“Buy when the cannons are firing and sell when trumpets are blowing.” This quote is often attributed to Nathan Rothschild who greatly expanded the family fortune by buying UK government bonds before news of Napoleon’s defeat at Waterloo reached London. There is no evidence he said, but it does highlight the fact that throughout history, wars and finance are intricately linked. Wars are expensive. The bigger the military operation, the more sophisticated the financial machinery required to fund it. The Bank of England, today still the UK’s central bank, was created in 1694 as the government’s bank, largely to finance its ongoing wars with France. Without the rise of the City of London as the world’s most important financial centre in the subsequent decades, Britain could never become the dominant global empire. Today it is Wall Street that underpins the USA’s unprecedented military might.
Wars are also big business, not just for those in the armaments industries, but for financiers too. Apart from speculating in the bond market, Rothchild made a fortune supplying the Duke of Wellington’s army with gold and silver to pay its troops.
Finally, wars destroy individual lives, but they also shape societies. This has an economic impact which spills over into asset values. The bigger the war, the greater the economic dislocation, particularly if you end up on the losing side. These dislocations create buying opportunities as in the case of Rothchild and the Napoleonic wars but can also destroy wealth. On the other end of the spectrum, it was military spending in the run-up to World War II that finally snapped the major economies out of the decade-long Great Depression. That war ultimately left the likes of Germany and Japan in physical ruins and Britain financially weakened. But the US emerged richer than ever.
To the victors the spoils
The impact of major wars and revolutions is clear looking at long-term asset class returns. London Business School academics Elroy Dimson, Paul Marsh and Mike Staunton have calculated real returns of bonds and equities in several major economies since 1900. Australia and South Africa, who were largely unscathed by the two world wars (and indeed benefited as suppliers of food and materiel) have the highest local currency real equity returns in this period, namely 7%. While a combatant, the US benefited from both wars and its long-term returns are 6.6% for equities and 2% for bonds. The ultimately futile wars in Vietnam, Iraq and Afghanistan and the shock of the 9/11 attacks did not detract nearly as much from those long-term returns as the home-made 2008 financial crisis did.
On the other hand, Germany suffered defeat in both world wars and hyperinflation after the first. At the end of World War II, equities and bonds lost 90% of their values in real terms. Thanks to the post-war ‘wirtschaftwunder’ (economic miracle), German equity returns recovered but the long-term number is still half that of the US. Long-term real bond returns are negative. Similarly, Japanese equities lost 96% of their value in World War II. Its own post-war miracle of 1949 to 1990 meant that long-term real local currency equity returns in Japan are still positive at 4%, but long-term real bond returns are negative.
Russia had a thriving stock market at the turn of the previous century. Dimson and colleagues show that Russia’s market capitalisation was 6% of the total in 1 900 (compared to about 0.3% on the eve of the recent invasion, according to index provider MSCI, who has now termed Russian shares ‘uninvestable’). Research by Yale professor William Goetzmann shows that the Saint Petersburg stock exchange outperformed its US equivalent substantially between its establishment in 1865 and 1917. But in the wake of the communist revolution, private ownership was banned, and stock trading would only resume with the collapse of the Soviet Union in 1990.
Revolution, confiscation, hyperinflation and a war in your back yard can be very hazardous to your wealth. But then so can excessive debt, chasing asset bubbles up and selling out after markets have fallen.
What we know and don’t know
Returning to the current situation, there is much we don’t know. The key questions to which no-one, perhaps not even Russian President Vladimir Putin himself, knows the answers are how long the war will last, how it will end, and whether it will escalate.
For now, the following is known. Russia has been subjected to severe sanctions that are shutting it out of the global financial system and hobbling its economy. These are probably much more severe than what Putin expected and might ultimately limit his ability to wage war.
Commercial banks and the central bank have been sanctioned, which means the latter’s much-touted $640bn in gold and foreign exchange reserves have largely been rendered useless. With the rouble collapsing to record lows, the central bank doubled interest rates to 20% to halt further capital flight. Foreign companies are pulling out of investments, even at the cost of billions. Russia has become a pariah state and its economy will suffer short and long-term damage as a result.
Ukraine’s economy will also suffer much damage, including physical damage to infrastructure, but it is a small economy in the global context (South Africa’s GDP is three times larger, for instance).
Chart 1: Economies ranked by nominal GDP in 2020
Source: International Monetary Fund
Russia has the world’s 11th largest economy, and it is headed for a deep recession that will detract from global growth. However, its economy is less than 2% of global GDP and is a fraction of the US, China or European Union. It is these three economies that determine the direction for overall global growth.
Companies that export to Russia will therefore suffer, but the main channel through which the conflict impacts the rest of the world is through higher prices for Russia’s key commodities: oil, gas, coal, aluminium, nickel and palladium. Russia is also a major exporter of fertiliser materials, and, together with Ukraine, one of the main producers of wheat and other foodstuffs.
Importantly, Russian oil and gas were still flowing to the rest of the world, particularly to western Europe. It is ironic, if not tragic, that Europe condemns Russia’s aggression while continuing to buy Russian gas it is dependent on. A sudden stop in gas flows would be a shock to European economies that could plunge them into recession. So far, this has not happened yet.
However, there is already evidence that many buyers of oil are shunning Russian crude. Banks are refusing to fund such transactions, insurers are not insuring delivery and shippers are not shipping the cargo. Over the weekend, the US government noted that it was discussing a ban on Russian imports with its allies. This saw the Brent crude oil price surge to $130 per barrel on Monday morning, the highest level since 2008. Russian crude now trades at a record discount to other global benchmarks.
Being largely self-sufficient in energy matters these days, the US is much less exposed than Europe. And though consumers will feel the impact of higher food and fuel prices, US households are in good financial health overall with low unemployment, the highest levels of wage growth in years and strong balance sheets. Of course, there is a tipping point where household finances become too stretched and consumer spending – 70% of the US economy – can decline. We don’t seem to be there yet even with the combination of rising interest rates and rising energy prices. Oil prices are not near historic extremes in real terms yet. And as a share of disposable incomes, both energy spending and interest payments are at the low end of historic ranges. Therefore, expect slower growth in consumer spending, but not outright contractions.
Chart 2: Real oil price (deflated by US CPI)
Source: Refinitiv Datastream
This episode also once again emphasised the unique global position of the US: largely energy independent, massive military might, the world’s deepest capital markets and reserve currency, cutting edge technology and crucially, a peaceful neighbourhood that is isolated from trouble by vast oceans on either side. One can never write off US assets even if they are currently more expensive than others.
Inflation and interest rates
The increase in global food and energy prices as well as other supply chain disruptions will put upward pressure on headline inflation rates across the world. This complicates matters for central banks. Before the Russian invasion, the inflation and interest rate outlook dominated the agenda for investors. The US Federal Reserve, the world’s most important central bank, is likely to commence a rate hiking cycle in March followed soon thereafter by a reduction in the size of its balance sheet. With consumer inflation running at multi-decade highs of 6% (or 7.5% depending on your preferred measure), and underlying growth and job creation strong, the Fed has little choice but to tighten policy and its Chairman Jerome Powell said as much in testimony to Congress last week. However, he also noted that the Fed would move carefully with an eye on how the war impacts the growth and inflation outlook. The same is true for the Bank of England but the European Central Bank (ECB) will have to be particularly cautious. The market no longer expects the ECB to raise rates this year, and the expected policy divergence with the US helped push the euro sharply lower last week.
Weathering the storm
For South Africa, there are three channels through which the Ukrainian crisis (or indeed any global crisis) impacts the economy.
Firstly, there is the direct exposure of South African businesses to Russia and Ukraine through export arrangements or ownership of assets, and conversely, the investments made locally by Russian and Ukrainian companies, and reliance on imports from those countries. Here the impact is not zero, but it is small. In 2021, South Africa exported more by value to tiny Lesotho or eSwatini (around R20 billion each) than to Russia (R6 billion). It imported R9 billion from Russia, half of imports from Belgium. A handful of local companies have direct Russian exposure, notably Mondi, Naspers and Barloworld. These assets might end up being severely impaired.
Secondly, there is the risk of financial contagion. As an emerging market, South Africa is always prone to capital flight at times of heightened risk aversion. The rand usually sells off, and this puts upward pressure on domestic interest rates as the Reserve Bank starts worrying about inflationary pressures. So far this has not happened. Unlike in 1998, when Russia’s debt default sent all emerging markets into a tailspin, the recent events had a relatively muted impact on other emerging markets, particularly commodity producers like South Africa.
Higher food and fuel prices will raise the headline inflation rate, but like its global peers, the SA Reserve Bank prefers looking through such price increases to focus on the second-round impact. In other words, where such price increases set off increases elsewhere.
Chart 3: Commodity prices over the past three months
Source: Refinitiv Datastream
Finally, global events normally impact South Africa through changes in commodity prices. As an importer of oil and petroleum products, higher global oil prices will hurt. But these have so far been more than offset by increases in the prices of commodities that South Africa exports, particularly coal, platinum, palladium, rhodium and gold.
These increases will support export values and have already boosted equity prices of JSE-listed miners. And of course, a share of the increased mining profits flow into the fiscus. Whether it lasts depends on how the war unfolds. Beyond a certain unknown point, the surge in commodity prices can trigger a sharp decline in global growth that will in turn pull commodity prices down. But for now, South Africa is weathering the storm. South African bond and equity returns have outperformed global investments since the start of the year in dollar terms.
Keep calm and diversify
Once again, this is a reminder of the importance of diversification. It would not have been obvious a few months ago that South Africa would be a relative safe haven in a very uncertain world. However, markets are unpredictable, and diversification is the best defence against such uncertainty.