“Thank God we lived through it. The Great War, 1914 to 1917”
Blackadder Goes Forth

While we hope that a resolution will be found to the current war in the Middle East following the announcement of the two-week ceasefire, it is impossible to know with any certainty. In World War I, the Chief of the German General Staff realised in September 1914 that victory was not possible on the Western Front. However, the political will was not there to even attempt to bring the war to an earlier conclusion, leading to continued massive loss of life.

So history rhymes with the war in the Middle East that has already lasted weeks longer than everyone had hoped, as has the war in Ukraine. Consequently, we still see the opportunity cost of owning more cash and bonds against the current background as low. Against the background of heightened tail risks, even with equity markets having derated somewhat despite the relief bounce, we believe valuations are not factoring in much risk.

The risk to oil and LNG (liquified natural gas) supplies is likely to be larger than that seen in the 1970s even though the global economy is less reliant on oil than it was 50 years ago. Following the Yom Kippur war in 1973, the S&P 500 Index fell over 40%, while the fall was even more significant for the UK equity market. The positive today is that growth in broad money was much lower going into the war than it was in 1973, unions are much weaker and economic growth has been more tepid, suggesting less pressure on core inflation and therefore less need for central banks to raise rates.

In the most recent selloff, the Polar Capital Financial Credit Fund fell 1.2% reflecting its defensive characteristics with over 80% of the portfolio in senior and Tier 2 bonds. It outperformed the ICE Global Financials Index’s fall of 1.8% in part due to the shorter duration of the portfolio. For comparison global bonds fell 3.6%, reflecting their longer duration, on average, while the S&P 500 Index fell 8.6% and EuroSTOXX 50 Index fell 10.9% at their worst before recovering. Spreads widened by 16bps for senior and Tier 2 bonds, so still remain tight on a historical basis, but we think for good reasons.

With pre-provision profitability significantly higher today for UK and European banks than pre-pandemic or prior to the Russian invasion of Ukraine, we feel they are much more resilient to any downturn. For example, UniCredit, Italy’s second largest bank, generated a return on tangible equity of only 6.7% in 2019 while in 2022 it had risen to 11.8% despite raising loan loss provisions by around 25% for the energy shock. Conversely, last year UniCredit delivered a 19% return on tangible equity and is targeting 25% by 2030. Consequently, if the war is prolonged what may negatively impact share prices could have a relatively limited impact on credit.

In Blackadder Goes Forth, the silence of the guns momentarily raises the hope that the war was over but as we know it went on for another year. Baldrick raised the prospect of another cunning plan to escape going over the top, to which Captain Blackadder replied: “Well, I’m afraid it’s too late. Whatever it was, I’m sure it was better than my plan to get out of here by pretending to be mad. I mean who would have noticed another madman round here?”.

An end to the war and reopening of the Strait of Hormuz will lead to bonds rallying – but, in a world which is increasingly unpredictable, we believe the asset class will continue to do what it says on the tin and remain an attractive diversification tool.