by Bill O’Grady

(Next week, we will publish our 2017 Geopolitical Outlook; it will be the last issue of 2016.)

In Part 1 of this report, we discussed the geography of the Philippines and examined the nation’s history, focusing on its relations with the U.S.  In Part 2 of this report, we will discuss President Rodrigo Duterte’s recent foreign policy decisions and their impact on U.S. policy in the region.  We will conclude with the impact on financial markets.

President Duterte

The 2014 Enhanced Defense Cooperation Agreement (EDCA) led to a significant shift in U.S./Philippine relations.  As the maps in Part 1 showed, the Philippines are key to controlling the sea lanes in the region.  If the Philippines were to become hostile to American interests, allies such as Japan, Taiwan and South Korea would be vulnerable to supply interdiction as the sea lanes would no longer be secure.

While the EDCA improved the security posture of the U.S. in the Far East, the Permanent Court of Arbitration’s ruling in July against China was a huge moral victory.  The international tribunal at The Hague offered a sweeping rebuke of China’s behavior in the South China Sea, completely rejecting China’s “nine-dash line” claims.  The Xi regime is furious over the outcome and has decided to simply ignore it.  Like most international agreements, there is no enforcement mechanism other than global reputation.  However, reputation does have some currency and it isn’t out of the question that the U.S. could decide to enforce the rule.  The U.S. Navy is powerful enough to dislodge Chinese forces off the rocks in the South China Sea, although it would likely trigger a wider war.  Still, at a minimum, the EDCA and the verdict at The Hague have given the Philippines leverage when negotiating with China.

However, the new Philippine president has jettisoned any advantage he gained from the court’s ruling by deciding not to press the issue with China.  Instead, Duterte met with Chinese officials and essentially told them he would not dispute Chinese sovereignty.  This decision followed a series of comments from Duterte which signal a rupture of relations with the U.S. and a turn toward China.

In October, Duterte indicated that he is “separating” with the U.S., claiming that “America has lost now.”  He also intimated that he would consider allying with Russia and China.[1]  Later in the month, he indicated that he wants U.S. troops out of the Philippines “in the next two years.”[2]    Although the U.S. continues to hold joint patrols, Duterte has indicated that he wants those to end as well, ostensibly because China doesn’t like them.[3]  Obama administration officials note that there have been no official requests to end these arrangements, but the tone has clearly been set.

It would be a major win for China if Duterte is able to follow through on this shift.  Not only would it have a clear exit from the first island chain (see map below), but China would have effectively divided that chain and put U.S. allies at risk.  In fact, American geopolitical objectives in the Far East are arguably in danger of being undermined.

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[1] http://www.cnn.com/2016/10/20/asia/china-philippines-duterte-visit/

[2]https://www.washingtonpost.com/world/philippines-duterte-now-wants-us-troops-out-in-two-years/2016/10/26/32bec8a5-8584-4d95-8e9d-4d7762865055_story.html

[3] http://www.wsj.com/articles/philippines-leader-to-end-joint-military-exercises-joint-naval-patrols-with-u-s-1475086567

by Bill O’Grady

(There will be no report published over the Thanksgiving holiday.  Part 2 of this report will be issued on December 5.)

In May, Rodrigo Duterte was elected president of the Philippines, winning 39% of the vote.  He is the first resident of the island of Mindanao to hold the office, making him a political outsider.  An unconventional political figure, he is considered populist in the mold of Turkish leader Recep Erdogan or Indian PM Narendra Modi.

Although Philippine economic growth has been generally strong, with per capita real GDP rising 4.2% last year, the general feeling was that only the political elites were benefiting from the growth.  Crime and poor infrastructure were the primary concerns of the election and Duterte promised to address both of these issues.

In fact, on the former, Duterte has unleashed a crackdown on drug dealers[1] with such fury and lack of due process that he has been facing criticism from the West.  Duterte’s response has been to vigorously[2] reject these charges and, in general, opinion polls suggest the policy is popular with the general public.

Perhaps the most controversial action Duterte has taken has been to embrace China and reject its long-standing ally, the United States.  If this rupture in relations continues, it will significantly change regional geopolitics.

In Part 1 of this report, we will begin with an examination of the geography of the Philippines, discussing its geopolitical importance.  From there, we will offer a history of U.S./Philippine relations.  In Part 2, we will use this history to discuss Duterte’s recent foreign policy moves.  It does appear that Duterte is moving his country to at least a neutral stance and downgrading the American relationship.  If true, it would seem that one of the signature foreign policy goals of the Obama administration, the “pivot” to Asia, has essentially failed.  We will conclude with the potential impact of Duterte’s actions and their prospective effects on financial markets.

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[1] Some 4,800+ have been killed so far.  See: https://en.wikipedia.org/wiki/Philippine_Drug_War.

[2] He described President Obama in derogatory terms, leading to the cancellation of a one-on-one meeting.  See:  https://www.washingtonpost.com/news/worldviews/wp/2016/09/06/the-son-of-whore-story-is-about-so-much-more-than-dutertes-dirty-mouth/.

by Bill O’Grady

On November 8^th, Donald Trump shocked the country and the world by defeating Sen. Hillary Clinton in the U.S. presidential race by accumulating a majority in the Electoral College.  Mr. Trump, the first president in U.S. history to gain the presidency without having been previously elected to office or served in the military, is something of an unknown.  In other words, we have little personal history to examine to forecast his geopolitical leanings.  All we really have are his public statements and campaign platform.

However, these sources do offer solid clues as to where he intends to take his foreign policy.  In this report, we will characterize our expectations of Trump’s foreign policy using Mead’s archetypes.[1]  From there, we will examine how we expect Trump to change America’s superpower role, which it has provided since the end of WWII.  As always, we will conclude with potential market ramifications.

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[1] See WGR: The Archetypes of American Foreign Policy: A Reprise, 4/4/16.  In our initial analysis of Trump, we postulated he was more Jeffersonian than Jacksonian.  We have revised our viewpoint in this report, arguing that he is almost purely Jacksonian.

by Kaisa Stucke, CFA

Speaking at the Boston FRB conference on October 14th, Fed Chairwoman Janet Yellen indicated that Fed officials are considering the benefits of running a “high pressure economy.”  This sparked speculation that the central bank would allow its inflation target to temporarily exceed 2% as the labor market and aggregate demand improve.

The Fed’s dual policy mandate calls for the central bank to maximize employment and maintain stable prices.  The central bank has designated a target of 2% as its inflation goal, but has not identified a policy target for employment levels.  Optimal employment levels change over time given the cyclicality of labor markets, so it makes sense to keep a moving target for the labor market.[1]  But why did the Fed choose to specify an explicit 2% inflation target?

This week, we will take a closer look at the reasons behind the Fed’s 2% inflation target.  We will also review the historical data and academic research that support this optimal level of price increases.

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[1]The Fed does target a natural rate of unemployment, which is unemployment arising from all other sources except fluctuations in aggregate demand: https://fred.stlouisfed.org/series/NROU.

by Bill O’Grady

In Part 1 of this report, we discussed how the reserve currency facilitates trade, provided a short history of the dollar’s evolution as the reserve currency and examined the theoretical backdrop of the reserve currency and its role as a global public good.

In this week’s report, we will conclude with the economics and geopolitics of the reserve currency and discuss potential market ramifications.

The Economics of the Reserve Currency
When the U.S. accepted the reserve currency role in 1944, the U.S. economy dwarfed the rest of the world.  However, the relative size of the American economy has declined, in part due to the success of U.S. policy in rebuilding the free world after WWII.  This situation accelerated with the development of China.  On a purchasing power parity basis, the U.S. is currently the second largest economy in the world, with China being the largest.

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by Bill O’Grady

One of the more interesting developments in this presidential political cycle has been the near total abandonment of free trade.  Neither presidential candidate supports the Trans-Pacific Partnership (TTP) or the Transatlantic Trade and Investment Partnership (TTIP), the topic of last week’s report.  The primary reason for this backlash against free trade is the fear that U.S. employment is adversely affected by trade.

Some of the earliest work in economics was on trade.  For example, the trade theory of comparative advantage was developed by David Ricardo in 1817.  With perhaps the exception of Marxism,[1] most economists assume that trade is positive for economies.  Most polls seem to suggest Americans still support free trade, but clearly the political class has concluded that supporting free trade is a risky stance.  So, how did we get here?

We believe that the general misunderstanding of the U.S. superpower role is behind the backlash against free trade.  In pure theory, it’s hard to argue against free trade.  Most economists adhere to the position that efficiency is an undisputable good.  However, the way trade works in the real world isn’t exactly how it works in the classroom.  Often, political pundits will contend that the growing rejection of free trade is due to the fact that the benefits are broad but the costs fall disproportionately on workers who are adversely affected directly by import competition.  Although this is a partial explanation, it is critical to understand that the global hegemon faces specific costs that are generally unappreciated.

In this report, we will begin with a narrative describing the use of the reserve currency in trade.  Next, we will offer a short history of the dollar’s evolution as a reserve currency.  In the next section, we will examine the reserve currency as a global public good, provided by the superpower.  Next week, we will discuss the economics and geopolitics of the reserve currency and, as is our usual fashion, we will conclude with potential market ramifications.

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[1] Some Marxists hold that trade is a form of imperialism and is another tool for capital to subjugate labor.