War And Financial Markets - What Are The Implications?
One of the biggest drivers of the Age of Austerity is, regrettably, going to be the need to spend on other priorities: Namely, military defense and security.
The "peace dividend" that the West received with the end of the Cold War is no longer.
War and all the death and destruction that comes with it, is back on the global menu.
This is not great and raises the rather uncomfortable question:
How should non-professional investors think about war?
It is always unpleasant to write about war. It is particularly so when you then need to speak matter of factly about the implications for other arenas beyond the most obvious.
Yet war is a fact of life. Increasingly so, for millions of people around the world.
At present, there are at least 30 active conflicts around the globe. While most are terrorist insurgencies or civil wars those are perfectly awful in their own right.
More worrying still, there are now 2 major regional conflicts.
Both Israel-Palestine and Ukraine-Russia are serious wars and they also have the very real possibility of spiraling out of control and becoming a global conflict.
Right now Israel is the big worry because of decisions being made in Tehran, not Tel Aviv.
You might not be aware but just in the last week:
Iran-backed Hamas firing missiles at Israel.
Iran-backed Hezbollah also firing at Israel.
Iran-backed Houthis firing on US warships.
Iran-backed Islamic Resistance firing on US forces.
In fact there is so much happening you likely missed the last 2 of these developments entirely. We nearly did. You can see how this can easily get out of hand.
This weekend the US State Department has formally told US citizens in Lebanon to leave while they still can. That is pretty ominous.
Whether that ends up being the right call is sort of irrelevant. Whatever the exact probability of a larger "hot war," the likelihood is surely rising.
There is one argument that while all of this may be true, it doesn't ultimately matter very much. Wars come and go but rarely really disrupt markets overly.
This (very useful) table from Bank of America has been making the rounds:
It clearly shows that most of the time, military conflict doesn’t really disturb financial markets overly.
This might be true this time but we would be very cautious about blithely assuming it will be the case. There is a reason that the US is preemptively striking Iranian backed militias in Syria and stalling Israel's ground invasion to try and send some very clear messages throughout the region.
We have been critical of the Biden administration in the past but there is little doubt they understand the gravity of the current situation in the Middle East. Once again the US is trying to focus on Asia and especially China but instead being pulled back into our least favorite geopolitical region of the world.
Regardless of whether a major conflict occurs, there are two clear implications of this new environment.
Be very careful thinking these conflicts have nothing to do with you, no matter who you are and....
Understand that, even in the best case scenario, these conflicts suggest a very different world going forward.
By different world we don't just mean different performance for financial markets but rather a different macroeconomic regime.
The long and the short of it is that, expecting things to work as they have in the pre-Covid past is highly unwise.
There are a few likely outcomes:
The first is that state spending will go up.
Governments will borrow this capital.
Spending money on war and munitions is not very productive.
Let us expand on each of these briefly.
Countries all around the world - and not just the US or even Western ones - are already spending more money on their armed forces.
This spending will likely rise from here - perhaps quite a bit.
When it happens - especially in an era of higher interest rates - this will require cutting spending MORE in other areas. Furthermore, this spending will be very significant perhaps exceptionally so.
This is because many countries are trying to manage three things in parallel: 1) rebuilding stocks of existing weapon systems 2) provide more for Ukraine (or Israel or other Arab countries nervous about Iran) 3) research and develop new systems and weapons based on lessons learned in the conflict in Ukraine and Israel.
Each of these goals would be expensive in their own right, in combination it will be ruinously expensive even for rich countries. Perhaps "especially for rich countries" that have gotten used to having their security and not paying for it too.
Second, there are big differences here but nearly all countries will be borrowing more, not less, to accomplish this military build up.
Heavily indebted economies are going to have to sell more debt more on the open market.
This is one of the many reasons that investors are scared of owning bonds right now. They know that spending is going UP, not down.
Many of them are also aware that bondholders can get hosed out of strategic necessity if and when war gets involved. That is unpleasant enough but even if it doesn't happen, greater borrowing will mean tough tradeoffs and conversations we outlined in our arguments around the deficit.
Lastly, borrowing and spending by governments on munitions and weapons is additive to the economy but it isn't very productive.
After all, you are spending money and building things to blow stuff up.
Yes, it is true that a lot of research and development for military purposes can advance technology significantly and have very productive usages in other arenas.
That could certainly happen in this case but those development cycles are very long and hard to predict. Furthermore spending billions on arms for war will be a very, very tough for societies that have gotten used to comfortable welfare states and lavishing money on other non-strategic priorities.
In a way this is understandable, even putting war aside, the world has a lot of challenges at present with climate change, demographic change, technological change and economic inequality at the forefront. But we will have to add "rearmament" to the list.
In summary you are dealing with:
Great state spending + more government borrowing + less productivity which all = a higher inflation, higher rate and lower productivity world than we are used to.
This new world isn't yet "priced in" to the markets and so in the same way that we thought you should care about inflation before the central banks did, we think you should care about the world of war long before most investors clue in and start to accept that these conflicts are both real and not going anywhere.
We think we know what will eventually cause the light bulb to go off though:
Greater spending on arms at the cost of other socio-economic priorities and outcomes.
That will be a significant shift and, in our opinion, it is just around the corner.
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