Italy surprised much of the world when it became the first—and only—member of the G7 to join China’s Belt and Road program in 2019. Just four years later, Italy withdrew from the initiative. The about-face served as a microcosm of the geopolitical landscape’s evolution. Policymakers have long viewed the economy through a geopolitical lens. But the overlap between the economy and national security has grown, increasingly becoming the focus of today’s geopolitical fractures amid global competition over trade, technology and defense.
This episode of The Outthinking Investor explores the ways in which nations are balancing economic and security priorities, and how investors can leverage geopolitical analysis to make informed portfolio decisions in a changing world. Our guests are Mark Esper, former US Secretary of Defense and author of “A Sacred Oath: Memoirs of a Secretary of Defense During Extraordinary Times”; Nobel Prize-winning economist Michael Spence, senior fellow at the Hoover Institution, former Dean of the Stanford School of Business and co-author of “Permacrisis: A Plan to Fix a Fractured World”; and Magdalena Polan, PGIM Fixed Income’s Head of Emerging Markets Macroeconomic Research. Topics include the three main forces affecting the global economy, how national defense is influencing economic policy, the geopolitical factors impacting trade flows and emerging markets, and whether the peace dividend is evaporating.
Do you have any comments, suggestions, or topics you would like us to cover? Email us at thought.leadership@pgim.com.
Episode Transcript
The Silk Road was an invisible network of trade routes connecting the Far East with Europe. It dates back to at least the second century BC. Silk was the first commodity trafficked along these routes. It wasn't long before all kinds of goods were traded. Paper, for example, was invented in China, but exporting it to Europe led to a massive societal change. The Silk Road became a bridge between the East and the West, fostering the exchange of commerce, culture, religion, and science. Thousands of years later, a modern version of the Silk Road emerged when China unveiled the Belt and Road Initiative in 2013. Emerging market countries benefited from a wave of investment from China that helped develop infrastructure and expand their economies. Italy surprised much of the world by becoming the first developed market country to join China's Belt and Road Initiative in 2019. Motivated by the potential for economic growth beyond the European Union, Italy withdrew from the initiative just four years later. This was amid the expanding Russia-Ukraine war as Europeans grew more concerned about the shifting geopolitical landscape and how that might impact national security. Italy's departure was a major blow to China's initiative. It also demonstrated how quickly lines are drawn and redrawn in the global economy based on geopolitics and national defense. The world is constantly changing, and the global economy evolves alongside major geopolitical factors, from trade relations to technology to national security. At a time when geopolitics are shifting rapidly, investors need to understand how this influences financial markets. What are the key issues to bear in mind? Are there significant differences in how emerging and developed markets might be impacted? And how can investors use this information to make more informed decisions for their own portfolio? To understand today's investment landscape, it's important to know how we got here. This is The Outthinking Investor, a podcast from PGIM that examines the past, the present-day opportunities, and the future possibilities across global capital markets. Mark Esper is the 27th United States Secretary of Defense and author of the book "A Sacred Oath: Memoirs of a Secretary of Defense During Extraordinary Times." Michael Spence is former Dean of the Stanford Business School, a co-recipient of the 2001 Nobel Memorial Prize in Economic Sciences, and a co-author of the book "Permacrisis: A Plan to Fix a Fractured World." Magdalena Polan is Head of Emerging Market Macroeconomic Research at PGIM Fixed Income. Given how economic and geopolitical issues have become so interconnected, how should governments balance policy for critical industries like microchips and energy with the principles of globalization, growth, and national security? Mark Esper explains.
>> I think you have to begin with the simple principle that national security is very dependent, of course, on economic security and economic prosperity. Arguably throughout time, critical to that was technological development and advancement. And the hallmark of United States military, at least in the modern era, has been that we always pursue technology as the dominant factor of our adversaries as compared to expending personnel. Our view is let's develop the technology and let's dominate in that regard. Chips are so instrumental to everything in the military sector and in the private sector as well. But in the military sector, it's everything from advanced autonomous systems, precision-guided munitions, or advanced fighter aircraft, nuclear submarines. But particularly in the AI autonomous systems domain that is still growing, we're still building out. We have to maintain the advantage there when it comes to high-capacity semiconductors. And I think that is one area where we need to maintain a dominant edge and work with our allies and partners to make sure that we restrain Chinese development so that we can maintain that qualitative military edge. Now, there may be some other technologies as well out there that we should find as well. I think we want to be careful. We want to be discreet in doing that. There are technologies by which we want to decouple, and I put semiconductors on that list. There's another set of technologies in which we want to reduce our risks by either onshore and friendshore and whatever the case may be. And then there's a whole list of other commercial products out there that we probably don't care whether the Chinese dominate in that sector or not or have a large share. And I think the challenge for government is to sort through those lists and make sure we get the right items in the right buckets and then proceed along the same lines.
>> Much of the current focus is on new technology, but, in fact, the underlying issues around economic and national security aren't new, as Mike Spence recalls.
>> There are analogies of this. In World War II, the automobile industry and the aircraft industry were scaled up massively to deal with the war effort. That would have been much harder if we didn't already have an automobile industry and an industry that built aircraft, and the automobile switched over to tanks, and so on. We're doing the same thing. We're doing things that on a narrow sense don't make economic sense, but from the point of view of national and economic security, they do make sense. This is not a temporary condition. I can't see a scenario in which the level of confidence and trust in all of our trading partners goes back to a level that we feel comfortable not taking these protective actions. The national security agenda is much, much more prominent in the way the global economy runs now than it was before.
>> Prioritizing the issues related to national security is a crucial role for government. When it comes to execution, progress will hinge on an effective partnership between the public and private sectors.
>> We're going to have to work together. I think from a business perspective, there's both opportunity and reason to be concerned. Obviously, if you're a company working in the financial sector, for example, or in the medical sector where you're concerned about a patient's health record, don't think about any other domains. You need to guarantee your customers, your clients that you have 100% security on their records because of the privacy issues. So we're going to have to work together on privacy issues. We're going to have to work together on reporting to make sure as incidents happen, we have reporting, that information can be shared quickly across both the public and government [inaudible]. Then, of course, from a business perspective, you want to make sure that you have, at least with allies and partners, like-minded countries, that you have similar regulatory regimes because what you don't want are businesses trying to navigate. You know, the EU does something one way, Brazil another way, the United States a third way, maybe Canada is a fourth way, and what you want is to ease the regulatory burden. You want to make business as efficient as possible to navigate this and yet protect that data and privacy from what's going on out there. You have to not just harden your systems but you have to make sure they are resilient. So how do you move to, example for, to Web 3.0? How do you create new algorithms that will allow -- that we could sell in the private sector to protect our health businesses, protect their data, protect their clients? And the simple fact that you have nations, states, governments involved really makes it tough in that domain to kind of protect data.
>> That just adds to the fact that geopolitical risks are increasingly complex and changing rapidly.
>> The way I think about the current situation is we have three powerful sets of forces operating on the global economy. One is a set of pretty severe and frequent shocks coming from multiple sources. So we have pandemics. We have two wars running now. We have geopolitical tensions. We have very large and increasing climate shocks that are disrupting global supply chains in addition to these other factors. So that's one set, and it puts the system kind of out of equilibrium, and it's actually pushing it to change structurally in a pretty major way. The second set are some secular trends that are a major challenge for growth, for sure, and challenges that have contributed to this sudden appearance of an inflationary environment that we didn't have for several decades. And these are things like declining productivity, aging societies, big changes in labor market behavior, along with the geopolitical tensions from the first set. And this is producing a difficult period in terms of sustaining growth, investing at a level that's consistent with achieving the goals associated with a sustainability agenda, and so on. But then the third set are really quite different. We're living in an age where we have just stunning scientific and technological breakthroughs. The three that we highlight in the book are the obvious multi-decade digital one with a huge surge associated with the applications of artificial intelligence and the appearance of generative artificial intelligence. But there's an equally impressive intersecting revolution in biomedical and life sciences, which has implications not only for health and drugs and vaccines and so on but for agriculture and for the sustainability agenda and all that. And then we have this massive energy transition, again, multi-decade, that we have to go through to achieve a sustainable pattern of growth and economic activity.
>> There's good reason to be optimistic about the future, but with a dose of realism, that calls for clear and sensible policy to guide national interests.
>> All the four flows of globalization are being partially truncated -- flows of capital, flows of people, flows of goods and services, and especially flows of technology. Business is pretty good, and so are investors at accepting whatever the status quo is. But the thing that's really difficult to deal with is uncertainty of that type, policy uncertainty, where you just don't know what environment you're operating in. We still have relationships at the level of business. The investment community hasn't completely abandoned various parts of the world. There's a flood of money coming into India. That's money that might have been going into China before is maybe coming out of China, and so on. And some of these movements are pretty dramatic, so they can cause temporary bouts of volatility, but that's the world we're living in.
>> Investors shouldn't underestimate the resiliency of the emerging markets or how countries respond to geopolitical risks.
>> The vast majority of emerging economies have basically made it transparently clear that they're not even slightly interested in living in a world where the architecture is determined by the United States and China not agreeing or getting along with each other, and they're going to deal with whoever their interests tell them to deal with.
>> According to Magdalena Polan, geopolitical risks vary across emerging markets' regions and countries, and that translates to the financial markets.
>> Countries in Europe rely quite a lot on the freedom of movement, not just of people but also of goods. But with the recent concerns about both the politics but also security, we saw some of the countries imposing controls yet again, and that may become a feature for this new landscape of global trade, or at least regional trade, in which these aspects of national security can sometimes interfere with the free flow of trade and goods, and that attractiveness of these countries as the new destination for investments. Part of the new investments may not necessarily be driven by concerns about the shortening of the production chain -- just because it may be more difficult from the point of view of just normal trade -- but that production may be brought onshore or to the region just for the sake of securing some of these basic but very, very crucial goods.
>> There's good news for investors. The economic outlook for emerging markets seems increasingly more positive.
>> Luckily for them, their productivity growth is still stronger, and they see higher rates of investments and inflows of foreign direct investment, which means they are growing faster than the core eurozone, let's say Germany or France, which also then reduces certain risks such as the fiscal risks, risks to deficit, or risks to medium-term growth outlook. Now, the Middle East is a bit different. Here, although the income levels are quite high, the progress on governance reform or structuring their economies is somewhat at a different stage. They are currently rapidly transforming their economies, trying to shift as far as much from reliance on oil and gas and moving towards other sectors. Obviously, oil and gas will remain still very important for these economies, but increasingly so we see that government revenues increasingly come from other sources than oil and gas, and also that growth in these economies is less and less dependent on the outlook for oil and gas, which makes it more sustainable and also more stable.
>> When it comes to energy, there is no single outcome for all the emerging markets countries. Each one has its own set of sensitivities to oil and gas. Looking at the shift in supply chains, there are regional differences between Europe and the Middle East.
>> Countries in Europe, and especially those that are already members of the European Union or are on the edge of the EU and may have a customs union with the EU can really benefit. They have all these existing linkages. They already have a lot of investments, factories, or, let's say, research and development centers from companies based either in the EU or in the United States. It's easier to invest there, to shorten those supply chains, shift production from other countries, or establish production of new crucial technologies on the edges of core eurozone rather than to look somewhere further [inaudible]. Instead only countries strictly in Europe, you can also think about countries like Turkey, which can freely trade with the EU, but countries also around the Mediterranean, Northern Africa, let's say Morocco, which can benefit from the shift of production closer to the final market. Now, Middle East, it's slightly different because the trading partners are also different. Obviously, oil and gas is traded globally and they are now shifting or have shifted recently towards other goods. These are mostly services, and it's much easier to trade them across borders rather than physical goods. They're also trying to build up their entertainment, hospitality sectors, and tourism is a slightly different good than, let's say, physical goods such as microprocessors, cars, or electronics.
>> It's important to understand the nuances of these countries while keeping an eye on the bigger picture. Mike Spence's experience with the Commission on Growth and Development under the World Bank illustrates how far we've come in appreciating the consequences of globalization.
>> I started to realize that the World Bank people were all divided up into silos. There was a Latin American crowd and the African group and the Asian group, and so on. And so I said to Roberto Zagha, the secretary, I said, "What fraction of people could give a coherent five-minute explanation of what's going on in China?" And he said, "Maybe 10 or 15%." I said, "What about the rest of them?" And he said, "The Latin American specialists are not interested." This is no longer true. So I decided to test this. I went to Latin America and asked some pretty senior people, "Are any of the experiences in Asia of relevance?" And the answer was absolutely not. Completely different world. And I thought to myself, "Well, that's nuts." But that's the way the world was configured. And the reason it's better now is that I think people have understood that the experiences and best practices and all that kind of thing, while they always have to be modified and adapted to the particular conditions in a local environment, they're still interesting. And we're much better at crossing these kind of artificial and not very helpful boundaries. And so we have less siloed approach. If we went back to the World Bank now and asked how many people have a pretty good working understanding of the growth experience in Brazil or Indonesia or China, you'd probably get a much different answer than I got then.
>> Having a more nuanced view of the world is crucial for understanding trade flows and forecasting which countries might benefit as trade flows shift along the lines of geopolitical alliances.
>> Central Eastern Europe stands out quite positively here, as does Turkey. Countries in Northern Africa that some of them have agreements to trade with Europe, such as Morocco. Even countries in Sub-Saharan Africa can benefit from that as they take on some of the lighter, less advanced manufacturing, such as textiles. We already see a lot of these goods coming from places like Ethiopia or, say, Kenya. And the same may happen in Latin America countries. They can trade more with the US, taking on some of that trade that used to take place with China. And then there are countries that are less affected because of the nature of their exports and trade. Countries that produce oil and gas tend to trade with almost anyone and they are subject to different forces, for example, growing energy independence of the United States. Thanks to the shale revolution in the United States. However, they also benefit, for example, following the onset of the conflict in Ukraine, Qatar signed a lot of gas contracts with Europe as Europe tried to diversify its sources. This provides a long-term boost to the economy and the stability of Qatari finances.
>> When we think of global trade, it's usually about cars and commodities and other goods. But among the emerging markets countries, trade is increasing across the services sector, including specialized services like consulting, computer programming, and even film production.
>> A lot of that has shifted to emerging markets. For example, Poland is one of the popular locations for Bollywood productions. And just recently, pedestrians were surprised by a double-decker London bus driving on one of the Warsaw bridges and falling into the water. This was an Indian film crew using this place as a location, but also as a post-production facility. So that trade has so many more dimensions than we think about when just thinking about these traditional goods that cross the borders.
>> Another aspect of shifting trade flows relates to the so-called peace dividend. When the Cold War ended in 1991, the US cut its military budget by nearly 40% and reallocated that money to other budget items. Many European countries did the same.
>> We realized too late that instead of the world being this peaceful evolution that would be linear, what we found is we returned to this era of great power competition. And so for 25 years, we did not build back up our military. And we got accustomed to being in a 3.2% GDP rate. And the Europeans far, far less than that. In some cases, you know, under 1% of GDP toward the feds. Many countries have now realized that we should not have at least taken so much of a dividend, that we should have been continually investing in our military as the foundation for a strong economy, as the foundation for maintaining the international rules and norms, a stable geopolitical order that would allow economies to thrive, countries to grow, prosperity to lift everyone up. And instead, now we find ourselves playing catch up.
>> Now, we're seeing a trend in the opposite direction, a response to the increasing competition primarily among the US, China, and Russia. Most Western countries have begun to increase spending on defense, or at least they're getting pressured by allies to do so.
>> Japan has committed to doubling its defense spending from 1% of GDP to 2% of GDP. Taking more money away from butter and putting it into guns because we see this competition possibly growing into conflict between the big powers. And that is no good for anybody. It's no good for the international order. It's certainly no good for international business. But we need to get back to a point where we have sufficient military capability between all of us, not just the United States but our allies and partners as well, to strengthen our diplomacy on the global stage against the Russia's and China's and Iran's, and to make sure that if worse comes to worse, if we're unable to deter military conflict, we're in the best possible position to win it quickly and get things back to a more stable international order.
>> This power struggle has blurred the lines between economic and national security issues, creating challenges for those countries with mixed alliances.
>> The challenge we see -- and this is most striking, I think, in Asia. South Korea is a case in point -- in their previous administration, not the current one, they wrestled with this. They went through this -- is they're so close to China, so much of their exports go to China that they saw China as their economic partner and the United States as their security partner. And I think they thought, at the time, that they could walk that tightrope. My view is you can't. At some point in time, one is going to pull you in one direction and the other in another. And I think countries are going to reach a point where they're going to make a fundamental choice of which side of the fence are they going to be on. I mean, India, for example, wrestles with that right now. You see India be too strong of a word to say supporting Russia with regard to Ukraine, but they're certainly not taking the stance that most democracies in the world would like to see India take, where it condemns Russia's invasion of Ukraine and supports Ukraine and applies sanctions toward Russia.
>> Globalization adds a relatively new dynamic to the world order, but geopolitics are ancient. Complex issues will come and go, and alliances will continue to shift. The challenge remains for investors to focus on what's material and ignore the noise. Thanks to our experts, Mark Esper, Michael Spence, and Magdalena Polan, for their insights on the macroeconomic and investment implications of geopolitical risks. To explore our 2024 Global Risk Report: Resilient Investing Amid Geopolitical Uncertainty, see the link in the show notes. The Outthinking Investor is a podcast from PGIM. Follow, subscribe, and if you like what you hear, go ahead and give us a review.