Tuesday, October 14, 2014

How wars can affect long-term returns

I had a number of discussions with readers in response to my post The one Big Bet made by most buy-and-hold portfolios.

To recap, I wrote that most studies of asset returns contained severe survivorship bias. Based on the data from the Credit Suisse Investment Yearbook 2014, I showed that most US studies of equity returns used long term data like this to estimate asset returns:

Despite having over 100 years of data, the drawback to that approach is that the US was only one country out of many at the dawn of the 20th Century and many countries and political regimes have disappeared in that time frame. Instead of US-like asset returns, how do you know that your returns won`t look like UK returns like the chart below. Note that US equity returns in the above chart showed a cumulative return of 1248, compared to 372 for the UK.

Worse still, how do you know your long term returns look like German assets in the same period? What if you had been invested in (*shudder*) Russia instead, where your asset prices likely went to zero after the Russian Revolution?

Here is the key conclusion from that post:
In summary, most investment policies today are Big Bets on world peace. For Americans, they represent an even bigger bet - the continuation of Pax Americana.

How war destroys asset values
Much of the feedback that I received agreed that most investment plans were indeed a bet on world peace and Pax Americana. However, it was a reasonable assumption to make given the geopolitical outlook for the continuation of US dominance in global affairs. As long as we don't see any world wars, everything is going to be fine.

While that statement is intuitively appealing, it is not true that asset returns are damaged if you get into a world war, or even worse, lose a war. While being on the losing side of an all-out war certainly destroys asset values - that is more or less an evident fact, being on the winning side can weaken an economy as to inhibit growth and impair asset values as well.

War is expensive
The simple fact of the matter is, wars are expensive. Consider this chart of the British debt-to-GDP ratio starting from the dawn of the 19th Century (via Global Financial Data).  The British debt burden ballooned enormously during the Napoleonic Wars (imagine if Napoleon had won at Waterloo!) and she spent the next century paying off that debt, aided by burgeoning growth and her overseas colonies. British debt rose sharply again during the 20th Century in response to World War I and, later, World War II.

The experience of the British empire shows that wars are very expensive. A decision to go to war can significantly weaken national finances. If a country with fragile finances were to experience a shock, whether it be the catastrophe of losing a war or other blow to the economy, it would most likely greatly impair asset returns.

Outspending the enemy 40 million to 1
Fast forward to today. While it is true that the world has not seen any major conflict on the scale of a world war in my lifetime, modern wars remain expensive affairs.

While this post is not meant to be a discussion about the pros and cons of engaging in any specific war, consider what happened the 9/11 attack of 2001. A handful of suicide attackers with a reported budget of roughly 100K provoked a US response that included an invasion of Afghanistan and Iraq, which is estimated to cost $4-6 trillion. On an inflation adjusted basis, that's roughly how much the US spent on World War II.

Erico Matias Tavares wrote the following about the Chinese general and strategist known for his treatise The Art of War:
Sun Tzu had something to say about this: “Victorious warriors win first and then go to war, while defeated warriors go to war first and then seek to win.” Seen in this light, has the Post 9/11 military strategy made the US a victorious warrior?

Source: Congressional Research Service (June 2010), Boston University (June 2014).
(a) US$ billion, in constant 2011 dollars, except for Post 9/11 which is in current dollars.
(b) Union and Confederacy added together.
(c) Includes $1 trillion in future obligations for care of Veterans through 2054.
In effect, America is telling its enemies: "Don't mess with us, we'll squash you by outspending you by 4 million to 1". While that tactic may be effective against a relatively insignificant insurgent group, what would happen if several adversaries banded together? Can the US continue to outspend all of its enemies by such an enormous amount?

Already, I see that the cost of the military campaign so far against ISIS is about $1 billion (does ISIS even have a total budget that approaches that amount?) and the estimated ongoing cost is $40 billion per year.  To put those figures into some perspective, a single raid into Syria costed more than the India's entire Mars mission.

Already, the latest Geneva Report entitled Deleveraging, what deleveraging? warns about the "poisonous combination" of debt and slow growth could derail the global recovery and may lead to another financial crisis (see Business Insider and The Guardian).

Don't just count on the absence of world wars
In conclusion, even though we are fortunate to experience a prolonged period of world peace where there are no World War style conflicts, the budgetary demands of American foreign military adventures are similar in scale to past global conflicts. Such levels of spending will undoubtedly put pressure on the US debt outlook and could pressure asset returns over the long run.

Imagine what the US government could do with $4-6 trillion. Think of the benefits it could provide tp its citizens, either in the form of incremental services such as healthcare and education or, if you don't like the idea of government services, tax cuts.

Or better yet, think of the number of bankers Washington could bail out. No doubt, JP Morgan is so starved for funds that they can't be afford to inform affected customers of a cyberattack data breach.

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