Blood and Taxes: What White House Hawks Mean For Wall Street

When the missiles start flying, oil and aerospace stocks take the lead. The rest of the market is a less predictable roll of the dice, but if history is any guide, an alert advisor can keep clients in the clear.

[caption id="attachment_41422" align="aligncenter" width="600"] U.S. destroyer launches into Syria at dawn local time. [/caption]
Now that President Trump has traded Twitter rebukes for Tomahawk missiles, the weekend pundits are already debating whether the one-time isolationist has picked up a taste for expensive foreign adventures.
They’d much rather see him focus on the domestic promises that have already gotten the equity markets back in the mood for breaking records: massive infrastructure spending, $2.6 trillion in tax reform, an extra $950 billion in the long-term Pentagon budget.
If those Tomahawk strikes spark a new U.S. war in the Middle East -- with or without complicating factors in the Pacific Rim -- campaign promises are going to need to take a back seat to strategic necessities.
Even little wars don’t come cheap. Something on the order of the War on Terror could cost $5 trillion that investors might have preferred to see Washington spend elsewhere.
And until we know where the geopolitical winds are blowing, Wall Street hates tension. The next few months could bring their share of shocks, requiring more than a little time soothing clients who equate sliding indices with the end of the world.
But let’s start with the likely scenarios first.
Not all shots start wars
While tensions are high, cooler heads have always prevailed in the past. Maybe Syria’s friends will rattle their sabers and nurse a grudge, but it’s kind of hard to extend yourself too far defending someone who gasses his own people.
As for Syria itself, Assad isn’t likely to put up much of a fight even if Trump decides to follow through on the air strike.
The sides are simply too unbalanced -- that country has already suffered so much chaos that the missiles we threw at it on Friday add up to 0.4% of current annual GDP.
We can keep blasting the Assad regime without real fear of reprisal as long as he can rebuild, but the hostilities probably won’t even get close to that stage.
As Lou Dobbs of all people reminded me back in the days when Saddam Hussein was around to test the “no-fly” walls around Iraq, planes get shot down and airstrips get blasted too often to really shake the markets.
Maybe Trump thinks his point has been made. In that event, Wall Street will simply price in an incremental risk discount and get on with the business of earnings season.
And if things escalate, Wall Street will price in those developments too.
Remember, back in September 2011 stocks dropped 12% when the market finally reopened, but by October 11 investors had recaptured all lost ground. From a pure financial perspective, even a shock of that magnitude resolved extremely fast.
Naturally the non-financial impacts took a lot longer to overcome. War destroys. If nothing else, the cost of military intervention drains attention and other resources from the civilian agenda.
That’s what might really unnerve Wall Street in the here and now. It’s traditionally hard for Washington to juggle guns overseas with the “butter” of investment in public works at home.
Question marks around the southern border wall multiply when that project needs to compete for its slice of the federal budget, for example.
And if cash gets tight, a tax cut may have to wait a year or two. Only George W. Bush managed to resist raising taxes in wartime, but he wasn’t operating in a world where sequestration rules mandate a balance between federal spending and revenue.
Cutting revenue when you need to spend more on the military breaks the current system. No tax breaks make Wall Street unhappy.
The long picture
In textbook situations, a more volatile geopolitical environment pushes money back toward low-risk assets, giving the ironclad Treasury guarantee a bid.
Friday we saw Treasury yields actually rise, which tells me that the initial response to unexpected U.S. military intervention was away from that traditional safe haven.
It wasn’t a big move, but it’s not exactly a vote of global confidence.
Big money seeks safety and flees surprises. Right now a lot of the big potential shocks are clustered around U.S. politics.

[caption id="attachment_41424" align="aligncenter" width="600"] The Mar-a-Lago war room: note Goldman Sachs alumni outnumber generals.[/caption]
Right now, as Trump says, Treasury borrowing costs are historically low so he could theoretically argue for tax relief and still support a war or two on credit.
But that kind of borrowing is ultimately inflationary, which naturally pushes yields up as bond buyers demand higher interest to compensate for getting paid back in a depreciated currency.
Inflation isn’t fun. A generation of investors has practically forgotten how painful it can be, but perceptive and nimble advisors can shield them from the active erosion of buying power.
We were already alert for inflation to edge up to 2%-3% in the next few years. Military adventures -- even to achieve the best of goals -- may accelerate that arc and give the Fed nightmares.
But unless Treasury yields stay ahead of inflation, a lot of investors are going to be unhappy. Make sure yours aren’t. Be ready to rotate toward asset classes that hedge against rising consumer prices, keeping your clients’ income needs as covered as you can.
The right kind of equities may do well. We may see blue-chip U.S. stocks take over some of the traditional role of Treasury paper, replacing the current cash flow component of fixed-income instruments and holding open the prospect of price appreciation as well.
Of course all of this may play out whether Trump gets drawn into foreign conflicts or decides to stay home after all. There’s a lot we don’t know about how policy will cost out in terms of the federal debt.
Moody’s is apparently nervous about the tax cuts. That’s not good for the Treasury’s credit rating, and adding a war to the calculations bends the math faster.
In terms of hypotheticals, it’s good to start managing your clients’ expectations now. Maybe none of these scenarios come true and the status quo continues indefinitely. Maybe the future will be glorious.
But even a five-year inflationary window can play out shockingly fast unless everyone’s prepared for it. Your clients will be grateful if you prepare them for it and it happens.
Strategists talk a lot about implied long-term interest rates and stock market returns. A shifting geopolitical landscape is the kind of catalyst that changes their assumptions.
Those assumptions are what drive everything in the retail investment world, from “retirement numbers” to allocation calculators.
And as always, it’s a moving target. Missiles fired on Friday may not even register on the market’s radar next week. Risk edges up and down, with lurches along the way.
Some benchmarks are always useful. The Cuban Missile Crisis is a great example of “cooler heads” talking the world down from almost unbearable tension. Stocks dipped 5%.
September 11 combined the tension with a recession, but even then, it took six months for the market to really start deteriorating. In 2003, the year we invaded Iraq, the S&P 500 rebounded 28%.
Likewise, formal wars haven’t been bad for Wall Street. Stock prices doubled between 1941 and 1945, despite a bad year at the beginning as the months ticked down to Pearl Harbor.
The early 1950s were equally good for investors despite the Korean War. Likewise, both Gulf Wars left the S&P 500 deep in the green, while the long Vietnam era gave shareholders close to “average” returns all in all.
After all, over the last 75 years the United States has been at war about half the time, if you count the long occupation of Afghanistan as ongoing. Add the worst years of the Cold War era and peaceful years are actually in the minority.
Markets kept moving. The hot sectors cycled, but the world didn’t end. If your clients get nervous, it’s good to remind them that history is actually on their side.

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