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The paradox of wartime financial history: what it teaches us is that it cannot teach much
Keith Leung
Managing Director & co-Head of Investor Relations
Economic disasters can have many catalysts, including natural disasters like Hurricane Katrina in 2005 and the Japan earthquake and tsunami in 2011, economic events such as the 1973 Oil Crisis and the 2008 Global Financial Crisis, and epidemics such as SARS in 2003 and Covid-19. Among them, economist Robert Barro argued that wars, not financial crises, produced the twentieth century’s greatest economic contractions. Yet, portfolio construction today largely ignores this historical reality — most allocations implicitly assume that world peace is sustainable, and US-heavy portfolios more specifically assume a continuation of Pax Americana. This appears to be a reasonable bet as peace is indeed the statistically more probable state. But for investors who wish to account for war risk, the fact that major conflicts have financially distinct outcomes makes it difficult to quantify and effectively hedge. How should portfolio managers deal with war risk? War reliably harms the economy, but its effect on any given portfolio is far less predictable — which is why it may be simpler to prepare for war rather than attempt to forecast it.
Those who recognise war risk may think about it in binary terms — winners and losers —and conclude that their asset performances follow the same verdict. It is true that victors typically fare better, but war tends to destroy physical and human capital on both sides. The financial impact differs from one conflict to the next as it depends on a confluence of factors, such as the nature and extent of the conflict, the prevailing monetary regime, and policy responses.
Asset performance can diverge even among winning nations, yet this is often obscured by the tendency to default to the US as a baseline. US equities have delivered strong returns over the past century, but this is not a representative case. Excluding the Confederacy during the Civil War, the US has not experienced massive destruction of domestic production capacity since 1815, and even saw robust economic activity in World War II. However, many other OECD countries had different wartime experiences, and their asset returns reflect this. The UK’s cumulative real return from 1900 to 2013 was 372x, significantly lagging the US’s 1248x. For investors, this means that correctly predicting the outcome of a war does not, by itself, guarantee optimal portfolio positioning.
The losing side demonstrates a similar dispersion in outcomes, except with a considerably lower floor. German equities offered cumulative real returns of 38x over the same period, after both world wars wiped out substantial portions of accumulated gains. Nations that transitioned to communist rule following armed conflict experienced more severe financial impacts. Following the Russian Revolution in 1917, the abolition of private ownership effectively rendered Russian assets worthless; Russian equities delivered just 3.1x cumulative real returns over more than a century.
Given the wide range of returns, particularly in equities, government bills may seem to be a better investment during periods of catastrophe. This intuition has some merit — government bills indeed outperformed stocks in most non-war economic crises, including the Great Depression and post-World War II depressions in Latin America and Asia. However, in economic contractions related to major wars, neither government bills nor stocks systematically outperformed each other.
Various circumstances can weigh on the value of government bonds in wartime, ranging from extreme cases of outright defaults, to the more common partial or soft defaults, characterised by severe inflation and currency devaluation.
Expected real interest rates are often artificially suppressed during major wars so that wartime governments can access cheap funding. Add to that the likely price controls imposed in wartime, as during World War II and the Korean War, when inflation was likely underreported, which means that expected real interest rates were overstated. Investors were accumulating losses on government bills in real terms, even without explicit costs or formal defaults.
Disaster risk is fundamentally asymmetric. Economic disasters have occurred throughout history, during which output plummets, as experienced during the Great Depression. Conversely, there have not been upside events of equal magnitude — while bull markets exist, the gains accumulate through normal periods of growth. Consequently, despite a low probability of disasters occurring, the outsized contraction of output creates negative skewness in the return distribution.
The asymmetry of disasters explains the equity premium puzzle on two fronts: the low risk-free rate and equity premium. First, the risk-free rate is depressed by the demand for safe assets in disaster states, and the absence of equivalent bonanzas means there is no opposing upward force. Second, as the previous section showed that even risk-free assets are not free from disaster risk, market participants would naturally demand a large premium to hold risky assets. The equity premium becomes less of a puzzle once the possibility of disasters, however rare, is accounted for.
But mere awareness of these dynamics — that asset returns differ between countries, and safe-haven properties are inconsistent in wartime — does not translate into actionable investment guidance. History is an unreliable predictor of wartime or post-war relative performance; every war has its own set of unique circumstances.
This unpredictability is evidenced by the differences between expected and actual World War II asset returns. Defying the expectations set by World War I, UK equities outperformed gold and US equities for ten years after World War II started, and UK government bonds outperformed US Treasuries.
Commodities similarly do not display a coherent pattern across major wars. After World War I, commodity prices surged broadly, then underwent a deflationary crash. World War II differed in various aspects: prices at the onset of the war were already depressed by two deflationary periods in the 1930s, and wartime price behaviour within the asset class showed greater divergence than what the previous world war suggested. Government price ceilings limited the price increases of some raw materials to less than 50%, while beef prices rose 116%. Aluminium prices even declined because the increased wartime demand was met by government investment in production capacity to scale supply accordingly. Post-war, no deflationary crash followed.
The evidence presented shows that there is no reliable playbook for investing through war. The question then changes from how to extract a pattern to optimally position a portfolio for war, to how to remain adequately positioned even without one. The answer lies in preparation rather than prediction.
While conviction may be absent, breadth remains available. Diversification across geographies, asset classes, and currencies reduces concentration in any single outcome. Although overall performance does tend to fall in wartime, and even a broadly diversified portfolio is unlikely to profit from war, diversification lowers the risk of irreversible impairment. And since conflicts can erupt with little warning, a diversified portfolio should be built during peacetime so it can be available when it is needed most.
Reducing position sizes adds a second layer of protection to a diversified portfolio during periods of elevated risk. Exiting the market entirely may be a tempting alternative, but this carries its own risk. Wartime dislocations create opportunities precisely because some investors exit; these opportunities can be captured by others who stay invested. Scaling back exposure is a more measured response to war, allowing one to remain invested with a proportionate adjustment to manage increased market volatility.
Quantedge applies these principles in practice, as demonstrated in the recent US-Iran war. The value of running a highly diversified fund was highlighted by our oil positions driving returns and providing a meaningful buffer against losses in other asset classes. Meanwhile, the fund’s constant total risk mechanism ensured that exposures were scaled down accordingly. Given the difficulty in predicting asset performance in wartime, Quantedge does not maintain a separate war-specific model. Instead, it uses these portfolio mechanisms, along with backtesting with both historical and hypothetical data to ensure robustness across extreme scenarios.
Nonetheless, acting with complete rationality still has its limitations, in that each war can rewrite the rules of the last. Applying the lessons of the First World War to the second would not have guaranteed better investment outcomes. The limitation is one of circumstance: there are too few data points and too much structural change between conflicts. From a humanitarian standpoint, we are blessed to have only a small sample of major wars. But in purely statistical terms, we do not have enough wars, or data from wars, to discern any statistically significant trading signals which would be applicable to future war scenarios.
Sources
• Barro, R. J. (2006). Rare disasters and asset markets in the twentieth century. The Quarterly Journal of Economics, 121(3), 823–866. https://doi.org/10.1162/qjec.121.3.823
• Dimson, E., Marsh, P., & Staunton, M. (2014). Credit Suisse global investment returns yearbook 2014. Credit Suisse Research Institute.
• Ferguson, N. (2008). Earning from History?: Financial Markets and the Approach of World Wars. Brookings Papers on Economic Activity 2008(1), 431-477. https://dx.doi.org/10.1353/eca.0.0003.
• Hui, C. (2014, September 3). The one big bet made by most buy-and-hold investors. Humble Student of the Markets. https://humblestudentofthemarkets.blogspot.com/2014/09/the-one-big-bet-made-by-most-buy-and.html
• Hui, C. (2014, October 14). How wars can affect long-term returns. Humble Student of the Markets. https://humblestudentofthemarkets.blogspot.com/2014/10/how-wars-can-affect-long-term-returns.html
This article is for general information and does not constitute investment advice.