We're on the Brink of Cold War 2.0

Kim Iskyan: It doesn't get any bigger than war... The U.S. and China are on a collision course... We're on the brink of Cold War 2.0... This one is a lot different... What could happen... A silver lining...

Here's a quick history riddle... with more than one right answer...

What countries are we talking about here... and from what time period?

Country A is a rising technological power with a fast-growing economy and a powerful military. It's challenging the existing international order that (for now) is led by Country B.

The two countries have deep and broad trade links. But Country B increasingly views Country A as a threatening adversary, rather than a "competition is good for everyone" rival.

Country B resents that Country A has gotten ahead so fast by taking shortcuts – for example, through government funding of strategic industries. In Country B, the private sector and markets call the shots.

In addition to harboring competing economic philosophies, Country A's political culture is fundamentally different from the more liberal values and traditions of Country B.

Country A is increasingly using its growing wealth and economic might to ensure access to resources, extend its geopolitical positioning, and export its ideology around the world. That's increasingly threatening Country B's position at the head of the global geopolitical table.

Country A wants to live up to its history to be recognized as a great-power equal. Country B knows that it's unlikely that Country A's ambitions will stop there... and is wary of losing its predominant position to what it views as an upstart power.

This should sound familiar...

And you might have picked up on what two countries – and from what time period – I'm talking about.

With a few tweaks, the scenario I (Kim Iskyan) described was virtually ripped from the headlines of the intensifying global rivalry today between the U.S. (Country B) and China (Country A).

But that's not all... It's also the United Kingdom (Country B) and Germany (Country A) – in 1914.

In today's Digest, we'll compare then and now...

Of course, we know what happened next between the U.K. and Germany. It was big, and it could happen again between Country A and Country B today. As Foreign Affairs magazine explains...

The course of the British-German rivalry that culminated in war [the Great War – that is, World War I] in 1914 shows how two great powers can be drawn inexorably toward a conflict that seemed highly unlikely – right up until the moment it began. And the parallels to today's contest between the United States and China could hardly be clearer.

The bold is my emphasis.

War isn't something we talk about often in the Digest...

But when we're thinking about things that could have a big impact on markets, well, it doesn't get any bigger than war.

And as we often say around here... history doesn't repeat, but it often rhymes.

And as I'll explain today, rhyming this time would suggest that the escalating competition between the world's two greatest powers could eventually lead to war... and more immediately, to Cold War II (or in tech-speak more fitting for today, Cold War 2.0).

The notion of the U.S. and China going to war – not a trade war, a battle over 5G, or a cyberwar, but an actual old-fashioned bullets-and-bombs (and in the nuclear age, something far worse) war – may sound absurd.

After all, the economies of China and the U.S. are so intertwined that Siamese twins are socially distanced by comparison...

The U.S. imports more goods from China (nearly 18% of everything it buys from abroad) than anywhere else... Without China, your local Walmart – which gets around 80% of the goods it sells from China – would be almost as empty as the paper-products aisle during peak COVID-19 pandemic hoarding.

In turn, the U.S. is China's biggest export market... and China is one of Uncle Sam's biggest creditors, via its holdings of U.S. Treasurys (around 5% of the total).

Would you start shooting at the guys who owe you $1.1 trillion? Probably not.

But money isn't everything...

A bit more than a century ago, the economies of the U.K. and Germany were also as close as Irish twins. And between the ongoing trade war between the U.S. and China, the evolving battle of technology (more on that in a minute), and global supply chain re-thinks that have been triggered by COVID-19, the economies of China and the U.S. are right now uncoupling faster than a midnight marriage at a Las Vegas drive-through chapel.

And on the military front, nuclear deterrence – the fear of mutually assured annihilation that was very effective in preventing destruction during the first Cold War – is showing its age.

Missile control systems are a few decades creakier. Like a bum knee, they work fine – until the unknown moment that they suddenly don't.

America's nuclear warhead arsenal is 18 times bigger than China's stash of 320, according to the Arms Control Association. But it only takes a handful to really wreck your day. And advances in technology today could allow for limited nuclear attacks – which could turn unlimited very quickly.

You might think war is a bit outdated...

In a world of instant communications, artificial intelligence ("AI"), and obligatory motorcycle helmets, the whole idea of war between the world's two biggest economies feels – especially for anyone under age 60 – as remote as a late-night History Channel documentary on Neanderthals.

That's partly because most people alive today are accustomed to – aside from some regional wars – the world being mostly peaceful.

It's easy for non-historians to forget that the "long peace" between the world's biggest powers since the end of World War II is historically unprecedented. Europe is in the midst of the longest period of peace between major countries on the continent in 2,000 years.

But regardless of the trappings of modernity and technology, we human beings are a bellicose species. As war historian Margaret MacMillan explains...

We like to think of war as an aberration, as the breakdown of the normal state of peace. This is comforting but wrong. War is deeply woven into the history of human society. Wherever we look in the past, no matter where or how far back we go, groups of people have organized themselves to protect their own territory or ways of life and, often, to attack those of others.

And humanity's track record of what happens when two big global powers reach the end of a game of global musical chairs isn't encouraging.

Legendary political scientist Graham Allison, as part of a research effort he heads called the Thucydides Trap Project, found that there were 16 occasions over the past 500 years when a major nation threatened to displace the incumbent ruling power – similar to the U.S. and China today.

My colleague Dan Ferris wrote about this concept earlier this year.

Of these 16 instances, 12 ended in war...

From France going to battle with the Hapsburgs in the first half of the 16th century, to the Dutch Republic and England facing off about a century later, to Japan fighting China and Russia in East Asia in the late 19th century, all the way up to World War II.

(One of the 16 cases that didn't result in war, of course, was the Cold War between the U.S. and the Soviet Union. Another that fits the bill is the U.K. and France staring down Germany for political influence in Europe over the past three decades.)

These countries fell victim to a trap that Greek historian Thucydides noted 2,500 years ago, when Athens and Sparta – the two biggest powers of the time – went to war. He wrote...

It was the rise of Athens and fear that this instilled in Sparta and made war inevitable.

A tense rivalry steeped in fear doesn't create war by itself, of course...

In 1914, the match that set off the Great Chicago Fire-like conflagration that became the Great War was the assassination of Archduke Franz Ferdinand of Austria-Hungary. That unspooled a chain of events that resulted in the death of around 20 million people.

Today, China provides plenty of geopolitical kindling ready for a spark...

Chinese sort-of-ally North Korea is like a gun-happy neighbor who at any moment might shoot out your window – or fire off a missile. Trouble in the South China Sea, where China regularly knocks elbows with five other countries for control over some resource-rich rocky islands, has been brewing for years.

Steel-toed, brass-knuckled Chinese domination of the Uighurs in northwestern China, and of Hongkongers in what was one of the world's most open and dynamic economies, could eventually spark a reaction from the rest of the world. So could China's so-called "hostage diplomacy," in which the government arbitrarily detains foreigners on bogus charges in retaliation for Chinese spies being kicked out of western countries.

The question of Taiwan, which China insists is part of its territory, is a yet-to-be-solved Rubik's Cube of modern geopolitics that periodically threatens to burst into the forefront.

Lingering questions about COVID-19 and its origins will be a source of tension between China and the U.S. for years to come...

There's also the potential for a cyberwar sparked by geeks – of any nationality – in their basement apartments to evolve into a real one involving the world's two biggest tech powers.

Then there are all those nuclear arms... and don't forget that China's navy has more ships than the American navy. China has an active military headcount almost 50% bigger than Uncle Sam's.

Former Pentagon official and academic Joseph Nye recently told the Financial Times that relations between the U.S. and China are "at their lowest point in 50 years."

Also, ironically, a slow-motion demographic collapse in China, the world's most populous country, might spur it into action sooner rather than later...

Of the 20 most populous countries, just three – the U.S., Canada, and Australia – will see an increase in the number of adults aged 20 to 49 (the most economically productive, and highest-consuming, cohort) over the next half-century.

But during that time, the number of Chinese in that critical age group will fall by 36% – or by an incredible 225 million young workers and consumers. (That's roughly the entire population of the U.S. except for the four most-populous states.)

If China is anticipating conflict, it would make sense to do it when it has the demographic wind at its back, right about now...

What's more, what's happening at home can push the leaders of big countries into conflict...

According to a recent Pew Research Center study, 73% of Americans have a negative view of China... That's an all-time high. One of the few things that both Democrats and Republicans agree on is the need to be tough on China. And despite the extraordinary – though waning – soft power of the U.S., Chinese views of the U.S. are similarly toxic.

Politicians sometimes hype external threats if they're facing political challenges or low approval ratings domestically. Nothing brings a nation together – and bolsters a politician's support or odds of re-election – like the "rally 'round the flag" effect that's created by conjuring up an external threat.

And that can be the tail that wags the dog, as former Australian prime minister Kevin Rudd writes...

Both presidents face internal political pressures that could tempt them to pull the nationalist lever... Are Beijing and Washington seriously prepared to escalate in a crisis to protect their domestic positions, conscious of the political price in each system for being seen as weak? Or are they institutionally equipped and politically willing to de-escalate to avoid disaster?

Some people – including many of those who cheered on Donald Trump for trying to call the bluff of Chinese leader Xi Jinping when the U.S. president launched the ongoing trade war – might wonder why America should even bother with what China does in its own backyard.

Part of Trump's "America First" foreign policy (which became more like "America Alone") has been to exit the foreign stage and let those foreigners over there do... whatever.

But whether or not it's politically convenient to admit it, the U.S. has a strategic interest in keeping global trade lanes open – and to allow for critical supply chains that extend throughout Asia.

The U.S. can't just give up on Asia... "Ceding the world's most dynamic region to China would do long-term harm to American workers and businesses," explained Foreign Affairs. And there's the give-them-an-inch conundrum... "A rising China would likely violate the agreement when its preferences and power changed."

Meanwhile, for China's ruling Communist Party, continued economic growth is a political imperative. Without delivering a steadily improving standard of living, the Communist Party won't be able to sustain its authoritarian control. But that's only part of the domestic pressure for China, as Allison, the political scientist, explains...

China's emergence as the number-one power in Asia – and its aspiration to be number one in the world – reflects not just the imperative of economic growth but also a supremacist world view bound up in Chinese identity... the deeply divergent civilizational values that separate China and the West... [is] an uncomfortable reality.

Thucydides Trap Project research from Allison shows that the odds of history are against the U.S. and China avoiding war... as I mentioned, three-quarters of the times over the past five centuries, when a rising power has challenged the existing No. 1, they went to war.

But that doesn't mean, by any stretch, that war is inevitable. Maybe – though this attitude is a major no-no when it comes to investing – this time is different.

The high degree of interconnectedness between countries, economies, and peoples may make global armed conflict less likely than at other times in the past.

Steven Pinker, a psychologist, thinks the "long peace" has evolved into a "New Peace," in which humanity is less violent. And a more restrained Joe Biden in the White House will be less likely than Trump to pour kerosene on the flames of disagreement and needlessly antagonize China.

But in the meantime... China and the U.S. are slipping into Cold War 2.0. And until the U.S. and China fall into Thucydides' trap, the evolving cold war will dominate technology, markets and geopolitics for years.

This one is a lot different from the first Cold War...

Though China's government is repressive and authoritarian like that of the USSR, China is a much stronger competitor in every way... it's not going to peacefully implode like the USSR.

China's economy is dynamic and growing, and is the most important trading partner for most other countries on earth... while the Soviet Union was a closed economy that helped out key allies (like Cuba) but otherwise wasn't much a part of the global marketplace.

Trade between the Soviet Union and the U.S. in the late 1980s totaled $2 billion a year – by comparison, trade between America and China is around $2 billion a day.

Philosophically, China is communist only by convenience, and it hasn't painted itself into an ideological corner. And though the threat of war between the world's two big powers today is very real, nuclear brinkmanship of the Cold War flavor has been less of a factor in to the U.S.-China competition – though if the two countries stumble towards Thucydides' trap, we could in coming years be having flashbacks of Season One of the Cold War.

Instead of nuclear arms and ideology, a principal battlefield of Cold War 2.0 is technology...

I'm talking about things like 5G, semiconductors, AI, the Internet of Things, autonomous vehicles, space exploration and quantum computing. Technology is a key driver of economic growth, business development, job creation, government control, and military strength.

And a lot of the fight regarding technology now – besides fending off hackers and cyberwar efforts to steal it – is over something that sounds as interesting as dry Rice Krispies, but which is as vital as oxygen: Technical standards.

Allow me to describe why... As think tank Policy Center for the New South explains, these are...

The basic specifications or technologies on which other technologies or methods will evolve – creating lock-in effects and path-dependency for future products and technical trajectories... [defining standards] can also carry significant implications for which technologies will dominate future markets and provide substantial advantages to those who master standardized technologies.

For example, think of the width of railway tracks... or the shape and voltage of electrical sockets... or the dimensions of shipping containers. By defining any of these for a particular market or country or area, you're laying down the terms under which everyone else has to participate.

Once you're committed to one standard (say, a country that builds thousands of miles of railroad on one gauge), you want to get everyone else to conform to your standard. In the 1970s, rival videotape formats VHS and eventual loser Betamax fought to become the video standard – with the winner dominating the VCR market for three decades.

Applied to the world of more modern technology, the struggle over – for example – the standards for 5G technology is a lot more than just which company (Huawei or Nokia, for example) gets some big orders.

What it's really about is who – in this case, China or the west – will become the standard for essential technologies for many years to come. Those standards will lay the foundations for future innovations and technological development... like the next stages of the Internet of Things, autonomous vehicles, big data, blockchain, AI, and much more.

It's not just a competition for market share... but rather, for domination of a market, and of the future of technological innovation.

Of course, there can be more than one standard. And that's another aspect of the first Cold War that will also feature prominently in the sequel: A big wall. Not one down by the Rio Grande, though.

A Chinese political risk analyst friend who lives in Shenzhen told me...

It's becoming inevitable that over the next few years, we're going to see a technology Iron Curtain.

What that means is that the world is increasingly split into two big technological and industrial blocs – based on which set of standards a country is party to.

What's happening now...

Notably, the U.S. has leaned heavily on European allies to not use Huawei, warning that anyone who uses the Chinese company's 5G technology opens the door to spying by the Chinese government. But the under-the-rug struggle is over standards.

My political risk friend in China laughs at the idea of Huawei being used to spy on its customers. While the Chinese government could pressure the company to spy on users, "If a Huawei 'back door' was discovered, its entire business would be destroyed overnight. The risk is just too great," he says.

Unfortunately for Huawei, the government has created the perception that it's the puppet master of all of corporate China... so it's not surprising that the U.S. government assumes Huawei is a Trojan horse for the Chinese government and its spymasters.

Meanwhile, the Chinese government is subsidizing technology research... last year, the Chinese government spent 200 times more than the U.S. government on AI research. And to extend its reach, China is exporting its technology standards in part via its Belt and Road Initiative, and selling cheap technology to poor countries, while building bridges with the rest of Asia.

The recently signed Regional Comprehensive Economic Partnership ("RCEP"), a free-trade agreement between 15 countries in the Asia-Pacific region, created the world's biggest trading bloc. It also gives member-country China – and its technology – preferential access to some of the world's fastest-growing economies.

Of course, a technological Iron Curtain already exists for much of the Internet...

As Cold War 2.0 evolves, the two worlds of technology will look a lot alike – though they'll be mirror images of each other... like Facebook (versus China's WeChat, which is a broad platform with far more offerings), Google (versus Baidu in China), Amazon (versus China's Alibaba and JD.com), and Netflix (versus iQIYI and others in China), for example, in services. The Chinese companies are all large, thriving businesses servicing a market of nearly 1.4 billion people... That's almost four times the population of the U.S.

The challenge ahead will be to prevent Cold War 2.0 – which also has other military and economic dimensions – from becoming a hot war. That then becomes a conflict likely bigger than most folks can imagine right now...

How do we avoid war?

It will take governments that are more concerned about the world tomorrow than their political standing today.

To start with, Allison suggests that the American government needs to figure out exactly what its absolutely vital interests are... and, for example, whether the question of Taiwan in fact is a life-or-death American concern. And then it needs to define a strategy that will make it easier for China to understand where it stands.

In the world of geopolitics, stability and predictability is like aloe on sunburn. It's a lot easier to prevent conflict if you know what the other guy plans to do, what matters to him, and why. Trump has stood up to China for American interests, but his approach has been the opposite of diplomatic... and dramatically raised the scope for conflict.

It will fall to President-elect Joe Biden to ensure that American policy towards China is straightforward and consistent. That simple change should go a long way in ensuring that the rivalry between the U.S. and China unfolds more like the largely bloodless one between the U.S. and the USSR... and not like that between the Britain and Germany that resulted in World War I.

Meanwhile, the U.S. can leverage vastly superior "soft power," which is one area where China lags, by continuing to attract the smartest people on earth to American shores to help advance its technological advantage. There is no dismantling of the tech Iron Curtain, and cyberwarfare – and Chinese efforts to steal western technology – will probably only accelerate. The digital divide between China and its tech allies, and the rest of the world, will grow deeper and wider.

One small silver lining of Cold War 2.0 is the explosion in tech investment – on both sides of the tech Iron Curtain...

The intense rivalry between the U.S. and China is driving innovation... and, as evidenced by the explosion in share prices of technology firms around the world, investors have been a big beneficiary.

And maybe all this innovation will do something truly useful – like facilitate peace, rather than war. That may be the best hope for us avoiding the fate of Germany and the British Empire, and the other geopolitical rivals that have fallen into Thucydides' trap in past centuries.

With all this technology, aren't we smarter than that?

I hope so.

New 52-week highs (as of 12/14/20): ARK Fintech Innovation Fund (ARKF), ProShares Ultra Nasdaq Biotechnology Fund (BIB), Morgan Stanley China A Share Fund (CAF), Green Thumb Industries (GTBIF), Innovative Industrial Properties (IIPR), MongoDB (MDB), Palo Alto Networks (PANW), Flutter Entertainment (PDYPY), Scotts Miracle-Gro (SMG), Take-Two Interactive Software (TTWO), Vanguard Short-Term Inflation-Protected Securities Index Fund (VTIP), Vestas Wind Systems (VWDRY), and Zebra Technologies (ZBRA).

In today's mailbag, feedback on yesterday's Digest in which we talked, in part, about COVID-19 vaccines. What's on your mind? Tell us at feedback@stansberryresearch.com.

"In [Monday's] Digest, it was remarked that you hadn't heard anyone saying s/he wanted to be first in line to get the vaccine.

"So, I'll be the first. I would be first in line if I could be. I have several co-morbid conditions that would prove a death sentence were I to contract the virus and not get the kind of treatment that guy in the White House received." – Stansberry Alliance member Stephen G.

"If the President, the Vice President, the Cabinet, the Senate and the House of Representative members and Dr. Fauci would all take the vaccine first, I'm sure a lot of concern for the vaccine effectiveness would be weakened. Let's see the 'Leaders' actually lead, put their money (and health) where their mouths are." – Paid-up subscriber Fred R.

Good investing,

Kim Iskyan
Dublin, Ireland
December 15, 2020