservative groups for intensive scrutiny, the excessive legal intrusion into reporters’ sources and the most recent problems surrounding the documents leaked by Eric Snowden (see WGR, 6/17/2013, “The Snowden Affair”), are clearly acting to distract the administration.

Again, it should not be surprising that the administration is struggling in its second term. What is unexpected is how soon these problems have developed.

Our primary concern is how the lame duck issue affects the president’s ability to conduct foreign policy. The administration appears to be working on three issues: first, two free trade deals, one with Europe and one with Asia; second, managing the relationship with China; and third, resolving the ongoing civil war in Syria.

The Free Trade Deals: Both of these free trade deals are examples of how a superpower uses its economic clout to shape the world. The deal with Europe is more significant for it than for the U.S. If the Eurozone breaks up, the divisions within Europe threaten to make the continent irrelevant, a crushing blow to a region that used to run the world. The free trade proposal would force recalcitrant European governments to reform by increasing the pressure from foreign competition. Germany, who is trying to shape Europe into a larger version of itself, supports the policy. France, trying to protect its culture and economy, is quite worried about the impact of this agreement. In fact, France has already vetoed any deal that doesn’t allow it to protect its film and other cultural industries. There will be massive fights over agriculture as the U.S. produces genetically modified grains (GMO) that many European nations won’t import. Essentially, the U.S., through this trade deal, is trying to open European markets to U.S. goods; if Europe fails to accept this deal, it will be much harder for the region to reform labor and product markets.

The key for the U.S. is to not settle for an agreement that is so replete with exemptions that it does not boost the American economy but supports European strength. The recent intelligence gathering scandals (including allegations that the U.S. bugged EU offices in Washington and at the U.N. in New York) have set European governments on edge. It should be noted that Germany, a supporter of the free trade agreement, is strongly opposed to the sort of intelligence gathering being conducted by the Obama administration.

The Asian free trade agreement visibly excluded China and is designed to change the trade situation to force China to adopt U.S. rules for international trade. If China fails to change in such a manner to join the group, it will be isolated in the region and will be surrounded by nations trading freely with each other and with the U.S. The nations in the group support the agreement as a way to ensure the U.S. remains a counterweight to Chinese influence. Scandal distractions could hamper efforts to seal this deal.

The Relationship with China: In June, the president and General Secretary Xi met for informal meetings in California. Although we were not privy to any of the discussions, media reports suggest the meetings were rather tense. Both leaders realize that constructive relations between the two powers is important; unfortunately, China, citing the historical record, worries that the U.S. will try to quash its rise, which is the usual pattern that develops between an established and a rising power. If President Obama’s influence is waning, Xi may find himself without an effective negotiating partner, or worse, view the weakness as a window of opportunity to project power regionally.

The Syrian Situation: The Obama administration is clearly at a loss on how to deal with Syria. On the one hand, the goal of removing Assad and weakening the relationship between Iran and Syria would be a significant gain. However, it would be an unacceptable cost if such an outcome occurs by creating a Jihadist state in a critical region of the world. Sometimes presidents, facing declining power, will engage in foreign adventures (e.g., President H.W. Bush and Somalia). Obama is obviously reluctant to engage in Syria militarily. However, as his influence wanes, he may be tempted to take such steps to appear “presidential.”

Overall, geopolitical risks arise when a president reaches lame duck status. These risks can run from the need for a president to prove to the world he still matters or when other leaders no longer take him seriously and use the weakness to cause problems. The recent travesty of Eric Snowden’s flight is an example of this situation. The fact that we seem to be reaching the lame duck condition sooner than expected is probably complicating matters.

Issue #2: Youth Unrest

Around the world, there seem to be conditions of rising protests from the young. The Arab Spring, the Occupy Movement, the Tent Movement in Israel and the Indignation Movement in Europe have been joined by massive youth protests in Brazil. The anger being expressed is widespread and diffuse. In Europe, it is tied to austerity programs. The U.S. Occupy Movement is against the finance industry, student debt and inequality. Similar themes emerge from the Israeli protests. The Arab Spring opposes the authoritarian regimes in the Middle East.

Common to all these movements is a distrust of authority and ideology. This generation has familiarity with the fall of Communism and, unlike protestors of an earlier generation, does not appear enamored by socialist ideologies. If anything, these groups seem to lean libertarian; they are socially liberal, supporting drug legalization and opposing racial, gender and sexual discrimination. At the same time, they seem to support free markets but only if these markets are not dominated by large institutions. They are also technologically savvy, supporting privacy laws; they also tend to take a dim view of intellectual property, believing that everything on the internet should be free. They are only peripherally attached to any political party. None of these movements have created a clear political agenda.

Throughout history, there have been similar movements; they tend to fall under the heading of anarchists. Unfortunately, anarchist movements have often turned violent. Frustrated by the lack of progress toward their goals (mostly due to their opposition to the political process), anarchists sometimes turn to the “propaganda of the deed,” which are seemingly senseless acts of violence against representatives of authority. So far, these movements have not been particularly violent. However, violence is a growing risk and one that is quite difficult for security forces to counteract. Perhaps the best antidote to this problem is global growth, but that outcome is unlikely in the current economic situation.

Issue #3: Europe

Since last summer, when ECB President Mario Draghi unveiled a program of virtually unlimited QE if a Eurozone country faces a crisis, Europe has been relatively quiet. In fact, Cyprus suffered a major banking system collapse without any serious contagion. The program of Outright Monetary Transitions (OMT) may be one of the most successful ever in that it has calmed financial markets without spending one euro…at least, so far.

However, the underlying problems that have caused Europe’s turmoil since 2010 have not been resolved. There is no plan to boost economic growth in the southern nations. Lending markets in southern Europe are generally ineffective; a company in southern Europe will pay much higher borrowing costs than a company in northern Europe even with equivalent credit risks. There is no pooling of sovereign debt. European banks remain vulnerable to sovereign debt problems.

Overall, we expect the Eurozone to remain a chronic problem. Essentially, the EU project was designed to use economics to solve a political problem. Namely, to prevent another world war in Europe, the nations of the continent will tie their economies closely together. The single currency, without closer union, has probably been a bridge too far.

At some point, Germany will either need to act as a regional hegemon or the Eurozone will likely break apart. Given the historical record of German dominance there is clear reluctance on the part of Germany and other nations to such action. However, it appears unlikely that any other solution will work. Until this situation is resolved, Europe will remain a risk.

Issue #4: The Problem of China

China has reached a critical juncture in its development. The economic model of development it has deployed, a focus on exports and investment funded through financial repression and an undervalued currency, has likely reached the limits of usefulness. For the past decade, Chinese leaders have been paying lip service to changing the model but, so far, only modest steps have been taken which have usually been abandoned at the first sign of slowing growth.

It appears that General Secretary Xi has decided the time has come to address this issue. We are seeing some removal of financial repression as interest rates rise and the exchange rate appreciates. The government is attempting to spur growth through massive urbanization which will require the creation of low cost housing. There is a growing crackdown on corruption. The government appears to be forcing banks to deal with bad loans.

If this shift is made, growth must slow. If the remaining growth is captured by households, the Chinese Communist Party (CPC) will likely survive with its legitimacy intact. However, this policy means that the benefit of growth will flow “to the people” and not to party cadres. In a democracy, that would be popular. It is hard to see how that policy will fly with CPC underlings.

Thus, the risks of internal unrest in China are rising. Communism as an ideology is discredited; the CPC has maintained legitimacy by delivering growth. Recently, General Secretary Xi gave a speech calling for CPC discipline and a return to basic socialist ideology. It sounded remarkably like a speech Chairman Mao would have delivered. Perhaps Xi is trying to change the CPC into a party of uncorrupt Mandarins that will rule a happy and well-funded populace with efficiency and fairness. That plan, however, is fraught with risk.


These are the issues that we believe will dominate the headlines over the next six months. From an investing perspective, these concerns increase the odds of “tail events,” which are low probability, high risk situations that may adversely affect markets. Overall, whenever uncertainty increases, it tends to lift volatility. Rising volatility may be the most likely outcome into December.

Bill O’Grady

July 1, 2013

This report was prepared by Bill O’Grady of Confluence Investment Management LLC and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

© Confluence Investment Management

© Confluence Investment Management

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