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Investing in a Time of War
08 Mar 2022
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War is an ugly thing, but not the ugliest of things: the decayed and degraded state of moral and patriotic feeling which thinks that nothing is worth a war, is much worse. John Stuart Mill, 19th century.

In the summer of 1914 the heir to the Austro-Hungarian Empire, Prince Franz Ferdinand, and his wife were assassinated by a Bosnian Serb activist on a visit to Sarajevo. Austria threatened to invade Serbia in retaliation. Russia, in turn, argued that if Austria invaded Serbia, Russia would invade Austria, as the Serbs were considered "blood brothers" given their Slavic status, Orthodox religion, and Cyrillic alphabet (tell that to the Ukrainians now). The Prussian Empire, Austria's ally, told Russia that if Russia dared to invade Austria, then Prussia would declare war on Russia.

France, honouring its alliance with Russia (the entente cordiale) threatened Prussia with invasion if it attacked Russia, a threat joined by the United Kingdom, also a signatory to the entente.

All these things were happening in the last days of July 1914.

How did investors react?

By ignoring them.

At that time, the "risk-free" asset was the British bond (the Gilt) and risk premiums were calculated on that bond. Well, risk premiums on Russian, Prussian, Austrian, and French bonds were at record lows despite the maelstrom that was about to devastate Europe. On August 11, the First World War began; a conflict that not only left 17 million people dead, but also ushered the ruin of many economies, and the default on many of the bonds mentioned here (among others, the Russian bonds of the Tsar, which were repudiated by the new Bolshevik regime that emerged from the 1917 revolution).

Why were investors unaware of something that seemed obvious? One error imputed on the profession of finance is its excessive inexperience. Some time ago I read data showing that the average age of a financial trader was 31, which in many cases means that they have lived through at most one financial crisis, and possibly no major war crisis.

Just a few weeks ago, many military, geopolitical and financial analysts were stating as a "base case" that Russia would not end up invading Ukraine, and some even strongly recommended buying Russian stocks on this premise. The reality has been very different, but the underlying logic is not so different from that of the summer of 1914.

Geopolitics and finance, unconnected

To draw another, closer parallel: in autumn 2012, credit default swaps to protect against a possible bankruptcy of Spain were at higher premiums than those of countries such as Egypt, the Philippines or Kazakhstan. In other words, a liberal democracy with a quasi-reserve currency (the euro accounts for 20% of central banks' global currency reserves) was riskier than a satrapy without a middle class like Mubarak's in Egypt. Utterly absurd, another sign of the disconnect between geopolitics and finance.

And we are sometimes surprised to learn that geopolitical shocks are less dangerous than financial crises. For example, the volatility of the US stock market, one of the best gauges of risk, has historically averaged around 20%. When Hitler conquered France in 1940, volatility rose to 44%. However, the collapse of Lehman Brothers in 2008 meant volatility levels of over 80%.

In other words, a banking crisis was twice as volatile as a geopolitical shock (in 1940 the French Army was considered the most powerful in Europe). Today volatilities are at 33%, and they will go down.

In the medium term, markets are efficient, in the short term they are sometimes not, driven by "behavioural finance", which makes many market players act "in packs", sometimes without any relevant geopolitical analysis. In any case, this war shows the world how the Ukrainians have not submitted to the degradation predicted by Stuart Mill and, moreover, it will fuel inflation, which will remain high for longer than expected, especially in Russia, which will be the economy that suffers the most after Ukraine.

As Nicolaus Copernicus said 500 years ago: "Numerous are the misfortunes which bring about the decadence of Kingdoms, Principalities, and Republics; the four most dreaded are wars, plagues, famine, and inflation. No one can ignore the evidence of the first three, but few people bother to understand the cause of the fourth... because it operates not in a sudden, but in a hidden and constant manner, which gradually undermines States".

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