Markets are complacent about the risks of war

There is a total disconnect between investors and politicians when it comes to geopolitical jeopardy

Given the risks, you might expect the ever-more apocalyptic warnings of world war three, now almost daily trotted out by the politicians and the military, to be more obviously reflected in the behaviour of financial markets.

Even comparatively localised wars tend to be deeply damaging to the economies involved, though there are exceptions, which I’ll come to.

But world wars are on another scale entirely – hugely destructive events which take decades to recover from; if fought in the modern age, with its lethal nuclear arsenals, it might even prove existential. Yet markets appear entirely blind to any such threat. A deep insouciance hangs over their every uptick. Donald Trump’s warnings of world war three are dismissed as little more than cynical electioneering; growing geopolitical instability is all Joe Biden’s fault and the only salvation is me, he keeps unconvincingly saying. Similarly, with the siren calls of the military for urgent increases in defence spending. What do you expect from armed forces starved close to death, with the so-called “peace dividend” diverted into burgeoning welfare budgets? They sense their moment, and are understandably going for it.

Whether the world is objectively any more dangerous today than it was two years ago when Vladimir Putin first invaded Ukraine is an interesting question. Markets plainly think not.

What Ukraine has demonstrated is that it is possible to have localised wars, even when they involve nuclear superpowers, without resorting to the mutually assured destruction of firing off a nuclear missile.

And be in no doubt that the West is in effect already at war with Russia. One of the reasons the UK military is demanding more defence spending is that so much weaponry has been diverted to the defence of Ukraine that it has left Britain short of even basic needs. But if nuclear weapons have failed to act as a deterrent to military action by an insecure authoritarian regime, they probably have been reasonably effective in limiting the scale of the aggression.

Horrific though the consequences are for besieged Ukrainians, markets take comfort from the way events have played out. Putin is considered very unlikely to also take a tilt at the Nato-guaranteed Baltics, and despite the cost of living crisis, the wider economic impact has been smaller than feared. Yet the politicians are taking no chances and, almost everywhere, rearmament has become a top priority. The trouble is that countries don’t tend to rearm unless they think there is at least some chance they might have to use those weapons. Nearly all wars begin with rearmament.

Adding further to the sense of global insecurity over the last week is the repudiation by North Korea’s Kim Jong-un of his peaceful reunification policy, a move which rightly or wrongly is seen as preparing the country for renewed war with the South and other regional “enemies”.

In any case, there is an almost total disconnect between market and political narratives when it comes to today’s mounting geopolitical tensions.

As far as I can tell, there is no attempt whatsoever by investors to discount what the politicians increasingly frame as a clear and present danger, even by way of what is known as “tail risk”.

Oil and gas prices have barely moved in response to the escalation of tensions in the Middle East, despite the region’s key position as a global producer.

This might seem faintly reassuring. If Mr Market thinks there is nothing to worry about, then perhaps there isn’t. Unfortunately, it doesn’t mean that markets are right. Historically, investors have collectively tended to be particularly bad at predicting wars, if only because all wars are economically irrational, and it is therefore assumed that this will act as a natural deterrent to waging them.

In a highly influential book, The Great Illusion, published in 1909, before the outbreak of the First World War, British journalist Norman Angell argued compellingly that the presiding age of global trade and international integration had made the economic costs of war so great that nobody could possibly hope to gain by starting one: the “great illusion” being that nations could still benefit from conquest.

Poor Mr Angell. He has been unfairly represented ever since as arguing that war had become impossible because economic interdependence was a “guarantor of good behaviour by one state to another”. In fact, his argument was only that trade made war less likely.

In the event, it made no difference at all, yet markets continued to believe in the logic of Angell’s argument even beyond the point of mobilisation. It wasn’t until borders started to close, sparking a chain reaction of defaults and a consequent collapse in the banking system, that investors fully appreciated the peril they were in.

Angell’s way of thinking none the less continues to instruct current analysis. For instance, Germany allowed itself to become dependent on Russian gas not just because it was cheap, plentiful and convenient, but because by economically embracing the Russian bear it hoped to tame it. Again, it made no difference.

Similarly with China, whose integration into the global economy has proved worthless as a guarantor of friendly relations. As tensions rise, Western economies are scrambling to disengage from complex international supply chains and make themselves more self-reliant.

Investors do admittedly wholly take on board the likely stagflationary consequences of this process of “de-risking”; it’s going to make goods and services more expensive and thereby crimp consumption.

Even so, markets don’t collectively seem to have thought through the wider implications. Why bother with self-sufficiency unless you think war, or at least some kind of effective blockade, might be coming down the line at you?

Few would ever welcome any war but, just occasionally, military conflict does have positive economic consequences, despite the destruction it inevitably visits.

For instance, there is little doubt that, as an economy, the US benefited significantly from the Second World War, finally ridding itself of the scourge of the Great Depression and establishing the country as the world’s dominant superpower and technological innovator.

Angell is therefore not entirely right to argue that nobody profits from war. The key difference here, however, is that the US was not the aggressor; its ascendancy was a by-product of Japanese and German overreach.

It’s also true that all Western economies, including Germany, grew much richer on the rebirth that eventually occurred after the war had ended.

But try telling that to the afflicted during the mayhem of the immediate conflict, when the idea that in the long run everything will be fine again would be regarded as positively insulting.

There is, of course, a sense in which there is no point in worrying about possible, but not yet baked-in, events. In a third world war, all bets would be off the table, and finance would change beyond recognition. Any such catastrophe cannot be priced in.

The current complacency is none the less an oddity that seems to stand an ever-higher chance of breaking asunder on the rocks of harsh realities.

‘Perhaps there is nothing to worry about. But investors have proven bad at predicting wars’