Headed Toward Conflict?

Year-to-date prices demonstrate the uncertain effects of possible war in Ukraine

This connection between political events and financial markets was important to my early work as a historian. Despite my best efforts, I continue to believe that most historians, particularly those writing about the modern age after the birth of bond and stock markets, undervalue the significance of the "cash nexus": the critical interface between power and money.

This is most likely due to the fact that professional historians seldom have the finances (or the desire) to speculate on their own. (My childhood idol, the great English diplomatic historian A.J.P. Taylor, was a financial moron who did horribly during the 1970s inflation.) They also choose to study emperors, kings and queens, presidents and prime ministers over bankers and brokers. Writing the histories of two of the greatest German-Jewish banking houses, the Rothschilds and the Warburgs, taught me to understand history from a new perspective.

The narrative of how the Rothschild brothers benefitted on early news of the Battle of Waterloo's result is legendary, including the toxic mythology of Nazi propaganda. The fact is that Napoleon's downfall, which occurred just 100 days after his return from exile on the island of Elba, was not at all what Nathan Rothschild had predicted. He and his four brothers had grown their father's firm from a tiny coin store in the Frankfurt ghetto to an international trading enterprise by capitalizing on two revolutions: the British Industrial Upheaval and the French political revolution. Nathan started by selling Lancashire fabric to the continent, but quickly realized that providing Britain's war effort with gold was a better way to make money.

By the time Napoleon was defeated for the first time in 1814, the Rothschild brothers had learnt two critical truths. Since of the economic upheaval created by war, the price of gold in sterling terms tended to rise because the gold-standard norm that permitted pounds to be converted into gold at a set price had been suspended for the length of the hostilities. Moreover, the conflict pushed up both short- and long-term interest rates. The lower the price of "consols" — the near-perpetual bonds that the British government had been using to cover its massive national debt since the mid-18th century — and hence the greater the return on those bonds, the worse things went for Britain and her allies. The lower the price, and hence the greater the return, of rentes, the French counterpart of consols, the worse things went for Napoleon.

When Napoleon returned to France and restored his imperial throne in March 1815, the Rothschilds expected another lengthy era of struggle. They positioned themselves properly, obtaining gold wherever it was available via their huge credit network. They misjudged the allied military reaction, which resulted in triumph at Waterloo on June 18.

When word of Bonaparte's defeat arrived at the Rothschild headquarters in St Swithin's Lane in London — carried by a messenger, not the legendary carrier pigeon — the brothers were shocked. If the war ended, the gold they had amassed would be useless and would quickly devalue in terms of sterling. Nathan saved the situation with a stunningly audacious deal that more than deserved his reputation as "the Napoleon of finance": he purchased consols on a big scale and profited handsomely when they surged on the news of peace.

We now know that Napoleon's decisive and irreversible loss at Waterloo signaled the beginning of a century of relative peace in Europe. There had been no significant conflict involving all of the big countries until August 1914, when World War I started. However, there were countless minor disputes that may have evolved into a full-fledged war. And, having acquired their money, the Rothschilds had every motivation not to lose it again by getting caught up in such a situation.

As I discovered while looking through their astonishing communication — the sometimes daily exchanges between London, Paris, Frankfurt, Vienna, and Naples — the Rothschilds' most essential issue was: Is the likelihood of another major conflict increasing or decreasing? Every piece of news let them answer that question more precisely and position themselves properly. They feared year after year, for example, that another French revolution would set in motion a rerun of the events of the 1790s, when a revolutionary state ended itself at war with Europe for the greater part of two decades. Revolutions in Paris in 1830, 1848, and 1871 raised the fear, but history did not repeat itself.

Of course, the Rothschilds and their contemporaries had to deal with a slew of additional issues. The variations of the business and credit cycle, which caused at least one large panic in the City of London every decade, were equally important in the 19th century financial markets. The ebbs and flows of liquidity were linked to a number of other occurrences, including the vagaries of European crops. Economic and political risk coexisted and interacted in the mid-1840s. Harvest failures, which caused food prices to skyrocket in 1847, were closely linked to the political uprisings that swept the Continent, particularly France, the following year. For the Rothschilds, 1848 was the most terrible year of the century, the point at which they peered into an abyss as markets and governments collapsed.

War and Peace in the Bond and Bills Markets

With the advantage of hindsight, we may consider the era from 1815 to 1914 as one in which economic and political risks decreased while financial markets expanded, deepened, and grew more robust. There were powerful forces at work. The Industrial Revolution gained momentum and extended over the Atlantic and Channel. Between 1789 and 1848, revolutionary principles transformed into nonrevolutionary political movements — liberalism and social democracy — while conservatism learnt to win elections.

Almost as important, finance became more stable. The gold standard expanded, and London panics became less common. Joint-stock banking resulted in larger, better-capitalized financial organizations with larger, more well-structured balance sheets. Savings institutions raised significant sums of money by collecting millions of tiny donations. For all of these causes (explained in further detail here), financial markets became less volatile, and the margins between risky and safe assets shrank.

Contemporaries, on the other hand, were less conscious of such long-term tendencies. The Rothschilds could not be certain that the world had fundamentally altered since their formative years, nor could they be certain that all of Europe's conflicts between Waterloo and 1914 would be relatively minor and brief. Just as we cannot be certain whether or not war would break out in Ukraine, the Rothschilds could never be positive that Europe would avoid a catastrophic conflict for a century.

For example, in 1875, German Chancellor Otto von Bismarck's mouthpieces in the German press wondered, "Is war on the horizon?" – causing panic in French markets The warning proved to be unfounded; maybe Bismarck's intentions were never more than to beat the militarist drum for domestic political purposes.

The news that their buddy, British Prime Minister Benjamin Disraeli, had pushed aside Anglo-Russian tensions over Central Asia in the sake of maintaining European peace provided comfort to the Rothschilds. "Last evening," Charlotte de Rothschild reported to her son Lionel, "[Dizzy] made a flying visit to your father, and informed him of his enormous success in negotiating for the preservation of peace on the continent."

The difficulty with extended periods of calm interspersed by little battles is that you get used to the tranquil existence. Even the Rothschilds, who were now two or three generations removed from the Frankfurt ghetto, struggled to envisage a global war by the summer of 1914. When the cannons of August began fire, they were taken off guard, as were the majority of investors.

We've all forgotten about it now, but the 1914 financial crisis — which started in July, before the war began — was the worst in history, much worse than the 1929 disaster. As the diplomatic situation worsened, the liquidity crisis became so severe that trading on all of the world's major stock exchanges had to be halted. From July 31, 1914, to Nov. 28 (when bond trading began) until Dec. 12, 1914, the New York Stock Exchange was closed (when stocks could be bought and sold again). That day, the Dow fell 24.4 percent.

There was a stark difference between the attitude to war in 1914 and the approach to war in 1939. Already in the summer of 1938, markets were bracing for war. Although British Prime Minister Neville Chamberlain's tactic of appeasing Adolf Hitler at Munich seemed to escape disaster, more savvy financial pundits (particularly the Economist) saw that he had only postponed it, perhaps allowing Hitler to strengthen his position.

Today's thinking is more like to 1914 than 1938. True, for most of the time between 1945 and 1991, the world was threatened by a nuclear war between the United States and the Soviet Union. However, as their arsenals of warheads got stronger, it became more difficult to envisage such a conflict, even when it came dangerously near to occurring over Cuba in 1962 and the Able Archer false alarm in 1983. Instead of Armageddon, the Cold War witnessed a series of smaller-scale proxy battles. The most serious hostilities were in Korea and Vietnam, although there were countless minor conflicts from Central America to southern Africa.

Markets mostly overlooked the danger of Armageddon as well as the proxy conflicts. After all, what form of commerce would benefit from mutually guaranteed destruction? It's impossible to be short on humanity and lengthy on disaster.

The most important Cold War transaction was the purchase of gold in anticipation of inflation. This paid off handsomely, particularly when President Richard Nixon severed the Bretton Woods relationship between the currency and gold. As inflation expectations rose in the late 1960s, particularly following the commencement of the Yom Kippur War in October 1973, being long gold was the winning strategy at a time when investors in bills, bonds, and equities were losing money. A second period of geopolitical unrest in 1979, which witnessed the Islamic revolution in Iran and the Soviet invasion of Afghanistan, rewarded gold bugs even more. However, then was the moment to sell, with the price exceeding $675 USD per troy ounce, approximately 20 times greater than when Nixon was elected president in 1968.

Gold-Plated Armor

A very precious metal in times of geopolitical risk

With Paul Volcker at the helm of the Fed, the big inflation ended, as did the gold trade. War risk vanished from investors' perceptions as the Cold War ended without a missile being launched in the late 1980s and the dot-com bubble gained traction. The financial consequences of subsequent geopolitical crises — the Gulf War, Balkan conflicts, 9/11, the Afghan War, the Iraq War, and the 2014 Ukraine crisis — were completely obscured by the massive monetary expansions that followed the Lehman Brothers collapse in 2008 and the Covid-19 epidemic.

If nothing else, Putin has reminded us that investors — even bottom-up, value investors who claim to be unconcerned about geopolitics or macroeconomics — cannot afford to overlook the unforeseen dynamics that lead to catastrophic conflicts. A Russian invasion of Ukraine would be nothing like 1914, since no one now is obligated to protect Ukraine in the same way that Britain and France were obligated to maintain Belgian neutrality. However, a conflict in Ukraine would be more significant than either the Afghan or Iraqi wars for two reasons.

First, even if Putin's plan worked and the Russians quickly overran the Ukrainian military, the rest of Europe would be forced to confront Russia as a major power capable of threatening Ukraine's neighbors and near-neighbors, rather than just a convenient source of natural gas, caviar, and rubles in need of laundering.

Second, and more importantly, the economic and financial sanctions imposed on Russia by the US and its allies would severely damage not just the Russian economy but also the economies of each of Russia's main trade partners. The impact would be exacerbated if the Russians enforced counter-sanctions. This scenario implies some career-making gains for anybody who began the month shorting Russia's currency, bonds, and equities and long gold, oil, and gas, as well as all the rarer commodities (e.g., titanium and palladium) that Russia sells. Only the concurrent diplomatic campaign to save the Iranian nuclear agreement, which would reintroduce Iranian oil into the official global market, has kept oil prices under control in the last week.

You may not be interested in war as an investment, but war is interested in you. One in Eastern Europe would greatly complicate matters for the world's central bankers, who are already dealing with the inflationary effects of the pandemic-induced fiscal and monetary measures of 2020-21. War would exacerbate inflationary pressures while also tightening financial conditions and perhaps harming European business and consumer confidence.

But it isn't all. If Russia is successful in decisively terminating Ukraine's attempt to become a Westward-looking democracy on a route toward European Union, if not North Atlantic Treaty Organization, membership, China's authorities may be persuaded to believe that violently eliminating Taiwan's autonomy and democracy may be possible. If they are correct, we may find ourselves in a post-American world — one in which China is No. 1 in the Indo-Pacific region and beyond — much sooner than most of us anticipated, with far-reaching implications for the world's willingness to regard dollars as the world's reserve currency and U.S. government debt as the safest of financial assets.

But if the Chinese get it wrong — if the United States decides to stick to its long-standing commitment to oppose a non-peaceful change in Taiwan's status — we could find ourselves in an even bigger war than what is currently being considered, with financial consequences that even Nathan Rothschild would have found daunting.