Overview
The aim of this installment is to identify and analyze events that could prove disastrous for many professional investors.
I. Nuclear War – Since the late 1940s, the world has recognized the immense destructive power of nuclear weapons. The response to this threat might be viewed as unsettling; the likely major belligerents maintain massive arsenals of nuclear weapons.
The notion is that no one would launch a weapon as it would likely result in their own nuclear destruction (i.e., Mutually Assured Destruction or MAD).
This requires a few assumptions:
1. The parties controlling the weapons are rational.
2. The attacked parties or their allies would be able to respond (in the case of an attack via a nuclear-armed submarine, the response window is approximately 12 minutes).
3. New entrants in the nuclear club (e.g., North Korea and soon Iran) view the world similarly to current members (e.g., US, Russia, UK, China, Pakistan, etc.)
Commentary – Even if a counterattack is launched, the outcome is devastation. Perhaps it is time to revisit the notion of Mutually Assured Destruction as the optimal approach to addressing this risk. Although some suggest a supranational authority to reduce the risk, there are a variety of hurdles before the nuclear-capable nations sign on. Further, biological and chemical weapon development may be more difficult to detect and cheaper to pursue over time while offering comparable devastation.
II. World War – Many historians argue that the proximate cause of World War I was the domino effect of mutual defense agreements between European nations, wherein if one were attacked, other allies would come to the victim’s aid.
Whether obvious or not, this is the current situation, and it appears to be escalating given the delivery of F-16 fighter aircraft to Ukraine. The underlying premise of NATO is that an attack on one member is viewed as an attack on other members, thereby raising the stakes for conflict. The developing situation is elsewhere whereby Dr. Kissinger’s fears are being realized. The late, well-regarded Dr. Henry Kissinger admonished Western nations, particularly the U.S., to do everything to keep Russia and China separated.
Unfortunately, the opposite has occurred, with the latest development being the addition of North Korea, Iran, and possibly Cuba to the mix. We have yet to see a public declaration of a mutual defense pact, but the statement of "everlasting friendship" between Russia and China comes very close.
Entanglement in European conflicts is hardly a new idea for America, whose first president promoted a focus on commercial relations with Europe rather than politics.
“The great rule of conduct for us, in regard to foreign nations, is in extending our commercial relations, to have with them as little political connection as possible. Europe has a set of primary interests, which to us have none, or a very remote relation. Hence, she must be engaged in frequent controversies the causes of which are essentially foreign to our concerns. Hence, therefore, it must be unwise in us to implicate ourselves, by artificial ties, in the ordinary vicissitudes of her politics, or the ordinary combinations and collisions of her friendships or enmities... it is our true policy to steer clear of permanent alliances with any portion of the foreign world; so far, I mean, as we are now at liberty to do it; for let me not be understood as capable of patronizing infidelity to existing engagements.” — George Washington's Farewell Address
Commentary – This is an intractable problem that has yet to be generally recognized, let alone addressed. While some in Washington believe any war is a good war, recent actions appear to have encouraged friendship between major adversaries.
III. Debt Crisis/ Currency Debacle – Pundits have commented for years on the rise in debt levels relative to GDP with the concern that creditors will at some time demand significantly greater compensation and possibly eventually driving nations into a debt death spiral. Perhaps the most notable case is the Weimar Republic, where the currency became nearly worthless.
Figure 1: Total Public Debt as Percent of Gross Domestic Product¹
Addressing this risk is rather daunting because it depends on the psychology of investors and the willingness of central banks to expand their balance sheets.
Commentary – We are less concerned about the latter than we are about the former. In fact, both are related as investors have been willing to continue investing while they are comfortable with the central banks stepping in when needed. Our view is that after the 2008 Credit Crisis, the central banks are now willing and able to support the economies when needed. At some point, a rebalancing is needed, but it is unlikely to happen soon.
IV. Constitutional Crisis – Lest we forget, the person who started World War II was democratically elected. Mr. Hitler essentially outlawed other political parties to monopolize power. Unfortunately, over the past decade many political norms have been broken. Hopefully, the country will revert to a more normal state over the coming years.
Conclusion – Addressing the issues mentioned in this report is painful and difficult, but it is critical nonetheless. Our hope is that all these risks are low-probability events, but if realized, the impact will be massive.
Sources
[Picture 1] Scientific American
[Picture 2] Assassination illustrated in the Italian newspaper La Domenica del Corriere, 12 July 1914 by Achille Beltrame
[Picture 3] https://www.bloomberg.com/news/articles/2021-04-15/zach-carter-on-the-real-story-of-weimar-hyperinflation
[Picture 4] Allposters.com