Hedging nuclear war's downside risk

Christopher Joye

After interviewing leading strategic thinkers I argue in the AFR that there appears to be a 1-in-10 to 1-in-4 probability of full kinetic conflict erupting between the US, South Korea, Australia and North Korea, possibly backed by China, which could turn radioactive, and you had better consider how you can hedge the direct and indirect risks of war (click on that link to read for free or AFR subs can use the direct link here). I go on to highlight the performance disparities between the Composite Bond Index and AAA rated Aussie government bonds, which have both delivered materially negative returns over the last year of around -1% to -2%, in contrast to the Floating-Rate Note Index, which has massively outperformed by some +4% to +5% over the same period. Fixed-rate bonds have been hammered by the re-rating of long-term risk-free rates, which we have long warned about. It is no surprise therefore to see floating-rate ETFs going gangbusters...Excerpt below:

"Back in 2013 I revealed that highly-regarded security strategist Hugh White believed there was a 1-in-10 chance the US and China could become engaged in outright war over the next 15 years. The feedback from interviewing the heads of ASIO, the CIA, and the NSA was just as dour: the tyranny of distance that protected Australia during World Wars I and II could quickly become the tyranny of proximity as Western-Sino tensions drove the probability of global conflict to heights not observed since the Cold War. So when the North Korean despot Kim Jong-un started lobbing intercontinental ballistic missiles (ICBMs) out across the region—powered by Ukrainian engines that catapulted the Hermit Kingdom's ICMB program—I reached back out to leading thinkers in the field. The response was not reassuring. A theoretical physicist who had worked with the Department of Defence and is now a top think-tanker put it bluntly: "This is genuinely worrying because you've got a mad-man dealing with a nut-case". He was talking about the "Team America: World Police" movie-like stand-off between an ever-hyperbolic Donald Trump and Kim Jong-il's basketball loving son. This PhD handicapped the likelihood of full-blown war between the US, North Korea, South Korea, China (one way or another) and care of the ANZUS treaty, Australia, at 10 per cent. Another PhD and high-ranking former defence official, who served as head of strategic assessments at Australia's peak intelligence agency, was even more pessimistic, advising that there was a 25 per cent chance the current turmoil could evolve into major power conflict involving the wonder down under. Why so high? There is an influential school of thought in Washington that the US must deal firmly with North Korea unless it wants to further embolden a rising China to embark on more bellicose crusades that destabilise the global balance of power. This view contends the US and its allies have repeatedly underestimated the speed with which China has assembled the second most formidable military capability on the planet, which is increasingly threatening traditional US dominance in the kinetic domain, and the related consequences of China deciding to unilaterally construct artificial (and now weaponised) islands in the internationally contested waters known as the South China Sea. The argument goes that as post-World War II US hegemony fades, and is replaced by a much more combustible, multi-polar mosaic of relations, it is essential the West, and the US as its titular leader, promptly act to discipline recalcitrant states in a credible manner that extends to the application of force to protect core interests. Put another way, the US and its brothers-in-arms must be prepared to go to war with North Korea to send a signal to China that the civilized world will not be relentlessly bullied by non-democratic rivals. History, after all, teaches us that appeasing ambitious autocracies rarely works...One thing that was interesting during the turbulent days of August was the poor performance of supposedly defensive investments like AAA rated government bonds and the high-quality debt tracked by the Composite Bond Index, which is the main fixed-income benchmark for superannuation portfolios. In August the AusBond Composite Bond Index, which has an average AA+ rating, actually fell 0.01 per cent as did the AAA rated AusBond Treasury Index, which declined 0.06 per cent. Over the 12 months to August 31, the Composite Bond Index has slumped 0.66 per cent while the AusBond Treasury Index has imposed an even greater 1.95 per cent loss. Now this has much more to do with the inevitable re-rating of long-term risk-free rates, which I have warned about here ad nauseum. It certainly seems that investors are getting the message that fixing your interest for circa five years makes no sense insofar as it is not a risk anyone can realistically manage, and it is much more rational to take a passive, "floating-rate" exposure that has one-sixth the volatility and allows you to focus on the quality of the asset rather than speculative interest rate bets that are impossible to get right over the long-run." Read full article at AFR here.


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Patrick Fresne

Though it is probably true that there is too much complacency regarding the chances of a significant military conflict taking breaking out, a WWIII scenario is perhaps less likely, as the demographics of the major world powers (China and the US) are quite different from those of the major powers on the eve of both the World Wars.

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