We’re writing about the war in the Middle East, but it’s important to note that there are many wars underway right now.
The Council on Foreign Relations shows almost thirty “major conflicts” around the world on its Global Conflict Tracker, affecting as much as 25% of the world’s population depending on what definition you use. The social and personal impacts on those in the conflict zones are the first ramification of war.
Economies and asset prices
As investors, we must consider the impact on economies and financial markets. By observing what’s happened to asset prices in previous wars, it’s possible to gain some understanding of what war usually means for investors.
War involves large-scale, rapid mobilisation of resources by government. It also involves greater borrowing and spending, changes to industrial policy, and more intervention in markets. War is inherently inflationary, except where prices are controlled, and thus the second ramification is inflationary pressure.
We know that economies affect asset prices, but, in turn, asset prices can affect economic activity, via wealth effects. Forecasting economic growth, inflation or stock market returns is hard enough during stable times, and nigh on impossible during a war. Looking back at previous wars, there seems to be no simple, recurrent pattern of returns for investors.
As a rough generalisation, though, bonds suffer; commodity prices increase when not supressed by government; and gold holds its value. Returns from equities and currencies vary wildly, depending on starting valuations, if the war was a surprise, whether or not a financial crisis ensues, and how the war ends.
How have asset prices behaved in the first three weeks of this war? First, bonds yields have risen as inflationary expectations rise and hopes for interest rate cuts fade.
Energy prices have increased, of course, but other commodity prices have been mixed. Gold has fallen by about 20% after a huge run up prior to the war. Currency moves have been modest. Effectively, markets are saying that they expect more (global) inflation, driven initially by higher energy prices. So far, so logical.
In the first two weeks of war, equities fell only modestly, suggesting that investors were ‘looking through’ this war to the other side, and expecting a relatively short conflict with limited medium-term implications for the global economy.
However, the Israeli attacks on Iran’s South Pars gas facility, and Iran’s counterattack on Qatar’s Ras Laffen LNG export facility, changed the calculus here, with QatarEnergy saying that the required repairs to the facility will reduce output for up to five years. The impact here is thus consequential and long-lasting.
Stockmarkets fell more aggressively as they absorbed this news, and at the time of writing are down almost 10% as a global average. Investors know that the longer the Strait of Hormuz remains effectively closed, and the more that regional energy infrastructure is targeted, the greater the inflationary shock and the worse the economic outcome.
Will there be a resolution soon? Although political decisions in Washington and Jerusalem will strongly influence the path of this war, it would be foolish to suggest that any political leader is in control of future events. I would argue that the third ramification of war is uncertainty, which hampers decision making.
Some other ramifications
War has other impacts, too. Perhaps the most obvious is its impact on technologies. The tools of war are changing, with drone and anti-drone technologies in the ascendancy. AI is clearly being integrated into warfare, with the Pentagon negotiating aggressively with Anthropic and Open AI on the permissible uses of their AI models, and Reuters reporting that the Pentagon will soon adopt Palantir AI as its core military system.
It could take years for us to understand the true impacts of these technologies. More obviously, geopolitics is impacted by this war: trust between countries shifts, and new alliances emerge. Relative power shifts; energy policies change; supply chains adapt.
It wouldn’t surprise me to see a series of incentives for gas storage from governments of energy importing nations – increasing a nation’s energy security at the cost of more government debt. Expect permits and generous fixed price contracts for new civil nuclear power projects.
Should investors react, or ‘look through’ the war?
Many fund managers have learned from experience that selling shares in reaction to a geo-political shock is a sub-optimal strategy. For about fifty years, it has paid to look through such shocks and ‘buy the dip’ in markets, so as to benefit from the eventual recovery.
You have to go all the way back to 1973 (and the Yom Kippur War) to find the obvious counter-example to this rule, when selling both bonds and equities was the best response. Economic ‘stagflation’ ensued in the 1970s.
Will we have stagflation again? No one knows: the International Energy Agency last week argued that “the conflict in the Middle East has created the largest supply disruption in the history of the global oil market”, while Federal Reserve Chair Powell stated that ”it’s a very difficult situation, but it’s nothing like what they faced in the 1970s and I reserve [the word] stagflation for that period.”
Most fund managers will try and look through this shock. Some fund managers have a tradition of investing defensively in normal times, but of adding to risk after a shock (we’re invested in one such fund) – their behaviour will be instructive. Some very active funds (mostly hedge funds) automatically reduce risk after experiencing losses. Index funds, of course, must remain fully invested.
In summary, as investors, we know that this war represents an inflationary shock and that opening the Strait of Hormuz, and preventing further destruction of energy infrastructure, is what matters most now for asset prices.
We don’t know what path this war will take, and we’d be sceptical of anyone who did claim to know. By investing largely in short-dated bonds, our bond positioning had been very conservative prior to the war, and this has helped performance.
Amongst equities, we hold a mix of passive and active funds. Cash and money market holdings have obviously been resilient. And, as mentioned, the managers of some of the funds we hold are experienced at investing defensively, but then buying shares after shocks – this provides upside potential for later.
James Clunie is a member of the Tyndall Partnerships Investment Committee