Diplomacy

The first tool usually employed by a country seeking to achieve a certain outcome while resolving a dispute with another country is diplomacy. Diplomacy is often conducted by direct contact between state officials, such as ambassadors or trade negotiators. However, as global telecommunications have evolved and made people more politically aware, influencing the citizens of other countries has become an increasingly important aspect of international relations. Convincing foreign citizens that your policies are the most desirable path for them to follow is not a new concept, but modern technology has certainly made it easier for governments to disseminate propaganda. The art of diplomacy therefore includes the use of propaganda as a key policy tool. Propaganda is often benign, where a country tries to promote a particular political cause. In its more sinister form, however, propaganda can be used to undermine the policy and political structure of a rival country, even to the point of destabilizing foreign political regimes. A former professor of mine, political scientist K. J. Holsti, noted that “[t]he officials making propaganda hope that these foreign groups or the entire population will in turn influence the attitudes and actions of their own government.”¹ Propaganda can therefore be aimed at an entire population, or a specific subsegment of the population, both with the desired objective of influencing a foreign government's policy decisions. Propaganda can take many forms, including persistent and repeated advertisements of ideas and slogans.

As well, diplomatic relations are more than simply symbolic. They are a valuable commodity, providing structure and assurance of a willingness to resolve disputes peacefully, and, where possible, to the general advantage of both parties. Having an immediate presence on foreign soil in the form of an embassy or consulate therefore shows a desire from both countries to maintain good relations. When relations break down, the withdrawal of embassy or consular staff is often one of the first actions taken by governments to try and coerce the other country into a desired course of action. Breaking diplomatic relations should therefore be viewed as an extreme measure and cause investors to reassess the businesses they own in those countries. Depending on the parties involved and the reason for severing diplomatic relations, investors should consider looking for a safer investment opportunity elsewhere.

Economic Incentives

Countries that are unable to resolve conflicts through diplomacy may pursue their goals using economic incentives. Concessions on trade or other economic matters, as well as supplying economic aid, may entice the opposing country to agree with the desired settlement. Naturally, not every country is able to use economic incentives as a policy tool effectively. Wealthy countries, especially those with exceptionally large economies like China and the United States, are in the enviable position of being able to use their economic power to achieve their economic and political goals. Reducing trade tariffs, aiding the foreign country in developing its infrastructure, supplying goods or loans, and loan forgiveness are examples of economic incentives that may be used to achieve foreign policy goals.

Military Coercion

The final tool available to countries for resolving disputes is military coercion, which is the threat or use of force. In situations where one country has a clear military advantage over another, the simple threat of force may be sufficient to convince the weaker country to concede. However, the threat or use of force may have unexpected consequences, including more powerful countries coming to the defense of the weaker country, drawing ridicule on the world stage, or causing other countries to employ economic or diplomatic sanctions against the aggressor.

Figure 7.1 shows the relative military power of select countries. These rankings are based on conventional (nonnuclear) military capability, but include all countries known to possess nuclear weapons.

It is not coincidence that the world's top military powers have large economies since wealth is needed to supply and support a military establishment. Economic and military strength enable a country to exert its influence throughout a region, or even around the world. This is referred to as the country's sphere of influence, and in world politics, a country that has considerable influence or control over a large geographic region is commonly referred to as a hegemon. Hegemons have great power and are capable of using all of the tools of international relations to protect their interests and project their influence. A country that is able to exert its influence over a significant portion of the world is referred to as a superpower.

War is one of the most terrible afflictions faced by humanity. The amount of human suffering and the destruction of property caused by conventional warfare is unimaginable for most people. All-out nuclear war would be far worse and could bring about the end of our species. For this reason, it is extremely unlikely that any country would intentionally use nuclear weapons, whose main purpose should be to deter others from attacking. Any reference to warfare in this book therefore relates to conventional (nonnuclear) warfare, and any notion of the financial markets being able to recover from a war assumes that nuclear weapons are not used. The devastation caused by nuclear weapons is so vast that the global economy and even the existence of humanity would be threatened in the event of their use.

It may come as a surprise that humanity's ability to adapt to even the most difficult circumstances means that conventional war usually has a minimal, or at least short-lived, impact on one's investments. Figure 7.2 shows the impact that wars have had on the US capital markets. The wars considered in this figure include World War II, the Korean War, the Vietnam War, and the Gulf War.

While large-cap stocks returned an average of 10.0% annually from 1926 to 2013, the return during wartime was actually slightly higher, at 11.4%. Small-cap stocks also performed slightly better than average during wartime. Not only were stock returns higher during wartime, but their level of risk (measured by the volatility of their returns) actually fell. Curiously, long-term government bonds and long-term credit (corporate bonds) generated lower returns during times of war. This may be because historically inflation has been higher during wartimes and bonds react negatively to rising inflation (bond returns are negatively correlated with inflation). Another possible explanation is that governments borrow more during wars, thus driving bond yields up and bond prices down.²

While the higher returns and lower risk shown by stocks during wartime may seem counterintuitive, it is often the period leading up to war and the early days of a war that uncertainty and risk are highest. Once a conflict breaks out and investors become familiar with the scope and size of the conflict, the stock market tends to recover fairly quickly. In addition, corporate earnings may actually get a boost from warfare, as governments increase spending to pay for the goods and services consumed while conducting the war.

Figure 7.3 shows how the US stock market reacted to the outbreak of the Korean War in 1950, and it illustrates how brief stock market reactions can be to war. In this case, the US stock market fell by 20.5%, technically entering into a bear market. However, the effect was short-lived, and the US stock market fully recovered to its prewar level by September 14 that same year, a mere 56 days after the war began.

The US stock market's reaction to the outbreak of the Gulf War is another example of a muted response to military conflict. The S&P 500 began to fall in July, just two weeks before Iraq's invasion of Kuwait on August 2, 1990. Once again, the market fell by slightly more than 20%, bottoming in mid-October but then fully recovering to prewar levels by February of the following year.

It is important to note that the data shown here relates to the US capital markets. Since the United States enjoys a significant economic and military advantage compared to most other countries and because the wars were fought in other parts of the world, any assessment made based on these examples may understate the effects of war on the capital markets. These wars would have had a more dramatic and enduring impact on the economies and financial markets of those countries where the war was actually being waged. The impact of war on individual stock markets will therefore depend greatly on the nature and location of the conflict and the countries involved.

Eastern Europe

Eastern Europe (Figure 7.4) is a focal point in the rivalry between Russia and members of the North Atlantic Treaty Organization (NATO). NATO is a military alliance that was formed in 1949 between 12 countries, including the United States, Canada, France, Italy, the United Kingdom, and several other European countries. Since that time, NATO has grown to 30 member states with numerous other countries aspiring to join the alliance, some of which are former members of the Soviet Union. As new members have joined the alliance, Russia has expressed concern over NATO's expansion eastward and tensions between the two military powers have escalated. Russia is a key supplier of energy to several NATO member countries, making the economies of both parties vulnerable to a potential conflict in the region.

While drafting the manuscript for this book, this situation deteriorated to the point that the largest conflict since World War II broke out in Europe. Russia's invasion of Ukraine on the pretense of self-defense in 2022 threatened to destabilize the entire region. Although the probability of the conflict widening to engulf more of Europe is low, there is still a risk of it escalating into a direct conflict between Russia and NATO, and thereby the United States. Both the United States and Russia know that a war between the two countries would be devastating and would increase the risk of nuclear warfare. The sanctions imposed on Russia by NATO members in response to the invasion are unprecedented and intended to apply pressure on Russian leaders to withdraw their forces from Ukraine. Russia retaliated with threats to cut off the supply of energy to Europe, which would have a significant negative impact on European and global economic growth. While higher levels of interdependence can help reduce the risk of disagreements becoming violent, it can also lead countries to underestimate how their opponents will react to the actions they take. It is clear that this is what has occurred between Russia and Western powers in 2022. Can it happen again in other regions and between different countries? Absolutely, especially when ambiguity exists and where countries do not fully understand one another's political agenda.

Iran and the Middle East

Iran (Figure 7.5) is a regional military power in the Middle East that is trying to develop nuclear weapon capability. Some Western countries see Iran as a threat to regional stability and have used economic and political sanctions, diplomacy, and propaganda in an attempt to pressure Iran into giving up on its nuclear aspirations. Iran has a strong conventional military, and some countries believe it may pose a threat to several US allies in the region, including Israel, Saudi Arabia, and the United Arab Emirates.

The Korean Peninsula

Like Iran, North Korea is viewed by most Western powers as a potential threat to regional stability. Although North Korea does not have the same conventional military power as Iran, it already possesses nuclear weapons. North Korea's proximity to US allies Japan and South Korea (Figure 7.6) also adds to the importance of this region on the world stage.

India and Pakistan

Another geopolitical hotspot is the disputed Kashmir region of India and Pakistan (Figure 7.7). Kashmir is split into two segments, one administered by each country. Skirmishes have broken out along the line of control between the two countries, resulting in some military and civilian casualties. Any one of these clashes had the potential of causing a broader military conflict. It is important to note that both Pakistan and India have strong conventional military capabilities and that they each possess nuclear weapons. Not far from Kashmir along the border between China and India, there have also been instances where Indian and Chinese forces have exchanged fire. Fortunately, none of these armed clashes has led to a major conflict.

The South China Sea

One of the most important geopolitical regions today is centered around the South China Sea. This is where the interests of the world's first truly global superpower, the United States, come into close contact with the interests of the world's emerging superpower, China. As the evolutionary cycle evolves, the probability of conflict between the current leading power (the United States) and an emerging world power (China) become elevated. This is especially true when the emerging power increases defense spending to match its economic growth. Rapid improvements in military capability by an emerging power are often perceived as a threat to the world's current leading power. This is precisely what we see happening today, with China's emerging strength seen as a potential threat to the current world order and the leading role played in it by the United States.

For millennia, China was the dominant economic and cultural center of Asia. In fact, China's role in Asia could be equated to that of the Roman Empire in Europe. The two empires coexisted, unaware of the other's existence, but each ruling their known world at the time. China's dominance ended in the first half of the nineteenth century when it collided with the more industrialized and militarily advanced countries of Western Europe. Today, China has recovered much of its economic, political, and military power and views most of the East and South China Seas as its sovereign territory, including the Taiwan region, shown in Figure 7.8 by what is known as the “nine-dash line.” This area includes smaller islands as well, some of which are claimed by competing countries, such as Japan. As we noted earlier, the South China Sea is strategically important to the global economy, with significant amounts of trade flowing through its waters. This fact, combined with defense alliances between the United States and several Asian countries, including Japan and the Philippines, places Chinese and United States’ interests at odds in the region.

China views the United States as an interloper in the region, while the United States wants China to accept and adhere to the current world order that the US established out of the ashes of World War II. The United States has therefore resisted China's attempts to expand its political sphere of influence in the region. The United States often sends navy convoys to the South China Sea to ensure the freedom of navigation for foreign vessels, while China responds by sending its own naval vessels to the region to deter what it views as interference in its internal affairs. There have been several near-misses between the warships of the two countries, and there is a risk that an accident could quickly escalate and lead to a military conflict. Although the odds of a conflict between the United States and China are increasing over time, war between the two countries is not inevitable. In the words of Graham Allison, “[h]istory shows that major ruling powers can manage relations with rivals, even those that threaten to overtake them, without triggering a war.”³

Geopolitical hotspots deserve special attention, but they do not preclude investing in businesses of the countries involved. While close calls and skirmishes will surely continue, and have the potential to develop into broader conflicts, there are some simple ways investors can limit the potential damage caused by these events.