Retirement Isn’t Happening

By John Mauldin


I have long said I don’t want to retire. I enjoy my work. It’s not too physical, other than the travel (which is finally beginning to wear on me). Also, my savings are not yet sufficient to sustain the retirement lifestyle Shane and I want. I could retire now but would rather wait.

Fortunately, I have the choice of continuing to work and adding to those savings. I realize many Americans don’t have that luxury. Some have to retire because of illness, or because their work requires more physical ability than their age allows. Many others don’t retire because they just can’t afford to.

TV commercials suggest a financial advisor is key to a leisurely retirement. A good one certainly can help, but only to the extent you’ve saved enough cash to give them something to invest. And as we’ll see, many Americans haven’t.

My readers tend to be conscious of these things. You probably have above-average income and savings. Maybe your retirement plan is on track, but that doesn’t mean you can rest easy. We all exist within a society and an economy. Its problems are ours, too, as we may find out when taxes rise to help pay for others to retire.

Today, we’ll look at the state of retirement in America, updating some data I shared a couple of years ago. Then we will look at some strategies to keep your plan realistic and on track.

Social Security Is Not Enough

How much money will you need to retire, and how much will you have? Answering those questions is one reason a good financial advisor is worth every penny you pay them. But let’s talk about some generalities.

Say you want to stop working at 65. You’re in good health and your family tends toward long lives. You expect to reach 90, having been retired for 25 years. Will Social Security alone be enough?

If you spent most of your life paying as much as legally possible into the system, and you retire in 2019 at age 65, your monthly benefit will be $2,757, which is then indexed for inflation (at least under current law). It jumps to $3,770 if you delay retirement until age 70.

Since I am not yet 70 for another eight months, I really haven’t paid much attention to what I will get when I start my Social Security. I assumed like the charts that I’ve seen below that it would be a couple of thousand a month. I was surprised to learn I may get significantly more. Considering how much I’ve contributed over 50+ working years, it’s probably not that great a return. Yet most people get less. Here’s the distribution.

A solid majority of Social Security recipients receive $2,000 a month or less, and many less than $1,000. The average benefit is $1,413, according to Social Security’s latest fact sheet. If that’s all you have, your retirement lifestyle is not going to include many cruises and golf tournaments.

Of course, it shouldn’t be all you have. Social Security was never supposed to be a complete multi-decade retirement plan. It was designed to keep retired workers out of poverty at a time when lower life expectancies kept retirement much shorter for most—if they lived to 65 at all. Now we live longer, and we have higher expectations, which political leaders have done little to dampen. Often they’ve done the opposite.

Bottom line: Social Security probably won’t give you much security. You need more.

Is That All There Is?

Ideally, people should avoid relying on Social Security and accumulate other savings as well. Many, perhaps most, do not. The reasons vary. I suppose some just spend their money unwisely and neglect to save anything. But income data says many Americans can’t afford to both live a typical middle-class lifestyle and save enough to finance a 20+ year retirement. Here’s a Doug Short chart to illustrate.

In constant dollars and adjusting for hours worked, average weekly earnings for non-managers are now $779, and that’s an almost 40-year high. Millions of those now approaching retirement age spent their entire lives earning the equivalent of $40,000 a year, at most. Little surprise they don’t have six-figure retirement savings. The simple fact of the matter is, it takes enormous discipline to save even 6% for your 401(k) at that income level.

In a country of 330+ million people, shockingly few have enough retirement savings to support the stereotypical leisurely golden years. Dennis Gartman shared some disturbing numbers last week.

Firstly, we note that there were 133,800 “millionaires” late last year with sums of more than $1 million in their retirement accounts, which on its face, sounds like a large number. But that is down from 187,400 at the end of third quarter of last year, according to Fidelity Investments. According to the Federal Retirement Thrift Investment Board, which oversees TSPs, as of the end of last year, there were 21,432 “millionaires” compared to 34,128 at the end of September in those TSP accounts. The 4th quarter of last year was a disaster to those solely involved with equity investments; it was merely “horrible” for those with a more balanced investment portfolio.

But these are not really our focus this morning; our focus is that the average balance in 401(k)s, 403(b)s, or IRAs fell to $95,600 at the end of last year from $104,300 at the end of the 3rd quarter for 401(k)s, to $78,700 from $85,100 for 403(b)s and to $98,400 from $106,300 for IRA balances. It was not the drops in value that caught our attention; it is the fact that the averages are only at or near $100,000, forcing us to wonder what sort of retirement can the average retiree look forward to with this minimal sum of money set aside? Is that all there is? Really? Is that really all there is? If so, we are in very real trouble.

The average IRA balance is not necessarily indicative of retirement savings generally, as many other vehicles exist, but it’s probably a good proxy. And an average of around $100,000 won’t yield much of a supplement to the monthly Social Security benefits described above.

I found this chart on CNBC, which also refers to the study Dennis quoted:

Many of our parents and grandparents had defined benefit plans and other guaranteed retirement benefits from the corporations they worked for. Those are increasingly an endangered species in the private sector while 401(k)s, IRAs, and Social Security aren’t giving the average person enough to retire on anything close to a comfortable lifestyle.

Average household savings for the bottom 40% are under $30,000. Median household savings for the bottom 40% are zero dollars. Clearly the top percentiles and especially the top 1%, skew the average. Note the bottom lines in the chart below is not the top 20%, but the top 1%. And the top 1/10 of 1%? Don’t make me giggle.


The point is that the 80% of households have less than $100,000 in savings.

That is not enough for even a minimal retirement. Let’s make the very aggressive assumption that you can take 5% a year from your savings plan. If you have $100,000, that’s $5,000 yearly or about $417 a month—on top of your Social Security. And if you don’t have your house paid off? Or car?

The Indexing Problem in Retirement Accounts

Nearly every article I read on this topic talks about the fourth quarter’s losses, but something else leapt out at me.

Back-of-the-napkin math (and a rough napkin at that) says these retirement accounts are at least 50% invested in equity index funds. Some of you are now asking, “What’s the problem? All those index funds have come back. Everybody is back to where they started.”

Not so fast, Jack. As I have said until readers are probably tired of it, bear markets (which the last little bump in December barely qualifies for) that are not accompanied by a recession have V shaped recoveries. Which is exactly what we got.

Bear markets that are accompanied by recession take a very long time to recover and will likely be in the 40 to 50% loss range. A 50% loss requires a 100% gain to breakeven. That took about five years from the bottom of the last bear market.

Now, let’s look at the chart from the S&P 500 for the last 10 years courtesy of Macrotrends. Note that the S&P is up well over 3.5x (give or take) in the last 10 years. But the 401(k)s and IRAs did not even double. Some of that is due to investors getting out at the bottom and back in later. Some is maybe due to high bond allocations in 2009 (bond funds had done very well, and we know people chase returns). But nonetheless, retirement funds have not performed as well as you might expect.

Source: Macrotrends

Further, when that next recession and bear market hit, it will take even longer to bounce back. The recovery will be even slower than this last one. As the research I’ve shared in previous letters shows, large amounts of debt slows recoveries. Very large amounts create flat economies. We are approaching large amounts in the US.

(Think what that large debt and recession did to Japan. What’s that song? Turning Japanese by The Vapors. The official 1980 video is not politically correct by 2019 standards but has some interesting historical tidbits along with the WWII propaganda silliness.)

In any event, the next recession will shortly cause a $30 trillion debt for the US government, soon to be followed by $40 trillion. Will that much debt turn us Japanese? That’s not entirely clear, since we have the world’s reserve currency and a unique role in global commerce and finance, but I think the recovery will be much slower, at a minimum. A double dip recession is clearly possible, making those stock market index fund losses even worse.

You must have some kind of strategy for dealing with market volatility. I don’t know how many times I can say that. But that’s the case only if you have savings to lose. Millions don’t, which means they have an even harder challenge.

Double Problem

I speak at a variety of investment events every year. Some are for high net worth investors, but others draw a broader crowd. Lack of retirement savings, both their own accounts and those of their neighbors and the rest of the country, is by far the most common worry I hear at those events. Sometimes it verges on panic, even among people who spent decades earning good incomes and saving all they could.

The Baby Boom generation that is now reaching retirement age has a double problem. First, many of its members didn’t save enough cash to support a comfortable retirement. Second, those many who did save enough could see it evaporate when we get into another bear market, which we certainly will at some point.

What can you do? Some suggestions.

First, whatever your age, save as much as you can. Stash it in your IRA, 401k, defined benefit plan, or whatever other tax-advantaged vehicles are available to you. Then save more outside them. If you look at your income and expenses and think “I just can’t do this,” think again. Start saving something, even if it’s $20 or $50 a month. Get in the habit and it will become easier.

(A personal note: If you have a small business, you should at a minimum have 401(k)s and business employment retirement plans. If you’re making a relatively good income, you should think about getting your own defined benefit plan. DB plans are not just for monster corporations. They can work extremely well for small, very closely held businesses. You can put away over $2 million of total contribution over your lifetime. If you start your plan and your age is 60, those can be some hefty annual contributions. Just another reason a good financial advisor can be useful.)

Second, invest in programs that give you at least a chance to dodge bear markets. Buy and hold works in theory, but not for most people because we are humans with emotions. We should recognize that and take steps to control it. As I continually say, we should invest in trading strategies and not buy-and-hold index funds in this environment. And of course, fixed income strategies like actual bonds, real estate, private credit, and so on.

Third, forget about retiring at 65 unless you are in truly dismal health (in which case, financing a long retirement is probably not your top worry). Keep working a few more years, even if you have to find a new career that better fits your circumstances. This will let your capital accumulate longer and you’ll get a higher Social Security benefit by waiting until 70 to start collecting.

Fourth, take care of your health. It will both reduce your medical expenses and keep you in shape so you can work and produce income longer. Further, staying physically active will keep you healthier. If that physical activity is involved in a job, that counts. There are studies that actually associate retirement with lower life and health spans. But gym time and a healthy diet are still important.

I’m personally doing all of the above, and I’m still concerned it won’t be enough. Laugh if you want to, but that concern for me is real. Relaxing is not in my personal makeup. I know a lot of people like me. I can only imagine the panic of those less fortunate and prepared. Their problems are yours and mine, too, because an economy with so many low-income elderly people has less opportunity for everyone.

While I think socialist and progressive policies are terrifying, they are spot-on when talking about wage and income disparity. Corporate profits are at their highest level ever percentage wise, yet labor is back to Great Depression levels. That is not healthy for our society. I am not going to start singing 1930s union songs, but this is a problem we must address. It is only going to get worse and the longer we wait, the more expensive the solution is going to be. Those of us with a libertarian bent may just have to suck it up and become part of the solution.

Cleveland, Eye Surgery, New York, and More Cleveland

Shane and I fly to Cleveland on Monday. I will speak to the CFA Society for lunch and then rush to the Cleveland Clinic for a bunch of exams prior to having cataract surgery on my left eye on Wednesday. Friday, we fly to New York where mortgage guru Barry Habib is taking us to an afternoon Broadway show and then dinner. Shane and I will have brunch on Sunday with Suze Orman and K.T. Both meetings are big personal thrills for both of us. Then some business meetings Monday morning and back to Cleveland to do my right eye the next week.

I am told that cataract surgery is not that big a deal for the vast majority of people, and I am going to Cleveland simply because of the quality of the surgeon (Dr. Edward Rockwood). I expect the procedures to go well and to be able to write a letter next week. But of course, things don’t always work according to plan. If you get no letter from me next week, it will be because the recovery is taking a little longer.

I finish this letter at home in Puerto Rico. For whatever reason, the electricity went off here and the generator didn’t immediately kick on. It turned out to be out of diesel fuel. Problem quickly fixed. Candidly, I didn’t pay as much attention to the generator process as I should have. I am glad the power went out on a beautiful day rather than in a hurricane. I am being trained tomorrow to deal with it, where I will pay very close attention and then will set up regular maintenance. Just one of the pleasures of living in paradise.

Well, that and an extra two hours of flight time to get anywhere as opposed to being in Dallas. But it is worth it. Shane and I are extremely happy to be living where we are. And now after a fabulous sushi dinner with friends, we are back at the house and the electricity is on.

Have a great week. I am looking forward to having at least one eye that isn’t blurry as I write the next letter, which will make it much better than simply a great week!

Your wishing I knew how to solve the retirement crisis analyst,

   John Mauldin
Chairman, Mauldin Economics

Behold the giants, the vast new buyout funds of private equity

Blackstone, Apollo and Carlyle lead the race and hope for lucrative profit streams

Chris Flood

A giant from French arts company Royal de Luxe is pictured in Liverpool. New PE funds from the likes of Blackstone and Apollo will also tower over rivals © Oli Scarff/AFP/Getty

The maxim that “size is the enemy of performance” for investment funds has been abandoned by private equity managers in favour of the motto “big is beautiful”.

Blackstone, Apollo and Carlyle are leading the drive to create vast buyout funds that will deliver lucrative profit streams to their top executives. Cinven, Apax, Permira and Advent are also set to join the race to create a new breed of mega-funds that are redefining the boundaries of the private equity industry.

The managers’ claims that they have the skills and resources to run these huge vehicles will be put to the test because the outlook for returns from PE strategies is weakening.

Rising investor inflows into PE funds over the past decade have led to intense competition among managers to win deals. As a result, deal valuations have risen to record levels. To secure deals, private equity managers are paying between 11 and 12 times earnings before interest, tax, depreciation and amortisation, a higher multiple than at the previous peak of the market in 2007, along with leverage multiples about six times ebitda, says Willis Towers Watson, the world’s largest adviser to pension schemes.

The fear is that deals have been “priced for perfection” and so returns could suffer if there is an economic downturn.

The response of some of the industry’s most experienced players is to look for areas where competition from smaller rivals is less brutal.

Blackstone is raising $20bn for its latest PE fund, a target it expects to exceed because of the high demand from investors. No explicit guidance on returns for the new fund, known as BCP VIII, was provided at an investor day in New York in September. Blackstone executives, however, repeatedly stated their confidence that performance would not deteriorate.

Joe Baratta, Blackstone’s global head of private equity, said at the investor day that the group has the potential to earn about $1bn a year from “carry” [performance fees] partly because of the scale of its PE funds, which have delivered annual net returns of 15 per cent since their launch in 1987.

Performance has weakened in the years following the financial crisis with the latest vintages of funds delivering lower returns compared with earlier, smaller vintages that were established when the industry was less mature and less competitive.

Mr Baratta said that “only a handful” of rivals could compete with Blackstone in large-scale PE deals and that three-quarters of these transactions were negotiated bilaterally with a seller.

This reduces the risk of overpaying.

“Competition for the very large deals is thinner as perhaps only four or five managers can write the cheque: they can be more rational about pricing,” said the head of private equity at a European pension fund who did not wish to be identified.

He believes that downside risks are more muted for the mega PE funds as their managers tend to target larger, more stable, companies that are better equipped to weather any market downturn or economic storm.

This requires a price to be paid in performance.

“Returns tend to be in a tighter band for mega PE funds, unlike the mid-market where you might earn 3.5 times your initial investment but where there is also a greater risk that the principal will be lost,” the private equity head said.

Many institutional investors believe there is less risk in working with the larger private equity funds, according to Andrew Brown, senior consultant at Willis Towers Watson.

“They are run by very smart people who are very good at negotiating and structuring deals so there is downside protection,” he said.

In addition, more pension schemes are looking to save governance costs by thinning out their list of external managers.

“An investor can write just one cheque and they might get a fee discount if they also agree a commitment to one of the private equity manager’s newer strategies,” said Mr Brown.

He is concerned that deploying capital for large PE funds could be a problem as there are few attractive buyout deals at the upper end of the market.

“There are not many available good buyouts deals that can be done at the upper end of the market. Deal pricing and debt multiples also tend to be higher [there]. As a result, more managers running large funds are reducing the target return ‘hurdle’ above which they can claim performance fees,” cautioned Mr Brown.

Robert Crowter-Jones, head of private capital at Saranac Partners, a London wealth management group, believes that investors in large PE funds should be braced for lower returns.

This is partly because of the weaker growth prospects of the more mature companies targeted by large funds. He is also concerned that deploying the huge sums of money raised over the life of a large fund could present problems. This could further bite into returns to investors.

“Passing 15 per cent plus annualised returns back to the fund investor will be increasingly difficult,” said Mr Crowter-Jones. Carlyle raised $17bn last year in new capital for private equity strategies.

“We have the ability to transact larger and more complex deals,” said Kewsong Lee, co-chief executive, speaking this month at the 2018 results presentation by the $216bn New York-listed manager.

Mr Lee also acknowledged that deploying capital could be difficult.

“High levels of dry powder [unallocated capital] across our industry combined with slowing global growth in volatile markets could affect both investment pace and realisations [money raised from asset sales] in 2019,” he said.

Another issue troubling investors is how the largest PE funds will perform in the event of a downturn. Fears have risen that the US economy could move into a recession as a result of interest rate increases.

Michael Elio, a partner with StepStone Group, a $46bn New York group that builds portfolios of PE funds, points out that large buyout funds maintained “mid to high single-digit returns” in the difficult years after the financial crisis.

“Loss ratios remained low in the last downturn because banks were willing to ‘amend and extend’ the terms of loans to prevent losses at the operating companies owned by large private funds.

“But a lot of the leverage now sits with private debt funds and private credit funds. They may not be as willing to amend and extend lending terms in the next downturn,” said Mr Elio.

Intense rivalry will hinder strong returns

Private equity managers are unlikely to deliver the strong returns of the past thanks to increased competition.

Higher investor inflows into PE funds have led to intense rivalry and managers also face a challenge from sovereign wealth funds and cash-rich publicly traded companies when pursuing buy-out deals.

As a result, deal valuations have risen to record levels and this has reduced the returns PE managers are likely to earn.

Investors should expect PE to deliver annualised returns of 3.9 per cent after inflation and net of fees over the next decade, only a modest advance over the 3.1 per cent net real returns expected from low-cost US stock market tracker funds, according to AQR, the $196bn US alternative investment manager.

“Private equity does not seem to offer as attractive an edge over public market counterparts as it did 15 or 20 years ago,” said Antti Ilmanen, a principal with AQR.

Institutional investors, however, retain high expectation for returns from PE strategies. They have continued to increase their allocations which leaves them open to disappointment.

PE managers tend to buy smaller companies and add significant debt to their balance sheets after the acquisition. This implies that an appropriate performance benchmark for PE strategies would be a leveraged small-cap equity index, rather than the S&P 500 index.

AQR’s analysis suggests that PE outperformed the S&P 500 by 230 basis points a year, net of fees, between 1986 and 2017. That outperformance dropped to just 70bp a year compared with a 1.2x leveraged Russell 2000 (US small-cap stocks) tracker.

“The bottom line for many investors is that private equity firms have clearly delivered higher net returns than the S&P 500 over the past 30 years, even if those excess returns could largely be accounted for by using more representative publicly traded benchmarks,” said Mr Ilmanen.

Performance data for private equity managers are commonly presented as internal rates of return but these are relatively easy to manipulate.

A better metric is the “public market equivalent” which assumes the same amount is invested at the same time in the stock market as the commitments made by a private equity fund. This metric suggests PE funds have delivered virtually the same returns as the S&P 500 each year since 2006.

Why a US-China Trade Deal Is Not Enough

If the US and China fail to reach a comprehensive trade agreement, bilateral trade will plummet, and the unraveling of the US-China economic relationship would accelerate. But even if an agreement is reached, that unraveling will continue, because, at its core, the trade war has always been about security.

Minxin Pei

us china trade negotiations

WASHINGTON, DC – As Chinese and American trade negotiators meet in Washington to try to forge an accord on trade, observers are largely focused on the countries’ economic disagreements, such as over China’s subsidies to its state-owned enterprises. But to think that an agreement on trade will protect the world from a Sino-American cold war would be as premature as it would be naïve. Of course, a trade deal is highly desirable. The collapse of trade talks would trigger a new round of tariff hikes (from 10% to 25%, on $200 billion of Chinese goods exported to the United States), driving down global equity prices and spurring businesses to move more of their activities out of China. Amid tit-for-tat tariffs, bilateral trade would plummet, and the unraveling of the US-China economic relationship would accelerate, creating widespread uncertainty and higher costs. 
But even if a comprehensive agreement is reached – either before March 1 or a few months from now – that unraveling will continue, albeit in a more gradual and less costly way. The reason – which many investors and corporate executives have failed to recognize – is that the trade war is not fundamentally about trade at all; rather, it is a manifestation of the escalating strategic competition between the two Powers.
True, the US has legitimate complaints about China’s trade practices, including its violations of intellectual-property rights, which, after more than a decade of failed diplomatic engagement, warrant a tougher stance. But if the US and China were not strategic adversaries, it is unlikely that the US would initiate a full-blown trade war that jeopardizes trade worth over a half-trillion dollars and billions in corporate profits. While China may lose more from such a conflict, American losses will hardly be trivial.

The US is prepared to sacrifice its economic relationship with China, because the risks posed by the two powers’ conflicting national interests and ideologies now overwhelm the benefits of cooperation. At a time when China, which has been rapidly gaining on the US in terms of international influence, is pursuing an aggressive foreign policy, America’s emphasis on engagement is no longer tenable.

A growing number of other stakeholders, including China’s nearest neighbors, seem to agree with US President Donald Trump’s move toward confrontation. This shift is epitomized by America’s attacks on the Chinese telecom giant Huawei. Beyond having Canada arrest the company’s CFO, Meng Wanzhou, who now awaits an extradition proceeding, the US has been warning allies not to use Huawei technology for their 5G wireless networks, for security reasons.

A US-China trade deal cannot resolve these issues. Indeed, even if the current trade conflict’s most acute manifestations are resolved, both countries will internalize one of its key lessons: trading with a geopolitical foe is dangerous business.

In the US, there is a growing consensus that China constitutes the most serious long-term security threat the country faces. Trade agreement or not, this is likely to lead to more policies focused on achieving a comprehensive economic decoupling. Severing an economic relationship built over four decades may be costly, the logic goes, but continuing to strengthen your primary geopolitical adversary through trade and technology transfers is suicidal.

Likewise, for China, the trade war has exposed the strategic vulnerability created by overdependence on US markets and technologies. Chinese President Xi Jinping will not make the same mistake again, nor will any other Chinese leader. In the coming years, China, taking advantage of any lull in the trade war, will also work to reduce drastically its economic dependence on the US.

But, however compelling the strategic rationale may be for China and the US, the economic decoupling of the world’s two largest economies – which together account for 40% of global GDP – would be disastrous. It will not only fracture the global trading system, but also eliminate any constraints on the Sino-American geopolitical rivalry, raising the risk of potentially devastating escalation.

The only way this outcome can be avoided is if China steps up credibly to assuage America’s security concerns. This means that rather than focusing on, say, purchasing more American soybeans, China should be dismantling the military facilities it has built on its artificial islands in the South China Sea. Only such a bold move can arrest – if not reverse – the rapid descent into a Sino-American cold war.

Minxin Pei, a professor of government at Claremont McKenna College and the author of China’s Crony Capitalism, is the inaugural Library of Congress Chair in US-China Relations.

HSBC Ain’t as Simple as Investors Might Like

The bank’s disappointing earnings undermine the idea that most of its story is about growth in Asia

By Paul J. Davies

HSBC HSBC -4.02%  didn’t perform much worse than its rivals amid the market mayhem at the end of last year, but its 2018 results still gave investors a shock on Tuesday.

The Asia-focused bank missed consensus forecasts for full-year underlying pretax profits by 24%. The bank argued analysts should have seen this coming given other global banks’ results. HSBC, though, is meant to have a simple story, driven by Asian loan growth. These numbers underline that it is still a complex beast.

For sure, HSBC wasn’t alone in having its investment bank suffer during the late-year market turmoil, which hurt bond and currency trading in particular. Trading revenue was down $519 million compared with 2017. But that drop was outstripped by a harder-to-predict $600 million drop in revenue from the bank’s insurance business, where falling markets hit the value of its investments while driving up the cost of its long-term liabilities.

Net-interest income was another disappointment, again for obscure reasons. The main problem was the separation of HSBC’s U.K. retail bank to meet so-called ringfencing rules. The split means that ultracheap U.K. deposits are no longer available to fund HSBC’s investment bank, much of which is based in Europe.

As a result, the bank’s net-interest margins declined both in the U.K., where it now has even more excess deposits, and in the rest of Europe where it needs to hold more safe, liquid assets while having to rely more on costly wholesale funding.

HSBC is meant to have a simple story, driven by Asian loan growth.
HSBC is meant to have a simple story, driven by Asian loan growth. Photo: Anthony Kwan/Bloomberg News 

The bounceback in financial markets this year is already helping HSBC to recover some lost revenue, especially in insurance. But with uncertainty over the path of global interest rates, expectations for interest revenue are likely to come down.

Ultimately, it’s looking harder for HSBC to hit its 11% return on tangible equity target by 2020, up from 8.6% last year. More than that, these results are a stark reminder that the bank is more complicated than many would like to think. Both factors will likely drag down its valuation premium over European peers like Barclaysand Credit Suisse .

The US, Germany and the Strategic Divide in Europe

The NATO divide is not just a trans-Atlantic split but a European one as well.

By George Friedman


The Munich Security Conference, an annual gathering of the trans-Atlantic security community, was held this weekend in Germany. Two things stood out. First, Germany is trying to redefine NATO’s primary functions in important ways. Second, the tensions between the United States and Europe are being redefined as tensions between a U.S.-led bloc and a German-led bloc. While Germany claims to speak for all of Europe, it’s actually leading a faction within the Continent against the United States and a group of European nations whose interests are more aligned with those of Washington.

At the conference, the most important disagreement between German Chancellor Angela Merkel and U.S. Vice President Mike Pence was over Russia. The American view is that Russia is an adversary whose strategic interests are at odds with those of the Western alliance. Its behavior in former Soviet buffer states, in the Middle East and in intelligence operations represents a threat that must be contained and countered. The Russian decision to support Venezuelan President Nicolas Maduro is a minor example of Russian hostility to Western governments, many of which have thrown their support behind the Venezuelan opposition.

The German position is that the dispute with Russia should be seen not as a security or military issue but as a political one. According to the Germans, the problem should be solved through the integration of Russia into the European system. But this view isn’t shared among all European states. The United Kingdom, which criticized Russia for allegedly poisoning a former Russian spy in the U.K., does not see Moscow as a benign actor. Poland and Romania, both on the frontier of the former Soviet Union, view the Russians as a major military threat. Warsaw fears an accommodation between Germany and Russia because historically such accommodations have been disastrous for Poland, a country that didn’t emerge from Russian, German and Austrian domination until after World War I. The Baltic and Scandinavian states also see Russia as a threat. Of course, this perspective is most pronounced in Ukraine.

Some of these countries are part of NATO and some are simply part of the Western bloc, but all share the American view that Russia is a security threat and military measures must be taken to block Russian aggression. On this topic, therefore, Germany doesn’t speak for Europe. There are other European nations that share Germany’s perspective on Russia, but Berlin can’t claim a European consensus on the matter. Thus, the perception that the main divide in NATO is between the U.S. and all of Europe is false. Both in North America and in Europe, the split is far more complex.
Different Interests
The U.S. and Germany have different approaches to Russia because their national strategies are also different. For roughly 100 years, the primary focus of U.S. strategy was to resist the domination of Europe by a single power. The United States intervened in the two world wars to block the German drive for hegemony. It engaged in the Cold War to prevent Soviet domination of Western Europe. This was the core U.S. strategy for a century, and Germany was at the center of it, both in the world wars and, as the primary zone of confrontation, in the Cold War. As Russia became more assertive in 2008 in Georgia, the strategic reflex was to begin the process of containing Russia. It is important to see that, apart from peripheral actions in the world that are far less predictable, this central strategy of blocking domination of a hegemon is both predictable and institutionalized.

Germany’s national strategy, on the other hand, has evolved from its own experience. It was fragmented before 1871, then united in 1871, divided again after World War II, then reunited after the Cold War. Since then, Germany’s strategy to achieve its primary imperative of maintaining maximum unification has been to maintain prosperity, solidify a European system that supports this prosperity, and avoid all military conflicts that would threaten German territorial integrity.

Germany and the U.S., therefore, have different interests. The U.S. and Poland are now reaching military cooperation agreements, which frightens Germany because it believes they might trigger its worst nightmare – another European war. Germany doesn’t want a buildup of U.S. forces in Poland or Romania; it wants a political settlement with Russia. But that process is too uncertain and lengthy for some Eastern European states. Thus the two blocks within the Western alliance are deeply at odds. The Germans see the Americans as reckless; the Americans see the Germans as getting a free ride. They can’t agree on what the next steps should be, much less what the real risks are.
A Deeper Problem
Behind all this, however, is a deeper problem. Germany needs the European Union as a market for its goods. But the EU is fragmenting for both economic and political reasons. The second-largest economy in Europe, the United Kingdom, is leaving in the midst of threats and recriminations from the EU. Italy, the fourth-largest economy, is in conflict with Brussels. Meanwhile, the EU is attacking Poland and Hungary for political deviation. A core component of German strategy is splintering, and Germany may not be able to hold it together.

In Munich, Merkel emphasized that NATO is not just a military alliance but a political one. But that’s true of every military alliance, so why did she need to state that now? NATO’s primary significance is not its political functions but its military component; it can draw members into combat in the defense of another member. This is what Germany fears. It doesn’t want to be pulled into military action or trapped between combatants. One way Germany has defended itself is by maintaining an extremely limited military capability. It has been able to do so because it isn’t facing any direct military threats, since Poland and Romania act as buffers and since the U.S. has provided both countries with military support. So even though the U.S. and German strategies diverge, Germany benefits substantially from the U.S. strategy because it gives Berlin room to maneuver.

The American strategy is simple, as good strategies should be. The U.S. doesn’t want a single country to dominate Europe or Asia. It’s trying to achieve this through fairly simple actions like deploying troops to Poland, raising tariffs on China and maintaining a presence in the South China Sea. Germany’s strategy is more complicated. It’s searching for a political solution to the resistance it’s facing from coalition partners. And it’s trying to hold together a fragmented Europe. Meanwhile, it can’t afford a split with the global power, the United States. As always, there’s no elegant solution to the German strategic problema.