The combination of economic crisis and social unrest is anathema to a political leader in an election year.    As Trump seeks to overcome domestic troubles, the temptation to escalate tensions with China will grow, and the implications for financial markets may be severe.   This should limit the dollar’s recent downtrend.

What made war inevitable was the growth of Athenian power and the fear which this caused in Sparta.

-Thucydides, Athenian Historian, 460 – 400 BC

China’s pattern of misconduct is well known. For decades, they have ripped off the United States like no one has ever done before.

– Donald Trump, US President, May 2020

Life is long gamma.

N.N. Taleb, ‘Antifragile’, 2012

The Peloponnesian War (431 – 404 BC) occurred, according to Thucydides, because Sparta feared that an emergent Athens would threaten its dominance of the Mediterranean.   This pattern, where a rising power threatens a dominant one, occurs regularly in history.  Over the past 500 years, there have been 16 occasions where this has happened, and most of the time (75%) it has ended in war.  This risk, known as the ‘Thucydides Trap’, and its application to Sino-American relations, is the major geopolitical danger facing the world today.  Current events, both economic and political, are rapidly escalating the tension between the two super-powers.  

As China’s economic and geopolitical power grows, it is hard to ignore the threat that it poses to American dominance.  At the turn of the century, China’s economy was a little over 1/10th the size of the US economy, and had just overtaken Italy to become the 6th largest economy in the world.  Now, Chinese GDP is about 2/3rds that of the US, and China is expected by some observers to overtake the US to become the world’s largest economy in the next decade.    On the geopolitical front, China’s cultivation of global power through its belt and road initiative, investing in infrastructure development throughout Asia, Africa and Eastern Europe, has been unequivocal.

The 2020 election will escalate US – China tension

So, the basic ingredients for geopolitical conflict, as described by Thucydides, are present.  Now add to this mix a global pandemic (originating in China), an economic crisis caused by said pandemic, the worst US civil unrest in decades (not caused, but almost certainly intensified by, the pandemic) and it is not difficult to see where this is going.

Normally, an incumbent president has a pretty good chance of winning re-election.  Of the 43 men who have held the office before Trump, only 10 have failed to win a second term (and one of those, JFK, was prevented from trying by assassination).  However, the Trump presidency is anything but normal, and Trump is in a dogfight heading into November.  Betting odds currently have him and Joe Biden in an effective dead heat to win the Presidency, and the risks to his re-election are growing.    Mass rioting, looting, and the nation’s capital going up in flames are not good looks for an incumbent President.  

Trump has always been hawkish on China, and it is inconceivable that he will not seek to exploit the electorate’s growing suspicions of Chinese intentions.  It is a strategy that will simultaneously allow him to:

  • Blame the pandemic on a foreign rival, and deflect from growing concerns over his government’s response; and
  • Exploit Biden’s dovish track record on China.  Just last year, when announcing his candidacy, Biden dismissed the notion of China as a threat by claiming: “China is going to eat our lunch? Come on man.  I mean…they’re not bad folks…they’re not competition for us.”
Markets remain sanguine…for now

Markets were relieved last week when Trump lambasted the Chinese for their recent assertion of power in Hong Kong, but provided little in the way of specific sanctions or threats.  Equity markets rallied (SPX +4%) and the US dollar sold off (EURUSD +1.5%), as ‘risk on’ took hold once again.

But this respite seems premature.  As November approaches, Trump will continue to ratchet up the tension and it is likely that he will drag Biden right along with him.  The Democratic candidate will be all too aware of his own Achilles heel, and will seek to minimize the damage by showing he can be just as hawkish as Trump.  And it is not all one-way traffic.  Yesterday we saw the dollar rally back down to 1.11 against the euro (before reversing back to 1.12) as news spread that China had ordered several companies to halt purchases of US agricultural products, as a warning to Trump not to interfere in Chinese affairs.    

As this move indicates, the Chinese leadership may be just as keen to escalate tensions.   Reliant upon continued economic growth to ensure political stability, they will undoubtedly be nervous about the implications of the COVID crisis on their own political stability, and will be anxious to find a distraction.  Is it a coincidence that recent political aggressions towards Hong Kong and Taiwan are occurring in the aftermath of the Pandemic’s economic impact?

These aggressive words and actions on both sides increase the probability of a ‘Thucydides Trap’ outcome.  This does not mean war is inevitable of course.  In fact, of the four examples where the rivalry between an emerging power and a ruling one did not lead to war, three of them occurred in the relatively recent past, implying perhaps the chances of overt conflict are lower with the presence of nuclear deterrents and mutually assured destruction.   But the probability of conflict will rise.  

The US dollar is long gamma…

Philosopher, author and former options trader Nassim Nicholas Taleb writes that ‘Life is long gamma’.  In the options world, gamma is the second derivative of an option’s price with respect to the underlying price.  To be ‘long gamma’ means that you will benefit from volatility, randomness and disorder.  Taleb, in other words, believes that, on average, we benefit from being exposed to volatility.  As Mark Zuckerberg said, ‘The biggest risk is not taking any risk’.  

And, like life, the dollar is also long gamma.  It thrives on volatility, randomness and disorder as the market’s most trusted and liquid store of value.  As geopolitical tension between China and America rises, the potential for a ‘Thucydides Trap’ grows, and the rhetoric (and actions) ratchets up in the coming months, we expect the US dollar to continue to benefit from its safe haven status.

China / US tension is not the only iceberg on the horizon.  Eurozone political stress (exacerbated by Brexit), rising levels of public and private debt, and second wave COVID risks all represent potential flashpoints about which the markets seem remarkably complacent.   Yes, EURUSD will likely rise if all of these risks remain contained, but it will only take one to push the dollar even higher.  For now, we prefer to be long gamma.

Author: Kevin Lester