Background
At the end of WWII, the United States, and impacted nations the world over, came together to revivify some semblance of cohesive international dialogue. Under the auspices of the United Nations, states negotiated frameworks for future trade, diplomacy, and economic engagement. From the latter, Bretton Woods was born, pegging the U.S. dollar to gold, and all other member states’ currencies were, in turn, pegged to the dollar. Fast forward to 1971, Nixon suspends the dollar’s convertibility to gold, and the Fed guarantees price stability as an anchor – making it the preferred currency peg for nearly all nations in a U.S.-led unipolar global order. This transition to a gold-free dollar became known as Bretton Woods II.
Jump to 2022, and the world has exited a global pandemic with near record-setting inflation, an ongoing war in Europe, and the end of the longest bull market in history dovetailed with record wealth destruction. In this scene, the stage for Bretton Woods III is set. This third iteration title coined by Credit Suisse’s Zoltan Pozsar, envisions a fracturing of the [1] “globalized system for trading commodities…result[ing] in greater monetary diversity, with different trade routes denominated differently” thus leading to “military spending around the world…increase[ing] [and] instead of the central banks guaranteeing that your money in the bank is actually good, it’s the world’s militaries guaranteeing that your cargo on the ship will actually get to its destination as advertised”. In this new framework we are “going to go back to commodity-backed money — where gold, once again, is going to play a big role. And not just gold, but I think all forms of commodities.” Certainly not a sanguine outlook, and one that essentially describes the end of globalization as we know it today, or rather, as we knew it pre-pandemic and Ukraine war.
Analysis
Pozsars’ more compelling point begs the question, does volatility of commodities price and acquisition translate to a fracturing of the global trade system both monetarily and militarily? Monetarily we posit no, but risks here are growing. The dollar’s status as a global reserve currency has had no shortage of detractors and doomsayers. Calls proclaiming the end of dollar dominance are again resurfacing as the currency experiences historical strength, some dusting off the term ‘doom loop’. While inflation running at 40-year highs gives central banks in the West little room to maneuver, the actual risk of global monetary fracturing rests with large commodity-producing, non-democratic countries (colloquially, petro-dictators). The effectiveness of Western sanctions has given these countries pause (whose currencies are also pegged to the dollar), worried the same could be done to them should they run afoul of Washington. Granted, these fears should be allayed less they plan to invade and annex portions of a sovereign neighbor; nonetheless, fear often translates to action. In this vein, Saudi Arabia makes an excellent example. After the OPEC+ decision to cut oil production by 2 million b/d, calls were made by a handful of U.S. lawmakers to withdraw troops from both Saudi Arabia and the UAE. While these calls likely won’t (and shouldn’t) materialize, they point to a seemingly historic trough in U.S.-Saudi relations. Accompanying this dramatic rift is the report in March that the Saudis were in talks to accept yuan instead of dollars for oil sold to China. While these risks combined represent compelling challenges for the relationship, we believe, ultimately, neither the Saudis nor Washington can completely walk away.
Christopher McNally, professor of Political Economy at Chaminade University, writes, [2] “First and foremost, the Saudi riyal is pegged to the U.S. dollar, meaning that any effective currency diversification would ultimately necessitate breaking this peg.” While countries similarly positioned to Saudi Arabia may have similar gripes with Washington, the dollar peg remains an economic and socially stabilizing force. This is a precious tool in and of itself for petro-dictatorships. To abandon the dollar peg would be to shoot themselves figuratively and literally in the foot as the Saudis “experienced more than 400 [drone and missile attacks] last year - from the Houthi rebels in Yemen”, as well as sustained military pressure from neighboring Iran. This is all before discussing the extensive military hardware and security logistics supplied by the relationship with the U.S.
Continuing that thread, we examine the second half of the question. Does commodity volatility impact global military divergence and spending? While U.S. calls for increased military spending among NATO members have grown louder over the years, 2022 is the year we are seeing this [3] materially come into effect. Outside of the 30 (soon to be 32) country alliance, China, Russia, India, Saudi Arabia, Japan, and S. Korea comprise the latter half of the [4] top ten largest military spenders as of 2021. However, while global military spending is on the rise, has this been the cause of commodity volatility, and will it be in the future? In part, we believe yes. Driven by unclaimed attacks on the Nord Stream pipelines, a Polish pipeline leak, and Putin’s ominous comment that the attacks show that [5] “any critically important object of transport, energy or utilities infrastructure is under threat irrespective of where it is located or by whom it is managed” European countries have a strong incentive to protect domestic and internationally shared trade routes with force. Of course, on the other side of this global increase is military deterrence geared toward Russia. This same reasoning can be applied to Southeast Asian countries facing similar threats from an ever-enlarging and capable Chinese navy threatening open trade in the Pacific.
These increases in military spending, however, do not mean disunity, or rather to quote Psozar, “it’s the world’s militaries guaranteeing that your cargo on the ship will actually get to its destination as advertised.” While we see signals that the U.S. is increasingly relying on military alliances for select regional assistance, we disagree with the insinuation that the U.S. won’t continue to play a defining role in coordination and leadership. As we’ve observed, military spending is increasing, but importantly spending does not translate to capability. In Europe, the U.S.-led NATO has proven to be effective in containing Russian military ambition outside of its immediate sphere of influence (a sphere that’s rapidly shrinking). Some point to the Russian invasion of Ukraine as a distinct failure of NATO, but following Putin’s [6] actions rather than his rhetoric, we can see a stark hesitancy in moving the fight anywhere close to alliance borders (rouge unclaimed pipeline disruptions withstanding).
Pivoting to the Pacific, where nearly half of global trade takes place. Military spending is also increasing in Asia (see above); however, few countries retain the blue water naval technology, training, and capital requirements to disrupt or protect trade at a global scale, save the U.S. and China (mainly disrupt in the latter’s case). To that end, the U.S. seems to recognize the potential that its role as a pre-eminent naval power in the region will at least be contested and, at most, be lost to China in the next decade or two. This is reflected in the [7] sharing of advanced naval technologies with staunch allies like Australia and an overall strategy of coordination with security partners globally. Indeed, the bargain made post-WWII is still intact. That is, the U.S. will provide global trade route security, so nations (small and large) can focus on economic development. This remains true today, with the U.S. still providing the role of security guarantor and regional allies playing support roles.
Conclusion
The volatility of essential commodities is but one in a seemingly growing list of challenges facing the U.S. While the current shock in commodities prices and availability is prone to disrupt global industry, hunger, and trade, we see ample safeguards protecting the unipolarity of security and currency, under the aegis of U.S. leadership. Globalization as a concept has changed on the periphery, and veneer will continue to evolve as geopolitical sea changes shake global institutions supporting interconnectedness at its core; however, anticipate the status quo to remain largely the same. This will be denoted by continued U.S. military leadership and activity in Europe and the Pacific, flare-ups in the Mideast, and a de-emphasis on Africa and South America. Monetarily, anticipate the U.S. to defend dollar dominance fervently should challenges arise, though this scenario is improbable. Any material challenges rest in key commodity trades, namely energy and the continued fate of U.S. – Saudi relations.
Themes
- Fertilizer & Agriculture
- Defense
- Semiconductors
Global events and geopolitical risk will continue to play outsized roles in markets and individual companies as the severity and volume of materially disruptive occurrences increase. As we consider investing impacts from a shifting risk environment, we believe the best way to capitalize should be centered on geopolitical events. As such, continued disruption to much of the world’s fertilizer production makes names in stable countries attractive. Even in a scenario that includes a near-term close to the war in Ukraine, food instability is likely to play to the long-term importance of agricultural development (potash in particular).
As Western arsenals deplete from the mass moving of hardware to eastern Europe, expect traditional U.S. defense names to benefit from restocking orders to provide U.S. and Western European NATO members with the latest equipment – a process that will be years in the making. This space is doubly relevant with potential conflict in the Taiwan strait to heat up in the coming 5-10 years.
Along the defense supply chain are semiconductors, critical components to all aspects of life, modern military hardware included. The sector took a hit post-Biden administration announcement of export restrictions that applies to any chips made with U.S. technology. We believe this initial weakness makes names in the space attractive from a long-term perspective. As Western semi names (TSMC included) take earnings hits from initial loss in sales to China, we believe continued global demand and short supply over the long run will support elevated prices. Additionally, China’s efforts to build a homegrown semiconductor industry, whether fruitful or not, no longer matters as the effects of U.S. export restrictions brought forward the impact of these sales losses.
Sources:
[1] https://www.bloomberg.com/news/articles/2022-04-07/zoltan-pozsar-sees-a-world-of-problems-that-money-can-t-solve
[2] https://www.chinausfocus.com/finance-economy/saudi-arabias-oil-exports-and-the-yuan
[3] https://commonslibrary.parliament.uk/defence-spending-pledges-by-nato-members-since-russia-invaded-ukraine/
[4] https://www.visualcapitalist.com/ranked-top-10-countries-by-military-spending/
[5] https://www.bloomberg.com/news/articles/2022-10-12/putin-says-any-infrastructure-at-risk-after-nord-stream-attacks
[6] https://www.nytimes.com/2022/03/28/us/politics/russia-ukraine-nato-weapons.html
[7] https://news.usni.org/2022/09/16/fast-track-aussie-nuclear-submarine-development-says-mp-on-aukus-anniversary
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