Originally sent to VIXCONTANGO subscribers on March 7th, 2018

Perhaps more interesting than all these conflicts are the recent new weapon announcements that Putin made at the March 1^st State of the Nation address in Russia. What are those weapons? Hold onto to your seat now:

Sarmat ICBM (intercontinental ballistic missile)

This will replace the current Voivoda ICBM system. Weighing 200 tons (same as Voivoda) it has a short boost phase which makes it difficult to intercept for missile defense systems. The Sarmat is equipped with multiple hypersonic nuclear warheads and the most modern means of evading missile defense. This missile can be used in any weather conditions. The Sarmat has no range restrictions (while Voivoda could only go 11,000 km). It can attack the US from the North and South poles. The Sarmat system can place nuclear warheads in low earth orbit and from there after orbiting for a short time they can fall on targets on earth. This system has no range limit. This system would allow Russia to attach North America from the South Pole which is the opposite direction from where the US early warning systems are oriented. A nuclear warhead falling from space from any direction is not something the US missile defense systems are capable of handling.

Voivoda (or anti-Ottoman militia captain) in 19^th century Balkans. Generally known as being armed to the teeth.

Nuclear Powered Cruise Missile

Russia has been able to miniaturize a nuclear reactor (“small-scale heavy duty nuclear energy unit”) and stick it inside a Cruise Missile. That gives the cruise missile an unlimited range. Imagine being able to fire Tomahawk missiles from anywhere on Earth to anywhere on earth! This is a missile that can fly a few feet above the surface, thus it is undetectable and invincible against all existing and prospective missile defense and counter-air defense systems. These missiles can also carry nuclear cargo. The only question is how many of these missiles can Russia produce. If they can product a large number, US defenses will surely be overwhelmed.

Nuclear Powered Underwater Drone

This one is a beauty. This an underwater drone that is powered by a small nuclear reactor, it is quiet and has hardly any vulnerabilities to exploit. It can carry conventional or nuclear warheads. They can be used to engage aircraft carrier groups, coastal fortifications and infrastructure. The nuclear power unit is 100x smaller than units that power modern submarines but is more powerful and can switch into combat mode 200 times faster. This nuclear drone can carry twice the power of the “Tsar” Bomb. That makes it by far the biggest nuclear bomb ever built.

So for example, this drone can be detonated in the Atlantic Ocean to create a tsunami wave 500 meters tall (or 1500 feet) which apart from rendering massive loss of life on the Eastern seaboard would also radioactively contaminate it. This is a weapon of last resort which is intended to inflict maximum damage upon an enemy in case Russia’s land based missile arsenal is disabled by a strike. Oh and this drone can be parked in the Hudson river or somewhere off the US coast and can hang out there for years without anybody knowing that it is there.

Hypersonic Missiles & Laser weapons

Simply put these are missiles that are too fast to be intercepted. They can be fired from the ground or from the air. They fly at Mach 10 (10x faster than speed of sound), can maneuver at all phases of its flight trajectory which allows them to overcome obstacles and anti-missile defense systems. They have a range of 2000 kilometers. In addition, Putin boasts of laser weapons that are already deployed in the Russian military. In addition to all the other stuff, Russia is improving its weaponry for more conventional conflicts as well.

Conclusion

So the world is more dangerous than ever before and NATO or no NATO, Russia seems to have vaulted ahead in the military game with the development of a miniaturized nuclear reactor. This really doesn’t change the balance of power much but if the US thinks it can drone its way to military victory in the future, quite a few nuclear powered hypersonic missiles and underwater drones can change that calculus. The Ruskies always fight in ways you don’t expect and this here is no exception.

What does this mean for financial markets? Well for one, if the US has to counteract these Russian advances, it might have to spend another 1-2 trillion on military spending. If the US gets into a war either in North Korea or the Middle East, that is automatically another 1-2 trillion in military spending. If you add $3-4 trillion in the next 4-5 years to an already 20 trillion dollar US debt, we are talking an additional trillion dollars in borrowing per year. If you think rates are 3% with current fiscal situation (after tax cuts and higher spending), the moment the US gets into another armed conflict you have to up the rates by a few more percentage points (think 5-6%). There is simply more need for borrowing, less investors to buy those US bonds and thus substantially higher rates.

Unfortunately the US faces some very difficult choices – it either spends more money on defense to keep up with Russia or starts to give up geopolitical significance in the Middle East. Either of those 2 developments will be a substantial negative for the US markets in the next few years (and a positive for Russian markets). The last thing the US wants is for the petro-dollar to die. If the petro-dollar dies much of the dominance of the US dollar gets rolled back and if that happens, the DXY could hit 60s easily and general standard of living in the US will be on the decline due to hyper-inflation. China and Russia and Europe have been working tirelessly on dethroning the US dollar and Russia’s recent military advances and gold stashing is sure to be noted by financial markets at some point.

Geopolitical Risks of 2018

I haven’t spent a lot of time discussing geopolitical risks over the past couple of years (with the exception of Brexit) because I thought they would be largely irrelevant. The worst case scenario for geopolitical risk is the outbreak of a war in an oil rich country which usually results in the price of oil going up. When the price of oil goes up, consumer spending in the US suffers because US consumers spend quite a bit on gas. Discretionary budgets decline and the economy usually struggles or enters a recession. The classic example of this is the recessions of the mid-70s, but we saw this more recently in 2007-2008 and 2011.

However, an oil spike in 2016 or 2017 actually would have been a welcome financial and economic event. When Oil overshot to the downside and went down to $25 that was a very bad development for the energy industry and the financial industry. Energy companies were forced to shut down production that was operating at a loss. Their debt wasn’t going to get paid which was bad for financial companies and crews were going to get fired which was bad for the economy. Oil going from $25 to $60 was a good event because US energy companies become solvent and they didn’t have to fire crews. At the same time, US gasoline prices were in that sweet spot between $2 and $3 which US consumers can handle easily.

However, now that Oil has broken above $60, any further appreciation in oil prices will actually be felt by US consumers. When gas prices at the pump have gone from $3 to $4 that has slowed economic growth in the past. As such now, geopolitical risks will start to matter. The US economy will not handle the next oil shock without a hitch.

But there is also another big geopolitical issue that was not a problem until recently. We knew Obama would avoid going to war as much as possible. But Obama is no longer the POTUS. There is nobody to restrain the Republican war mongers. If the US goes to war again, the US budget deficit is going to explode even further. Unlike 2001, when the US had a Federal Surplus, the US is now running at a gigantic deficit. The US budget deficit was at $666 billion in 2017. The CBO projects 1 trillion deficits by 2020 after the passage of tax reform. Tax cuts have added about 250 billion to the deficit per year. Lower revenues lead to larger deficits and increases in total debt which in turn leads to debt service increases. Once you go into a debt spiral, the compounding math works against you and it gets bad quick. In addition, Debt-to-GDP ratio is now north of 100%, whereas in 2001 it was roughly at 50%, a substantially better financial position.

Initial estimates of the cost of the Iraq War in 2003 were for $50 billion. Larry Lindsey, director of the National Economic Council in 2002, was fired by the Bush administration for projecting costs as high as $200 billion. After 15 years in Iraq, the actual cost of the Iraq war is estimated to be nearly $5 trillion dollars. That is 5,000 billion or over 100 times the original projections. Since the US government was operating at a deficit over the past 15 years, the US had to borrow money to finance the war and a substantial part of the increase in debt during the Bush and Obama years is actually war spending. Most of the deficit spending during the Obama years was to finance a prolonged war started by a Republican President and a Republican Congress which lasted for a lot longer than was projected.

If the United States enters another prolonged war in North Korea or in Iran, it is very easy to see that war cost north of 2-3 trillion dollars at minimum excluding reconstruction costs. That means that the projected debt of the United States will go dramatically higher. We could be at 25 trillion debt by 2020 easily. If we add to that a normal recession, which after 9 years of expansion will be a perfectly normal event, we could be looking easily at 130% to 150% Debt to GDP ratio for the US.

Once the US reaches these Greek type debt levels, I think the US credit rating will be downgraded once again. If the US enters another war, I am certain that credit agencies will downgrade US treasury debt.

If you look at the VIX, you would think that everything is just fine in the world, but in reality, the world is a giant tinderbox waiting to burst. Geopolitical risks have never been higher with a couple of states pushing for nuclear proliferation. With the implicit backing of China, these states are trying to upend the dominance of the United States in world politics. And with Trump as President, the chances of the US entering another war haven’t been this high in a decade. Let’s look at the biggest geopolitical risks in the world today:

North Korea

The 1950-1953 Korean war caused nearly 34,000 US casualties and 1.2 million South Korean casualties. The GDP of South Korea was cut by 80%. South Korea was not the economic actor then that it is today. If Samsung and other South Korean companies were to be disrupted today, the economic impact will be substantial. A 50% fall in the South Korean GDP today will knock off a full percentage point off global GDP. The disruption of trade flows will be substantial. The war and the reconstruction will be enormous. Most expects think that US debt will increase by 30% if this war was to transpire.

Obviously North Korea is a proxy to China and if the US is fighting North Korea, it is in effect fighting China. A war between the US and China will upend the current economic order and the biggest losers out of that conflict are US multinational companies which outsource and sell to China. If you want to see earnings of the S&P500 disappear into thin air quickly ala 2008, a war with China can do that. The SPX is trading at 25 GAAP PE and that means we assume that the current benign international setup lasts for the next 25 years. I am not so sure that will be indeed the case. The old international order could start breaking if the US enters a war with North Korea and many countries in the world will find themselves in the uncomfortable position of choosing between China and the United States.

Many experts think the odds of a war with North Korea are at 50/50. Some put them even higher at 70%. Lindsey Graham, a Republican senator with expertise in foreign policy, said 2 weeks ago that there is 70% chance of war if North Korea tests a 7^th nuclear missile. According to him, another nuclear test will put Trump over the edge. All I can tell you about Lindsey Graham is that every war he has advocated for over the past 30 years has come to fruition – Iran, Iraq, Syria, Lybia, Serbia, he was an advocate for intervention everywhere. The neocon wing of the GOP has put North Korea in its sights now for some reason and Obama is not there anymore to control them. I am not sure to what extent Trump will be able to resist the neocon overtures. He has been very amenable on greater military spending and has greenlighted larger US involvement in the Middle East. If North Korea is next on the neocon radar, unfortunately a war may be inevitable. The recent capture of ships that were delivering oil to North Korea could soon lead to more serious escalation of tensions. Hopefully the recent progress around the Olympics defuses tensions long term.

Middle East

Another war that is brewing under the surface is the situation in the Middle East. Now that ISIS has been defeated there is a war over the spoils. Putin is aiding Syria, the US is aiding Israel and Saudi Arabia which want to stop Iran from gaining a military foothold in Syria. Turkey is going after the Kurds who are US allies and want to establish a state that probably would have about 30 million people in it. And if it was created, it would be comparatively one of the larger countries in Europe by population. The situation in the Middle East is a complete mess and it could explode at any point. Tom Friedman ranks the Israel vs Iran situation as #2 on his global risk list. Analysis of the Middle East is not my specialty, all I know is that it is a very difficult puzzle to solve and all I can do there is just evaluate the financial involvement of the US. If the US gets involved more substantially, we are talking at least a 2-3 trillion dollar commitment.