How to invest for the new Cold War

One thing you can say about the media in general is that it’s never good news. Happy stories don’t sell papers or generate clicks. But even accounting for that tendency, it’s fair to say that the geopolitical situation today feels wobblier than it has done in quite some time. There’s the rise of ever-more brutal incarnations of Islamic extremism in the Middle East; there’s the ongoing tension between China and Japan (more than half of Chinese people asked in a recent poll expect the two nations to go to war at some point); and, of course, there’s Russia, playing a game of cat-and-mouse with the West, all the while consolidating its grip on Ukraine.

Like natural disasters, war and revolution have a horrendous human cost; but from an investment perspective – like natural disasters – their impact often seems minimal. There have been many instances where war, or the prospect of war, has had little or no effect on stockmarkets. Since 1950, noted a recent JP Morgan Asset Management report, “with the exception of the Israeli-Arab war of 1973 (which led to a Saudi oil embargo against the US and a quadrupling of oil prices), military confrontations did not have a lasting medium- term impact on US equity markets”. Markets shrugged off the Falklands War, the Soviet invasion of Afghanistan, and America’s invasions of Grenada and Panama.

However, this perhaps takes rather too narrow a view. Vietnam, for example, helped to transform the entire monetary system – the high cost of the war forced president Richard Nixon to stop backing US dollars with gold in 1971, ending the gold standard once and for all, and contributing to the massive inflation seen during the 1970s. Meanwhile, the 1989 collapse of the Berlin Wall, and the apparent triumph of democracy it represented, opened up a whole new world of cheap labour and new consumers. This dis-inflationary wave enabled Western central banks to keep interest rates unusually low for long periods of time without driving inflation higher. So the argument that geopolitics isn’t important, because markets don’t always react instantly, might be comforting, but it’s too simplistic.

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That’s why it pays to keep an eye on what’s going on – and on Russia in particular. The risk is that a renewed Cold War could result in the loss of many of the economic gains seen after the Iron Curtain was first torn down. So far, the biggest economic casualty of the conflict has been Russia itself. Sanctions have made it harder for Russian companies to access funding from the West. While the country has plenty of breathing space to pay its debts and fund its own companies, the Russian rouble has been hammered, and the Russian central bank has been forced to raise interest rates to stop capital flight. With the oil price falling too, Russia’s economy looks very vulnerable.

But the freezing up of relations with Russia will have consequences in the West too. As winter approaches, it’s worth remembering that Russian gas accounts for 5%-10% of consumption in many Western European countries (though not Britain) and more than a third of some in Eastern Europe. Although Russia would suffer the most from any shutdown, as its revenues from energy sales plunged, some of these countries will have to find alternative power generation methods. Germany is also suffering – the impact on its trade with Russia has contributed to a slowdown in the economy, which is bad news for the eurozone as a whole.

In the longer run, as Charles Dumas at Lombard Street points out, if sanctions push Russia closer to a reliance on China, “this holds out the prospect of a new polarisation of world politics – in effect, a renaissance of the Cold War”. For example, the BRICS nations (Brazil, Russia, India, China and South Africa) recently set up an alternative to the World Bank, which will help developing nations to fund infrastructure. The question of how much influence this has isn’t really relevant. The point is that America’s dominance of the global economy is partly down to the fact that the US dollar is the world’s reserve currency. These moves could represent the first serious step towards a time when a significant challenger to the dollar arises. One thing is for sure – just as cooler relations with Russia will encourage Europe to find alternative sources of energy, Russia also has a very strong impetus to find alternatives to a US-dominated financial system for trade and capital-raising.

All of this is happening at a time when central banks in the US and UK are hoping to be able to wean their economies off the drip of low interest rates and printed money at a slow and steady pace. That’s a tricky job as it is – this might make it a lot trickier. The things that made the era of near-omnipotent central banking possible – disinflation from cheap labour and imports from developing nations, and the globalisation of financial markets – now threaten to go back into reverse.

Ultimately, however well deserved, sanctions have the same impact as protectionism. They make it harder for goods and services to move between countries, driving up costs. And if we’re moving to a world where nations scrabble to secure supplies of vital resources because they can’t trust their former trading partners, then we can also expect resource scarcity to become more of a problem. In short, a less secure world is a more inflationary world – and that could be very bad news for anyone who still expects interest rates to remain at these low levels for the forseeable future.

So what does this mean for your money? If inflation were to become a more serious issue (and that could still be some way off), and central banks come under pressure to raise interest rates more rapidly than they would like, then debt is clearly the most vulnerable asset class. At the very risky end of the spectrum, investors are pricing in little chance of companies or nations defaulting – they are snapping up junk bonds and loans from countries with short or flawed credit histories. Any reversal in the fortunes of the bond market could see things turn nasty very quickly. As for ‘safe’ government bonds like US Treasuries or UK gilts, they could be hit particularly hard if rates rise faster than expected. In previous bond bear markets, investors have at least had high income yields to compensate them for capital losses. With yields so low at the moment, any losses would be a lot more painful for today’s investors.

As for stocks, we’ve said before that Russian stocks look incredibly cheap – and they still do. In fact, Russia is one of the cheapest markets in the world. History suggests that usually if you buy markets when they’re cheap and hated, then in the long run, you’ll be rewarded. The trouble is, there are potential risks with Russia that you don’t see in many other markets – the threat of nationalisation, for example, and a state that can be very hostile to shareholders when it wants to be. A bet on Russia could pay off – there’s no doubt about that. But it has to be viewed as a speculative investment at this stage. If you’re tempted, the JP Morgan Russian Securities (LSE: JRS) investment trust is one option. It trades at a 11% discount to its net asset value (in other words, you can buy the shares for substantially less than the underlying portfolio is currently worth).

Another option in a more war-torn or paranoid world is to invest in defence stocks. If countries are running out of trust, then spending on both conventional weaponry and also cyberwarfare tools is likely to increase. Promising companies in the defence sector include BAE Systems (LSE: BA) and Raytheon (NYSE: RTN). If you’re specifically interested in a play on cybersecurity, then Symantec (Nasdaq: SYMC) is worth a look. It trades on a relatively modest 12 times forecast earnings for 2015, due to concerns that large companies are bringing their cybersecurity work in-house. However, Symantec aims to stop this trend by upgrading the quality of its products. JP Morgan reckons that the company’s high margins mean that even a small boost to sales will deliver a significant boost to cash flow.

The newly-frosty relationship with Russia will also have an impact on global energy resources. The Russians need Western technology to help them to develop new potential sources of energy, such as in the Arctic. That’s not going to happen now – so at the margins, at least, the outlook for new oil discoveries has deteriorated a little.

On the other hand, the drive to find alternative natural gas suppliers to Russia can only be good for the fracking industry in both Europe and the UK. David Stevenson of The Fleet Street Letter writes about fracking regularly (learn more about it at caseforfracking.co.uk). One of his favourite UK-based fracking plays is iGas (LSE: IGAS). The company concluded a promising deal with French oil giant Total in February for two of its licences.