Going Nuclear

Good morning! I hope your Tuesday is going well so far. There’s lots going on this week as usual and one piece of news I’m anticipating is the annual update from Social Security about the cost-of-living adjustment for beneficiaries next year. Estimates are in the high-8% to 9% range, according to a variety of sources, and anything close to that would be welcome news for obvious reasons. The details are expected soon, and I’ll likely post a note about them next week.

But this week let’s touch on a weighty and unfortunate question: How should we think about investing if/when it comes nuclear war? Certainly an uncomfortable departure from worrying about Fed policy, recession risk, and so forth, but some of you have asked about it so here goes…

The war in Ukraine has amped up in recent days and so has the rhetoric. Russia’s president has obliquely, or perhaps openly, depending on one’s perspective, threatened the nuclear option. The US responded with its own rhetorical volley, and this has lots of serious people talking about the increased risk of nuclear war.

The temperature rose again this weekend following the demolition of a strategically and psychologically important “Russian” bridge into Crimea by Ukrainian forces. That led to missiles being fired by Russia into areas occupied by Ukrainian civilians. These stories imply that a country and its leader are being backed into a corner from which desperate action becomes more likely. Or at least that’s what people are discussing.

Unfortunately there are no easy answers for investors when it comes to considering a nuclear crisis. It’s either all scary talk and no action or all action and, well, one can only hope that the doctrine of mutual assured destruction would cool down some heads. But is there anything investors should do to prepare? Is this even something to worry about from an investment perspective?

Here’s some insight from a note sent last week by my research partners at Bespoke Investment Group (emphasis mine).

From Bespoke…

Last night President Biden made comments to a party fundraiser in New York City suggesting that the risk of nuclear war is currently the highest since the Cuban Missile Crisis in 1962. While we aren’t capable of generating a quantitative estimate of the risk of nuclear weapons use, there’s definitely a qualitative case to be made that Russian President Putin’s allusions to nuclear weapons use as a way to achieve diplomatic and tactical military goals is destabilizing. Since the fall of the Soviet Union, nuclear weapons risk has been concentrated around rogue weapons or proliferation to new powers.

Russian threats (veiled or otherwise) to use nuclear weapons to defend territory captured (and tenuously held) from Ukraine introduce a new risk: that existing nuclear powers may decide to use nuclear weapons more cavalierly, either as a bargaining chip or in actual deployment. The novel risk vector makes the characterization of increased nuclear weapons risk seem reasonable.

With that in mind, how should investors respond? An analytical framework for investing through a nuclear war would first require a clear framework for what a nuclear war looks like. We do not have such a framework. A “demonstration” use of a tactical scale nuke near Ukraine by Russia would almost certainly illicit a military response from NATO-aligned nations as well as nuclear powers like Israel, India, and Russia. But the scale of that response could run anywhere from a passive blockade of Russian territory to a total effort at neutralizing Russian nuclear weapons capabilities. It could even stretch to a full nuclear exchange. Obviously, under that latter scenario, market outcomes are irrelevant.

The combination of extreme uncertainty and an increased possibility of even more extreme negative outcomes if nuclear exchanges actually take place means that investors are better served worrying about other risks. If nuclear weapons risk rises, we would expect a higher risk premium for markets generally. But that risk premium will either pass as risks of nukes fall, or be realized, in which case “anything goes”.

Therefore for investors, we argue that there should be little attention paid to the rhetoric and game theory of Putin’s nuclear threats. To be sure, the international community faces a unique and dangerous problem dealing with those threats. But unfortunately, markets are not well-designed to capture either the numerical risks of such a scenario (which are entirely dependent on the plans and reactions of a small number of individuals which are not knowable ex-ante) and the potential outcomes (anything from a slight increase in radioactivity near Ukraine to an extinction level event). Markets are certainly powerful information digesting frameworks, but they aren’t perfect.

My take on this: There’s nothing for investors to do, so it’s best to ignore the issue from that perspective. That seems uncomfortable, perhaps even callous, but potential nuclear war is another on the long list of things we have no control over. Maybe that’s not a great answer, but I think it’s the right one for investors.

Have questions? Ask me. I can help.