The world changed on Oct. 7, 2023, when Hamas launched a brutal rampage upon Israel that shocked people with its barbarity and depravity. Almost as shocking was the realization that many people throughout the globe celebrated the carnage as a first blow in the struggle against what they denounce as “colonization.”
This is far less shocking to those of us who study history with a realistic and sanguine view. Periods and incidents of unimaginable brutality are so common historically that even professional historians cannot possibly remember, much less study, them all.
We have not entered a new paradigm. We merely have returned to a norm that many previous generations lived under. War and death are more of a reality than all but the very oldest of us understand on a visceral level. The Second World War ended 78 years ago. Almost no one alive today remembers it well.
A recent report by Bank of America on economic history pointed out that in 2005, there were only 12,000 war deaths worldwide. That figure rose to 50,000 in 2019, and with the war in Ukraine, the total rose to 250,000 in 2022.
I would be cautious about these figures because war deaths are difficult to assess both because of counting issues and determining the cause of deaths. Wars can result in large numbers of deaths due to starvation, disease and the collapse of medical systems. In fact, there is a large range in estimates of the death toll of the Second World War, despite it being the most documented conflict in human history.
The Bank of America report has a fascinating chart of the estimated 15-year moving average of global war deaths per 100,000 from the year 1400 AD. The 15-year moving average has been declining over the past half century, but is still above the pre-First World War period. This trend seems poised to reverse as we head into a period of more war and civil strife. Furthermore, modern weapons, despite high-precision targeting, have the capacity to kill many people very quickly.
We may very well find ourselves in a long-term global conflict with defined lines. On one side, we have the United States, Europe and Asian nations such as India and Japan that are threatened by Chinese imperialism. On the other side we have Russia and China, and Iran leading the part of the Muslim world that hates the West.
In a more dangerous world, investment markets will adjust. Some industries in the free world that have traditionally done well may struggle. Companies that rely on trade globalization and China could underperform.
Other investments and industries may do exceptionally well. In a more dangerous world, adjusting to this new paradigm will be crucial.
The combined gross domestic product of the free world is about US$60-trillion dollars, or between 60 per cent and 65 per cent of total global output. The not-so-free world, made up of China, Russia, Iran, Turkey and North Korea, has a combined GDP of about US$20-trillion.
Most of that is China. The rest of the world makes up less than 20 per cent of global output. Military spending in the free world will increase substantially over the next decade. Nations such as Germany, Japan and Poland have indicated that they will radically increase defence spending. Russia is already on a war footing.
Conservatively, if the Western nations and our Eastern allies increased military spending by only 1 per cent, that would mean US$600-billion more in military spending per year. As we have seen in the wars in Israel and Ukraine, advanced weaponry is crucial. New missile systems, surveillance systems and drone technology are crucial. The Israelis are reportedly using artificial intelligence to deal with the Hamas tunnels.
Those investors who want to take advantage of this new epoch and who do not have any ethical issues, or who may even see investing in military contractors as a patriotic duty, can just purchase the iShares U.S. Aerospace & Defense ETF (ITA-A). The ETF had a total return of 3.37 per cent over the one-year period ended Oct. 31, and 3.90 per cent annualized returns over five years.
There is no bubble in this space yet, so the market has not priced these stocks for the opportunity ahead. The weighted average P/E ratio of the ETF is 26 times trailing earnings, compared to 25 times for the S&P 500.
As one would expect, the industry is dominated by giant companies. The top 10 holdings make up more than three-quarters of the portfolio weight. In fact, the top two holdings, RTX Corp. (formerly Raytheon) and Boeing, make up more than a third of the portfolio weight. Given the complexities of this industry, we would probably refrain from picking individual stocks unless one is willing to put in many hours of research.
Wars are financed by taxes and debt. Given the high tax levels of most developed countries, I doubt much of any coming rearmament will come from tax increases since, at this point, the marginal effectiveness of tax hikes on total revenue is low.
That leaves debt. Government debt levels are high, but can go higher. Regimes often issue bonds in times of war, increasing the supply of debt while simultaneously pressuring yields lower. These lower yields historically have assisted governments in their financing efforts. Central banks may also attempt to keep yields low with their open market operations.
Once peace is declared, inflation ramps up and bondholders take huge losses, but that situation is many years away. Interesting fact: Many people believe the myth that the U.S. grew its way out of Second World War debt. That is only partially true. In the first three years following the war, inflation rose by approximately 33 per cent.
Meanwhile, investors want safety during periods of strife, which will drive wealth toward the U.S. dollar. Gold, silver and essential commodities will be valued. In a war-torn world, emerging markets are shunned. We are already seeing many countries such as Lebanon, Egypt, Argentina and many others collapsing economically. That list will get larger before it gets smaller. Supply chains will be affected so, potentially, food commodity prices may rise.
War is a terrible thing. We have known that for four millennia, yet we seem unable to go very long without new conflict breaking out. We have yet to figure out a way to permanently do away with war. Yet we are entering one of those periods now. You should be aware, and manage the risks involved.
Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed income and asset mix strategy. He is a former lead manager of Royal Bank of Canada’s main bond fund.
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