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July 28, 2022 | 8 Minute Read
Co-Chief Investment Officer, Multi-Asset Solutions
The ongoing confrontation between Russia and the West has renewed concerns about a developing Cold War 2.0. Compared to the broad ideological conflicts that took place in the 20th century between the Eastern and Western blocs, the initial phases of Cold War 2.0 have been more targeted and localized. However, it appears likely to do more damage to global economic growth and cooperation—and without nearly all of the silver linings associated with the first one. Considering the economic, political, and humanitarian costs for all sides, Cold War 2.0 may not have a winner. In current conditions, we expect commodities to play a more central role in driving economic growth than they have in previous business cycles. The traditional investment playbook should also be re-assessed to account for elevated geopolitical risks across developed-market (DM) and emerging-market (EM) opportunity sets.
In the 20th century, the world saw a prolonged period of rivalry between the United States and the USSR—as well as among their respective allies. The two blocs represented opposing ideological beliefs and engaged in a wide range of competition, from military development to economic growth. Each side hoped to demonstrate the superiority of its own system and encourage others to emulate it. In the 1950s and 60s, the US economy grew about 3.8% per year, while the Soviet economy grew at a slightly higher rate of 5% per year.1 Centrally-planned projects on industrialization and defense developments were a main driver of Soviet growth.
Countries in the Eastern and Western blocs also sought to strengthen their growth through mutual assistance and trade liberalization. The US enacted a number of foreign aid programs that played an important role in Europe’s post-war revival, including the US Marshall Plan, which provided some $13 billion to finance rebuilding efforts after the war and is widely recognized as an economic and foreign policy success. Trade liberalization programs such as the GATT also boosted economic gains in the Western bloc. In a somewhat parallel fashion, the USSR formed the Council for Mutual Economic Cooperation (Comecon) among socialist countries, though its impact was limited.
The Soviet economy started to lose steam in the 1970s. After a short-lived windfall from the energy crisis, the expensive arms race eventually took a toll on its growth. The decline continued throughout the 1980s oil glut and contributed to the Eastern bloc’s formal dissolution in 1991. The US managed to overcome its own setbacks in the ’70s to ’80s and maintained an average growth rate above 3% during this period.
This year’s geopolitical tension has its origin in a regional conflict between Russia and Ukraine but quickly evolved into global confrontation as Russia weaponized its commodity exports to threaten the economic welfare and energy security of Ukraine’s Western supporters. The situation is sometimes dubbed Cold War 2.0, since it recalls the East/West power struggle in the 20th century—but with greater economic damage this time around.
During Cold War 1.0, the two blocs grew independently despite the everlasting arms race. In recent years, however, Europe’s increased reliance on energy imports presents an opportunity for Russia to inflict economic pain on countries that it deems “unfriendly.” The US is in a better position in terms of energy independence, but it is not insulated from the perils of elevated living costs and production costs. Weaker purchasing power is likely to dampen household consumption, whereas the reduced willingness to produce can worsen the supply chain disruptions that have been hurting the global economy for quite some time. As for Russia, oil and gas exports still account for nearly half of the country’s revenue. For the time being, the reduced quantity of these exports are being offset by higher prices, but the damages are likely to sink in over time. Western sanctions have restricted Russian oil products to trading in smaller markets with steeper discounts, whereas expenses continue to accumulate from the hot war on the ground with Ukraine. If the global economy does enter into a period of material slowdown, energy prices would likely decline along with demand, further undermining Russia’s position.
Cold War 2.0 is also likely to be more divisive than Cold War 1.0. At the start of the Russia-Ukraine conflict, EU countries promptly embraced a unified stance toward the humanitarian tragedy. However, member states have been taking much longer to agree on the implementation of Russian gas sanctions given their varying degree of reliance and ability to adjust. It is unlikely that a modern-day Marshall Plan or some other form of international assistance can immediately solve Europe’s gas dilemma, since the distribution infrastructure takes years to build and re-route. On the other hand, traditional Russian allies, such as Kazakhstan, have been taking a distance during the current stand-off. Russia has also been seeking partnership with China. Historically, Russia-China relations have been more strained than many Westerners appreciate, even during the original Cold War. Asking for China’s support during Cold War 2.0 is creating new challenges to the two countries’ relationship as it runs counter to China’s close ties with Europe.
In contrast to Cold War 1.0, this year China has been working carefully to maintain a balanced relationship with Russia and the Western countries. The size of the Chinese economy now ranks second in the world, only after the US and much ahead of Russia who ranks the eleventh. Given China’s current stance, there should be very limited risks of it joining forces with Russia and engaging in direct conflict with US and Europe during Cold War 2.0. However, as China continue to grow its international influence and competitiveness, it is not unlikely to see more friction between China and the US down the road, who may view China’s rise as a challenge to its dominance. In recent years, China has also been pushing for the internationalization of the RMB as a reserve currency and building up its own cross-border payment and clearing systems that are in parallel to the Western mechanism. The dominance of dollar-reserves and dollar-based financial infrastructure face few challenges today, but emerging alternatives should increase the possibility for bypassing sanctions, thus making them less effective in the future.
When we turn to the geopolitical considerations, the outlook for Cold War 2.0 looks even gloomier. Russia’s original objective may have been tightening its grip on Ukraine and preventing it from ever joining NATO, which in recent decades has welcomed several other former Soviet and Eastern Bloc countries. However, Russia’s military aggression against Ukraine shifted public perception of risk in the region and prompted new countries to seek enhanced protection against Russian invasion. Finland and Sweden went so far as to abandon their long-held neutrality and apply for NATO membership; if the accession deal is completed, it would mark the most significant enlargement of NATO in years and strategically enhance the alliance’s presence in the Baltic region. Such development runs counter to what Russia may have intended and further escalates the standoff between the two sides. Future tit-for-tats are possible, and the path forward appears highly uncertain.
For quite some time, commodity shocks have become less disruptive to economic growth as a result of improved supply, enhanced efficiency, and the availability of alternative energy sources. Yet the current situation shows that markets have largely overlooked the geopolitical vulnerabilities in global energy supply-demand balances. It required the exploitation of these vulnerabilities in a time of war to change that. With Cold War 2.0 still evolving, we expect commodities to play a more central role in driving economic growth, whereas traditional central banking tools are likely to be more limited in their ability to smooth out externally-driven growth and inflation shocks.
Subsequently, Cold War 2.0 may end up re-underwriting the list of DM safe havens and could weigh on the outlook for EM assets. In the near term, the US dollar has already outperformed European currencies as well as the Japanese yen (JPY). The outlook for traditional safe havens such as JPY may continue to be overshadowed by the respective economy’s dependence on energy imports. For EM, dollar strength and reduced global risk appetite also implies a more challenging path forward. While commodity exporters may have some capacity to offset growth and inflation challenges with trade balance improvements, countries that are reliant on food and fuel imports can be particularly vulnerable, even if they are not directly trading with Russia.
Implications on global diversification is more nuanced. On one hand, increased fragmentation under Cold War 2.0 means lower correlation and better diversification opportunities, but investors should also take into account the heightened political risks that may arise in the Cold War 2.0 era. For example, if China and India are perceived to be too closely aligned with Russia, there is a risk that they may face retaliations themselves and become secondary targets of Western sanctions. In the event of sudden regulatory changes, the free flow of capital may not be sustained. To reiterate, we continue to think international diversification has its key benefits, but the opportunities should be evaluated carefully at a time when geopolitical risks are being re-priced into markets.
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1 Source: Maddison, A. (2001), The World Economy: A Millennial Perspective.
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