Daily Comment (February 12, 2024)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

With China and much of Asia celebrating the Lunar New Year, and with most of the US focused on yesterday’s Super Bowl, it’s a very slow news day, especially for economic and financial news.  Our Comment today is therefore focused heavily on political issues, starting with former President Trump’s controversial comments over the weekend about the US commitment to the North Atlantic Treaty Organization.  We next review several other international and US developments with the potential to affect the financial markets today, including a disputed election in Pakistan and the retirement of a key anti-China member of congress in the US.

United States-NATO-Russia:  At a campaign rally on Saturday, former President Trump said he would “encourage” Russian leaders to do whatever they want to NATO nations that don’t meet the alliance’s target of spending 2% of gross domestic product on defense.  Of course, it’s not clear whether the statement was mere electoral bluster or a harbinger of real policy if he is elected in November.  Nevertheless, the statement is likely to spur even greater doubts in Europe about the US’s commitment to defending NATO territory.

  • Trump’s longstanding focus on the 2% target is likely unsettling to the non-US members of NATO for several reasons.
    • For one, it suggests that a NATO member’s defense budget is the key measure of its contribution to the alliance. In reality, it fails to capture the benefit that the US gets from being able to base its troops throughout Europe, extending the US defensive perimeter some 4,000 miles to the east of US shores.
    • The 2% figure is also somewhat arbitrary. To make its optimal contribution to alliance defense, a country might need to spend more than 2% of GDP, while another could make its optimal contribution with less.
    • Of course, the Europeans could also artificially boost their defense spending by rolling nominally civilian budget programs into the military budget, arguing those programs contribute to defense.
      • Another way they could game their budgeting system and inflate their defense budget would be to give their troops an enormous boost in pay, only to take it back by imposing higher income taxes on service members.
      • On average, personnel costs account for more than half the defense budget of NATO’s non-US allies. Simply boosting troop pay and benefits by 50% could therefore lift a typical country’s defense burden from 1.6% to the target 2.0% of GDP, with no change in troop counts or capability.
    • Even if the Europeans met the 2% target, they likely fear that Trump would raise the ante as there is no reason Trump couldn’t then demand 3% or 4%. The Europeans also probably fear that he would demand outright cash transfers to the US for its “defense services,” not recognizing that Europe’s armed forces, military cooperation, and US basing rights also contribute to US defense.  Trump could try to justify the move as a way to help cover the US budget deficit or fund tax cuts.
  • Many people likely hope or believe that Trump’s threat to withhold US defense support is mere posturing. However, even if it is, the real-life impact has been to undermine our European (and Asian) allies’ trust in the US commitment to them.  If our European and Asian allies increasingly doubt the US will stand shoulder-to-shoulder with them in a crisis, the US could face unsettling unintended consequences going forward.
    • In our latest Bi-Weekly Geopolitical Report, to be published later today, we note that doubts about the US commitment have already begun to spur US allies into hiking their defense budgets and starting to rebuild their armed forces to deter aggression against them. Since nuclear weapons are the gold standard for deterrence, politicians in Europe and Asia are also starting to call for their countries to develop their own, independent nuclear arsenals.
    • In our report, we note that Beijing and Moscow likely relish the idea of the US pulling back its support from its European and Asian allies, but they may get more than they bargained for.
      • If key US allies in Europe or Asia develop their own nukes, China and Russia could find themselves surrounded by close-in nuclear powers.
      • For example, Russia could eventually face a nuclear Poland or nuclear Baltic states. China could face a nuclear Japan, South Korea, or Australia.
    • By the same token, if the US creates too much doubt about its mutual-defense commitments and prompts its allies to create their own nukes, it could face a nuclear Germany or a nuclear Japan, only a century or so after fighting each of them in World War II.
  • In any case, all these developments point to an increasingly chaotic, tension-filled world, which could create headwinds for many investments, but it will also likely create some investment opportunities. Here at Confluence, we continue to focus heavily on managing investments with a keen eye on those risks and opportunities.

Finland:  In national elections yesterday, former Prime Minister Alex Stubb was elected president with 52% of the vote.  In Finland, the president is the commander-in-chief of the armed forces and also takes the lead on foreign policy, so Stubb will be instrumental in determining Finland’s new role as a member of NATO.  Given his past experience heading up Finland’s finance, foreign, and trade ministries, Stubb is believed to have “safe hands” for steering the country’s foreign and security policies into the future.

United States-China:  Representative Mike Gallagher of Wisconsin, a former Marine Corps intelligence officer who is now the China-bashing chair of the House Select Committee on the Chinese Communist Party, said on Saturday that he will retire from Congress at the end of his current term.  The announcement comes just days after Gallagher was one of only four Republican lawmakers to vote against impeaching Homeland Security Secretary Mayorkas for his handling of migration at the southern border.

  • Gallagher’s sudden retirement announcement suggests he may have faced punishment by the Republican Party for his vote against impeaching Mayorkas.
  • In any case, Gallagher has been a persistent, forceful, articulate advocate for the US to push back against China’s aggressive effort to build its power in the military, diplomatic, economic, and technology spheres. Unless Gallagher finds a new position to advocate for stronger anti-China policies, his retirement could take some of the wind out of the sails for China hawks in Congress, potentially easing US-China tensions and giving a boost to Chinese stocks.

Pakistan:  The final results of last week’s elections were released over the weekend, showing former Prime Minister Imran Khan’s party won the most seats in parliament even though Khan has been jailed on apparently trumped-up charges.  The results are being seen as a rare repudiation of the country’s military and its obvious efforts to keep Khan from power and could point to an increasing risk of political strife in the country.

Israel:  Moody’s has cut the country’s sovereign debt rating from A1 to A2, citing the possible fiscal impact of its war against the Hamas government in the Gaza Strip.  Moody’s also cut Israel’s debt rating outlook to negative from stable out of concern that the conflict with Hamas could spread.  Even though the Moody’s rating is still solidly investment grade, the downgrade will likely raise some concern about Israeli stock and bond values.

US Commercial Real Estate Market:  With interest rates high and vacancies making banks reluctant to roll over property-backed loans, investors who have set up funds to buy distressed properties are finally reporting that prices have come down enough for them to snap up buildings.  According to data firm Preqin, global private-equity funds focused on real estate are sitting on $544 billion in cash that could be put to work on distressed properties, potentially helping prevent a crisis as bank lending to the sector dries up.

US Nuclear Energy Market:  According to CEO Boris Schucht of privately held British fuel processor Urenco, a bill in Congress that would ban imports of uranium from Russia will help encourage a secure domestic supply chain for the nuclear fuel used to generate electricity.  According to Schucht, the law would create enough market certainty to spur millions of dollars in new nuclear fuel capacity in the US and the rest of the West.  The statement is consistent with other signs of growing interest in expanding the nuclear generation industry in the US and abroad.

US Military:  Just weeks after sparking controversy by not informing the White House or the public that he was being treated in hospital, Defense Secretary Austin this morning was rushed by his security detail to Walter Reed National Military Medical Center and put in intensive care for an “emergent bladder issue.”

  • Coupled with the previous controversy and his recent treatment for cancer, today’s incident will probably raise new calls for Austin to resign.
  • If Austin does resign, he could be replaced by someone who would push for a faster military buildup and an expanded defense industrial base to counter the rising geopolitical aggressiveness of China.

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