How the theme of ‘great power competition’ could shape the macroeconomic backdrop in 2023 and beyond.
- The impact on global markets of Russia’s invasion of Ukraine has been felt most manifestly in the form of even higher inflationary pressures (which were already elevated after Covid supply-chain and labor-market disruptions).
- We expect to see a continuation of significant supply-chain realignments which are now showing up in the foreign direct-investment data for certain countries in the Asia Pacific region and North America.
- We anticipate that China will pursue a more intense form of state-led economic development in the years to come and we believe the risks of (further) policy missteps are consequently higher.
- As industrial economies increasingly turn to renewables and new-energy substitutes in the years ahead, competitive advantage is likely to be greatly defined by who has access to key material inputs including battery materials, composites, rare earths and precious metals.
- While the US dollar will continue to benefit from its safe-haven status at certain points of heightened volatility in 2023, we expect to see non-democratic alliance countries increasingly seeking to diversify away from the dollar.
- We believe it is likely that post Covid, China will double down on its efforts towards manufacturing its own effective semiconductors and make convergence with the West a national effort.
- The decade ahead could see a substantial increase in defense spending by democratic countries, with global defense spending expected to double by 2030.
- In our view, global defense stocks should remain an attractive place to invest. Furthermore, many companies involved in defense and space technology may also prosper.
Last year will be remembered as one of the most geopolitically significant years in a generation – a year in which a major power staged a land invasion, occupation and annexation of another European country for the first time since World War Two. Most political analysts did not believe such an event could happen and that peace in our time would prevail. The ensuing fallout has been profound for markets given the disruption to commodity supply chains and the political repercussions for Russia, which has been disconnected from the Western economic system. The impact on global markets has been felt most manifestly in the form of even higher inflationary pressures (which were already elevated after Covid supply-chain and labor-market disruptions, coupled with two years of excessive monetary and fiscal stimulus by Western governments).
Central banks and governments in most developing economies, by contrast, had demonstrated far more conservatism and moderation. If inflation was to be the economic fallout from the Ukraine war, one of the principal political fallouts emerged in the shape of China’s reluctance to condemn Russia for its actions. In fact, with Russia’s invasion coming merely four days after the Beijing Winter Olympics ended, it appeared to most observers that President Xi had explicitly endorsed Russia’s actions. Although the relationship of the two powers is undoubtedly closer following the event, China’s response has been one of caution and trepidation about providing explicit support to Russia for fear of inviting secondary sanctions.
Autocrats versus Democrats
Russia’s belligerence towards Ukraine made it considerably easier for President Biden’s US administration to push its global liberal and human-rights agenda, deepening several alliance relationships in 2022. The North Atlantic Treaty Organization (NATO) accepted Finland and Sweden as new pending members. In the Indo-Pacific, security relationships strengthened further with the Quadrilateral Dialogue countries holding their first heads-of-state meeting in Tokyo in May. These developments, coupled with the financial and economic sanctions placed on Russia, led to a sense of deep unease by the so-called autocratic sphere. It remains too early to declare a new global schism along democratic-autocratic lines as between communism and democracy during the Cold War, but 2022 has certainly laid the foundations for continuing ideological drift.
Erstwhile US House Speaker Nancy Pelosi’s visit to Taiwan in August was a major political statement and test of China’s resolve. The US maintains that ‘strategic ambiguity’ is its official policy towards Taiwan and continues to officially uphold the One China Policy. Pelosi’s visit and other comments by the White House in support of Taiwan’s security put into question both notions. We think geopolitical attention will remain strongly centered on Taiwan in the years to come because it sits directly at the nexus of national interest for the two great powers, China and the US. The likelihood of China attacking or blockading Taiwan has increased owing to events this year, but in our view remains a relatively low-anchored probability. In 2023 and beyond, the outcome is most likely to hinge on the extent to which Washington and the Taipei government are prepared to test and stretch the limits of China’s red line, including continuing military assistance, formalized trade agreements and the push for independence.
China experienced a very different 2022 from that which many anticipated, owing to its strict adherence to a zero-Covid policy and the enormous headwinds emanating from its real-estate sector. China’s 20th Party Congress, which took place in October, was the most important political event of its calendar, and the outcome was even more extreme in terms of President Xi’s consolidation of power than most experts had forecast. In our view, it means that China is likely to pursue a more intense form of state-led economic development in the years to come, and we believe the risks of (further) policy missteps are consequently higher.
Last year was characterized by continuing trade conflict and the first signs of significant supply-chain realignments which are now showing up in the foreign direct-investment data for certain countries in the Asia Pacific region and North America. Financial markets have anticipated such realignment since the US administration first targeted Chinese trade in 2018 with c.US$300bn worth of tariffs, but the Covid pandemic provided an interlude, and China turned out to be a major beneficiary of the pandemic disruptions. Under the Biden administration, US trade measures taken against China are evolving and no longer merely take the form of arbitrary tariffs applied by the Commerce and Treasury Departments. Above and beyond this, the US Congress is now actively legislating and discriminating against Chinese trade with new laws such as the Uyghur Forced Labor Protection Act, the CHIPS and Sciences Act and the Inflation Reduction Act (IRA). These new laws restrict market access and channel significant amounts of subsidies towards US-based companies at the expense of Chinese (and in some cases European) manufacturing.
With no clear change in the course of US-China relations, an increasing number of Western companies are beginning to accelerate their ‘China+1’ supply-chain strategies. Vietnam, India, Indonesia and, to a lesser degree, Mexico all saw an acceleration in foreign direct investment during 2022. We expect these countries will continue to benefit disproportionately from the unfolding supply-chain realignments. US onshoring of high-end manufacturing could also be a major theme to watch in 2023, and with the extreme tightness of the US labor market that we have seen in recent years, we think high levels of industrial automation are likely to be an important accompanying investment theme.
The ‘other’ and more rapidly developing trade war that few had anticipated at the start of 2022 of course played out between Russia and the European Union (EU), principally in energy and commodities. After Germany terminated the Nord Stream 2 gas project in response to Russia’s Ukraine invasion, Russia slowed and then fully cut off supplies of natural gas through the Nord Stream 1 pipeline, leaving Europe scrambling to find alternative energy substitutes, with Germany raising its energy supply alert to level 2, encouraging voluntary demand curtailments from industry and households.
The outlook for global oil supplies also remains uncertain, as EU sanctions on Russian seaborne oil exports came into force in early December with a US$60 per barrel purchase price cap for exemption, which Russian President Vladimir Putin has declared will not be honored. With this latest measure there is a risk of exacerbating a twin energy crisis. While energy prices are likely to remain heavily volatile, driven by demand and seasonal factors, we believe it is geopolitics and the ‘weaponization’ of both supply and demand that will keep energy prices elevated in the years to come.
Resource competition goes well beyond energy, however. As industrial economies increasingly turn to renewables and new-energy substitutes in the years ahead, competitive advantage is likely to be greatly defined by who has access to key material inputs including battery materials, composites, rare earths and precious metals. China has around a decade’s head start in securing these supplies across Latin America, Africa and the Asia-Pacific region. Given the scramble for critical resources to feed the latest green industrial revolution that we expect to play out over the next few years, it was noteworthy that Canada recently terminated three lithium licenses held by a Chinese company. More intense resource competition in the years to come is likely to mean that democratic countries will seek to protect their assets for their own companies. Meanwhile, increasing levels of material processing (to date largely the preserve of China) will need to be built out within developed countries.
Tech War: How Will China Respond?
Technology has emerged as the principal domain through which the US seeks to contain China’s economic and military ascendency, with semiconductors the key enabler of tech. In 2022, the Biden administration tightened semiconductor restrictions on China, effectively preventing any US company, or any third country that uses US technology, from supplying semiconductors to China that have a speed of less than 14 nanometers. This blanket restriction is a significant escalation from the targeted restrictions that were previously in place on specific Chinese companies. To continue to promote the US’s own semiconductor industry, the administration has established a ‘CHIPS 4’ alliance comprising the US, Japan, Taiwan and South Korea. Although this has not been formalized, it is expected that these countries will now cooperate more closely on high-end semiconductor developments. To enhance the US’s own semiconductor national security, the passage of the aforementioned CHIPS and Sciences Act provides US$52bn of subsidy support to companies prepared to make investments in the US.
Can China Close the Semiconductor ‘Gap’?
The big question now is how China responds in 2023 and beyond, and whether its tech fate has been sealed. It should be emphasized that the vast majority of consumer and industrial applications can operate on semiconductors with 14+ nanometer speeds, which China will still have international access to. However, the country will need to develop its own capability to produce more advanced semiconductors. China’s semiconductor gap to the West may look unassailable but China is assembling huge domestic resources, including subsidies and a c.US$50bn public-private investment fund, along with scientific institutes and universities, to develop its own semiconductor industry. We think it is likely that post Covid, China will double down on its efforts toward manufacturing its own effective semiconductors and make convergence with the West a national effort. We believe that it remains too early to write off China’s domestic semiconductor industry, and that investors that do so may miss out on valuable opportunities.
Despite the US dollar’s long-term broad international dominance and hegemonic currency status, Russia’s invasion of Ukraine truly underlined the degree of geopolitical leverage the status of the dollar and corresponding control of the international financial system gives to the US. The US government was able to freeze approximately half of Russia’s foreign exchange reserves (c.US$300bn) that it held outside the country, while access to the SWIFT international payment system was suspended for most of Russia’s banks. Russia was even prevented from making periodic coupon payments on its international sovereign debt, which led to a technical hard-currency debt default. Many observers may consider the above events a routine economic response to an act of military aggression. For many autocratic regimes around the world that are heavily dependent on dollar payments and assets, however, geopolitical leverage of the dollar and Western financial system is a sharp wakeup call. The geopolitical implications in the years to come are likely to be profound.
In our view, investors should not confuse the cyclical with the structural, and the dollar is likely to enjoy periods of safe-haven support in 2023 during periods of heightened geopolitical volatility. In the medium term, however, we think there is little question that non-democratic alliance countries, which fear falling foul of Washington, will seek to diversify away from the dollar. Data from central banks and the World Gold Council highlights the significant extent to which such regimes have already been increasing their holdings of physical gold in recent years, and many continue to add to gold reserves.
China has reduced its exposure to US Treasury bonds since 2015 by around 30%. Initial efforts were undertaken this year by some commodity exporters to price a portion of their oil sales in the local currencies of their customers, including Saudi Arabia selling in Chinese renminbi and Russia selling in Indian rupees. While this process remains nascent and the dollar remains the dominant pricing mechanism for most trade, the trends are becoming clearer. One thing that we believe macro investors should watch for in 2023 and the years beyond is the effective rollout of central-bank digital currencies (CBDCs) by some of the larger countries, which would allow for instantaneous (and dollar-bypassing) trade clearing.
Historians will look back on 2022 as the year that triggered regime change for military posture and consequently for defense spending. Most policymakers entered the year working under ‘liberal peace theory’ assumptions that had prevailed for the last 30 years. Few, if any, will have ended the year attached to the same assumptions: trade and investment interlinkages with a geopolitical competitor are no longer a guarantee of peace. Similarly, outsourcing defense and national security entirely to the US is no longer an option that can be fully relied upon.
The democratic alliance is likely to continue to forge ever closer relationships around security. We anticipate that recently formed alliances such as the Quadrilateral Dialogue and AUKUS will continue to blossom, while Sweden and Finland’s application to join NATO is a further example of enhanced defense cooperation catalyzed by drastic circumstances. However, we believe the major consequence of the events of 2022 is that the decade ahead should see a substantial increase in defense spending by democratic countries, with global defense spending very likely to double by 2030, outgrowing global GDP growth by a factor of two or three times. Immediately after Russia’s Ukraine invasion, the German government set up a one-off special defense fund of €100bn and pledged to increase annual defense spending to the level of 2% GDP (in line with the NATO target) from around 1.4% in 2020. Other European countries such as Italy that continue to lag this threshold are also set to raise spending.
At the other end of Eurasia, Japan has been unsettled this year by events around Taiwan and continued saber rattling by North Korea. At the very end of 2022, this resulted in Japan’s government pledging a doubling of defence spending to 2% of GDP by 2027 and attaining a pre-emptive strike capability for the first time in its post-war history. For investors in 2023 and beyond, we believe this means that global defense stocks could remain an attractive place to invest. Furthermore, as a large portion of the incremental spending will be directed to areas of defense technology and space, many companies involved in these areas may prosper.
It is no exaggeration to proclaim that 2022 has been a year of seismic geopolitical disruption which is likely to be felt by investment markets for multiple years. While events themselves are usually impossible to predict, the good news is that having a robust thematic research framework in place can help investors to be more systematic about capturing opportunities and avoiding risks that arise from their fallout. In deciding how to allocate capital to navigate the geopolitical environment in 2023, we believe the following non-consensus views could have value:
- Play defense in macro and micro: Geopolitical and macro caution could generally prevail in 2023.Despite a weak start to 2023, the US dollar could see renewed support as a safe-haven currency at certain points in 2023. Great powers may remain skittish and nervous of their adversaries. Security dilemmas are likely to persist, and thus defense spending could grow strongly, and the defence sector should remain attractive for investors.
- China bouncing back: China has been on the back foot dealing with real-estate and zero-Covid lockdown challenges in 2022. In 2023, particularly during the second half of the year, the government should have more capacity to turn its attention to domestic technology development to counter challenges from US restrictions. It may become increasingly possible for investors to identify who the domestic champions are set to be.
- Global supply-chain realignment: Big government may grow bigger and broader in scope. Nowhere is this likely to apply more than Europe, which needs to respond to both energy crises and state-subsidy competitiveness challenges laid down by the US. We anticipate measures by the EU to boost the support of local manufacturing, electric vehicles and renewables possibly around mid-2023. Provided EU inflation is on a normalising path, we believe that European equities should perform strongly at this point.
 US, Japan, India, Australia
 A trilateral security pact between Australia, the UK and the US.
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