Shock, Part 3 (The End of Pax Americana)

We are all trying to make sense of the election of Donald J. Trump to the presidency, and a few weeks ago I outlined the possible economic agenda and its consequences the administration may pursue (http://blog.angelesadvisors.com/2016/11/shock-part-1/). In the month since the election, US stocks have risen more than 5%, and bonds have turned one of their worst months on record, as 10-year Treasury yields soared 60 basis points to almost 2 ½%. The markets’ message is that tax cuts, deregulation and large government spending on defense and infrastructure will boost economic growth with only moderately higher inflation. Apparently, trade wars and mass deportations are not on the agenda. So, celebration.

In the last post, I did caution that economic prosperity is sustained only through gains in productivity, and discussed the structural challenges investors will face (http://blog.angelesadvisors.com/2016/11/shock-part-2-the-asset-allocators-dilemma/), irrespective of the economic policies of a Trump presidency.

Our principal focus has always been on economic policies, and their implications for investors. At this very premature moment, Trump economic plans appear to have potentially widely divergent consequences, so any investment conclusions drawn would range from tentative to foolish. Some of the policies discussed in the campaign are immoderate, with severe implications for investors. And the very wide range of possible policies, and their consequences, in addition to inflammatory and contradictory rhetoric, create much heightened uncertainty and potential volatility. It is therefore especially important to pay close attention to the actual policies that the Trump administration will pursue.

The Trump administration may turn out to pursue a moderate, pro-growth agenda of lower taxes and regulatory burdens, and a less intrusive government in the economy: a modest, comfortable swing back to the center after eight years of a Democratic administration. But the election of Donald Trump as President of the United States “feels” like it could be something much different, a pivotal moment in history marking the end of one era and the transition to a new. If so, we will see the consequences in the economy and in the markets. But the most profound impacts may be beyond the economic data, in the realms of politics and society. And so, while these are not areas in which I have any special insights, the possibility that the Trump election marks a profound shift in both the global order and our society demands our attention. I’ll start with the global order.

The narrative for me begins just over a hundred years ago, when Pax Britannica reigned across the globe. In the century following the Treaty of Paris (1815), Britain secured the sea lanes, maintained a balance of power (in her favor), and provided the world with capital and its reserve currency. Her enemies and allies embraced (more or less) this protective world order. The major powers (mostly) avoided conflict with each other, trade rose to record heights, and economic growth soared.

The world order imposed by Pax Britannica brought a golden era of economic prosperity to much of the world, but by the end of the 19^th century, Japan and, especially, Germany, had gained economic strength, and with it, military might. Britain’s hegemony both permitted their economic ascent, and thwarted their political ambitions, and it was only a matter of time before this conflict boiled over and Pax Britannica would be challenged (by Germany). The United Kingdom won the first world war, but her supremacy was shattered (forever, as it turned out). Without a world power willing or able to supply the global public goods of free trade, rule of law and military enforcement thereof, the world order collapsed. The first half of the 20^th century was marked by two world wars, the rise of fascism, revolutions in Russia and China, and the deaths of 100 million people from the resulting chaos.

The United States reluctantly engaged in world affairs in the waning months of World War One by sending more than one million “Doughboys” to fight in France. But the US promptly disengaged after the armistice, and remained (mostly) apart for the subsequent two decades even as the rise of fascism brought the world into conflict again. When Germany invaded of Poland in September 1939, marking the start of the Second World War, the US Army had fewer than 188,000 active duty troops, on par with Bulgaria. It took an attack on American territory in December 1941 to bring the US back into world affairs.

At the end of that war, the United States accounted for more than half the world’s economic output, and imposed a new world order in which trade was liberalized (GATT, which became the WTO), security was protected (NATO, SEATO, et.al.), and capital was available to any country that requested it (Marshall Plan). American troops were stationed in Europe and in Asia, not to protect America, but to protect her allies (they’re still there). In the second half of the the 20th century, Pax Americana led to new heights in trade and economic prosperity for those who participated in it, underpinned by the principles of free movement of goods, capital and people. Enforced by the United States military, of course.

Pax Americana was, from the perspective of the United States, enlightened self-interest. Yes, there was a cost in an absolute sense (US military spending accounts for fully half the total military spending in the world) and in a relative sense (the US share of world GDP has halved even as it has, in dollars, more than octupled—not sure that’s a word). But Pax Americana brought the world unprecedented prosperity and allowed the United States (mostly) to advance its economic and political interests, crowned with the collapse of its principal threat, the Soviet Union.

The world order under Pax Americana is now clearly threatened. Perhaps history will see 1989, with the fall of Berlin Wall and communist regimes in eastern Europe, as its peak; perhaps in 2000 or 2008, or another year, but American dominance of world affairs is in relative decline. At the moment, that diminished power is manifested regionally, not globally, most noticeably in the Middle East, where power has diffused and Russia and Iran have ascended, and in Asia, where China has become dominant. A global challenger to US hegemony has yet to emerge (although China will double its military spending in the current decade, and is the most obvious rival to American leadership).

The Obama administration was wary of projecting American power, and the Trump administration is likely to retreat further by redefining American interests more narrowly. A single political interest may be pursued—the defeat of Islamic State, for example—and countries will align for or against this position, but American military will not likely be projected abroad for any political goal, short of a direct threat on the US homeland. Rather, international affairs will be defined by economic interests, and the tools of American diplomacy will be tariffs and sanctions rather than bombs and missiles.

This scenario may be appealing to many: the withdrawal of American military power as the “world’s policeman” and an aggressive defense of economic self-interest sounds better than putting American airmen, seamen and soldiers in harm’s way. It’s an approach that can be followed for years, as I suspect it will, but history shows that there will be eventually one of two consequences. A new world order will emerge, with the rules set by a dominant power that is not us, and we will have to accede to the rules set by the new hegemon, undoubtedly in its best interests. Alternatively, the resulting global chaos from American disengagement will force the US to intercede to restore order. It is naïve, and will ultimately prove false, to hope that US retrenchment in world affairs will proceed benignly, with benefits and little harm to the US and her allies. But this is the path I expect we will pursue.

The next post will look inward, offering an explanation for the election of Donald Trump, and some broader observations.

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