In May 2017, Graham Allison released his “Destined for War.” The book, which quickly became an international bestseller, describes what happens when a rising superpower challenges an existing superpower.
Specifically, “Destined for War” considers the question: Can the United States and China avoid the Thucydides trap?
Allison explains that, historically, 12 out of 16 times that we’ve faced a situation like the one we find ourselves in right now, the result has been war. Financial analysts love to reference the point because of its impact. On its face, the statistic implies that the current chance of war is 75%.
In reality, many other factors help to determine whether or not countries fall prey to the Thucydides trap.
In our efforts to understand the current situation between the United States and China, the 16 examples described in the book offer little help. The fundamental similarity between today’s conflict and one of those discussed in Allison’s book is the fact that two nations have enough atomic capabilities to annihilate each other.
It was their respective nuclear arsenals that prevented the United States and the Soviet Union from resorting to actual war during the Cold War, and it’s one of the reasons why war cannot happen today.
The other is that China and United States are so trade-reliant on one another that a military conflict wouldn’t make any sense for either side.
The United States is China’s biggest trading partner, representing 19% of total Chinese exports. China, on the other hand, represents only 8.6% of U.S. exports and is only third on the list of U.S. trading partners. However, China is the market every U.S. corporation wants to access, because of its size and rapid growth.
Given the strength and sway lobbies and corporate forces hold over the U.S. government, I see no scenario in which this trade dispute ends in an actual war. I believe the outcome will be quite the opposite and that the two leaders will reach a new trade agreement before the end of Trump’s presidency.
Emerging Markets Are Bottoming Out
2018 has been a bad year for emerging markets (EM). The adverse effects of the trade dispute with China spread to other EMs, and the Federal Reserve interest rate hikes made things even worse. The hikes led to a rising dollar, meaning rising costs of dollar-denominated debt, a favorite type of debt among emerging economies for the last decade.
However, as I will explain, the sell-off is now over. If you have been on the sidelines waiting for the buy-the-dip opportunity, this is it.
I’ve already described, the U.S.-China trade dispute doesn’t make long-term sense and will be resolved. First steps have already been taken. The United States is refraining from additional tariffs, and China is purchasing larger quantities of U.S. soybeans.
Soybeans, in particular, are essential for Trump. If he wishes to secure re-election, he will need crucial votes from farmers, who are suffering directly from the tariffs.
The second factor behind the launch of the trade war was rising U.S. dollar-denominated debt. These troubles are now over. The Fed is slowing down the rate of interest rate hikes, and the dollar will likely remain at current levels over the coming months. I see no scenario in which it can gain further strength. Additional Fed rate hikes would be viewed as negative for the U.S. economy, and no further rate hikes should keep the dollar stable.
The third reason the emerging market outlook is optimistic is to do with regional trade agreements. These don’t get mentioned enough, but they are the solution to the rise of protectionism among Western economies. The two most important ones are the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP) and the Regional Comprehensive Economic Partnership (RCEP).
The CPTPP, the successor of Trans-Pacific Partnership (TPP), will take effect in less than two weeks. When it does, it will be the third-largest free-trade agreement in the world, representing 13.4% of global GDP.
The RCEP is even more ambitious. Members continue to negotiate the intricacies of the deal, but, when the agreement is signed, the RCEP will be the world’s largest free-trade zone, representing 39% of the global GDP and incorporating nearly half of the worldwide population.
The Smart Money Is Already Moving In This Direction
Of course, I am not the only one to spot this opportunity. The smart money is already on the move. Bain Capital, one of the world’s premier private equity firms, managing more than $100 billion in investment capital, recently closed fundraising for its new Asia-focused fund. This was one of many such private equity launches this year, leading to a record $336 billion in fresh Asia-centric funds, yet to be invested.
That’s more than most countries’ GDPs, roughly equivalent to the GDP of Ireland.
Bain Capital has been successful in timing the bottom before. In 2016, the company launched a similar fund, at the height of Chinese market turbulence, when most investors were looking how to get out of the market, not in. The fund returned a 60.9% IRR in only one year and a half.
I think the same situation is playing out now. The emerging markets have been hit by a barrage of bad news this year, but the momentum is now shifting. The billions in investment funds will begin pouring in these markets, just as they did in 2016.
And here’s the catch. Private equity firms have to announce beforehand which markets they intend to target, literally signaling where you should invest, and giving you a rare opportunity to get in ahead of the curve. I’m watching closely and will be sharing specific buy recommendations in coming days and weeks.