The 99 states of America, how NATO is set to become a de facto $ zone. Investors need to think accordingly

After a New Year bounce in markets, we began to notice that asset allocators were buying ‘tail risk’ insurance ahead of the March options expiry and saw the reason for this as geo-politics and in particular the one year anniversary of the war in Ukraine. We have studiously avoided trying to comment on the prospects for the war on the basis that the one thing we know is that we do not know what is happening; the fog of war is dense on both sides. However, there are a number of longer-term issues that have already arisen from these events that we see as continuing, regardless of the actual outcome of the war, and while investors wait for greater clarity on earnings and interest rate policy, it is perhaps worth thinking through a few of these.

First and most important is that we now have a de-facto multi-polar world. The freezing of Russia’s US$ assets by ‘the west’ has effectively forced ‘the rest’ to accelerate a programme of de-dollarisation. Holding $s in the western banking system now makes you subject to US Foreign Policy as well as US Monetary Policy. Initially that means reducing $ usage, trading between themselves in currencies other than the US$ and that has started most obviously in China paying for energy and other commodities in Yuan. The announcement at Davos by the Saudi finance minister that they would accept payment for oil in other currencies effectively announced the death of the Petro $ and the birth of the Petro Yuan. Given that much of our current financial market system essentially emerged from the birth of the Petro $ when the US came off gold in 1971, that alone should give us pause for thought. Another important consequence of this, one that is not attracting enough attention in our opinion, is that China no longer needs to sell large volumes of low margin goods to the US in order to earn $s with which to purchase energy. It can instead focus its economic resources on its own domestic consumption, while the west will have to deal with the removal of a dis-inflation impulse. Meanwhile, having moved further up the value added chain, the industrial strength of China will see them exporting more higher value goods like autos.

The, Ukraine related, sanctions have of course accelerated this process, but they have also had another (perhaps intended) effect, which has been to shift European energy dependency away from Russia and onto the US and in doing so take away the historic cheap energy advantage enjoyed by Germany in particular. Meanwhile, the zero carbon agenda has combined with the sanctions to leave much of Europe facing a considerable cost of living crisis.

Which brings us to our key point and which is where Australia fits into all this. In our view, the most likely outcome of the war in Ukraine is that the world splits into a NATO + Japan/Korea $ zone, containing around 1bn people and with a collective GDP of around $50trn and a non $ zone containing the other 7bn people with an almost equivalent level of GDP, but where all the growth is. Thanks to Zero Interest rates, US private equity is now sitting on $3 trillion of dry powder that will be used within the $ zone to take ownership of the best businesses and thanks to Zero Covid supply chains to outside the $ zone have already been disrupted, allowing for new $ zone chains to be built. Finally, thanks to zero carbon, the US consumer and producer continue to enjoy the cheapest energy within the $ zone and thus will be the biggest beneficiaries of re-shoring and re-industrialisation.

Continued belligerence, not just against Russia with its cheap commodities, but also against China with its industrial competition, will almost certainly be used to establish a new form of Mercantilism, albeit with ‘free trade’ within the $ zone. Sanctions will act as a common tariff barrier, while ‘Global initiatives’ on tax and regulation will result in a largely common policy framework. This would of course be similar to the policies used by 19th century America, although would now extend to 99 states, not 50. The rules of course would all be made by the ‘multi national bodies’ like the UN, the WHO and the BIS, but where of course it is the US FDA, the Fed, the SEC and the US State department that actually direct policy. In effect it would be like a reverse takeover of the EU by the US, with Australia, NZ, Japan and Korea added in. As the other NATO members pick up half of the $800bn Pentagon budget to establish the hard borders of the $ zone, (the AUKUS deal on submarines being an obvious example) the US can continue with subsidy programmes like the risibly named Inflation reduction act, which effectively subsidises reshoring to the US in the name of Building (the US) Back Better.

Investors need to think how companies, sectors and even countries will now fare within this new $ zone. The best will like be taken into foreign (US) ownership, while the less able will find themselves deprived of resources or subject to unfair competition. Industrial policy will favour those with cheapest energy and best access to capital, which means the US most likely. Emerging Markets will now be the non $ zone and, assuming that the ESG world allows investment there (not an idle threat), investors in the $ zone will have to deal with a new level of home country bias. Interesting times are ahead.