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The art of the deal? “When the facts change, I change my mind. What do you do, sir?” John Maynard Keynes, the great 20th century economist, is often credited with this saying which aptly captures the mood in financial markets today. Events of the past 18 months have unveiled several inconvenient truths which necessitate investors to reassess the basic assumptions in portfolio construction. Recall that Trump won his second presidency on the premise that he would stop unnecessary wars, lower cost of living, and reduce America’s fiscal profligacy. Investors, in turn, positioned their portfolios along those lines. But the direct opposite has happened since, with the administration waging military campaigns in Middle East and Venezuela, while the One Big Beautiful Bill adds trillions to the national debt.
The Iranian war debacle, a campaign with no clear strategic endgame, is going down in history as one of the biggest strategic blunders of the US military. Aside from massive financial costs, the other lasting damage the war has created is the rupture within NATO – a situation which brings into question whether American security guarantees can even be relied upon anymore. Right now, negotiation with Iran for a peace deal is still ongoing and looking at the state of play, it is clear that Tehran has the leverage and holds the cards. Iran’s nuclear programme will be a thorny issue that is unlikely to see concrete resolution in the ongoing negotiations.
So why is Trump willing to accept a bad deal? The truth of the matter is, there is no better optionality. Faced with plummeting popularity, surging gasoline prices, and a looming midterm election, things can’t get any worse, and the price of dragging on with a meaningless conflict will be larger. Resumption of military strikes is not feasible either as Iran’s asymmetric counterair campaign through clever usage of low-cost drones has changed the war dynamics. A bad deal, it seems, is the only viable option left on the table now.
The Aftermath: Structurally higher inflation. The Pentagon has guided that the war will cost USD25bn so far. But such an assumption is based on the historical cost of weapons and does not reflect the reality of replacing them at current prices. This, coupled with the cost of repairing the destroyed military bases in allied countries, will increase the damage significantly. Based on the estimates of Harvard Professor Linda Bilmes, the war will cost closer to USD1tn in totality. Separately, the administration had asked Congress to boost US defence spending to USD1.5tn, the highest since WWII.
US fiscal deficits, coupled with elevated energy prices, suggests that investors are under-pricing inflation tail risks. Buoyed by AI optimism, equity investors are already off to the races. The AI capex cycle had rooms to run and with it, driving corporate earnings higher. We concur with this view. But portfolio downside protection matters. It makes sense to watch your downside at this point while equities are already pricing in an eventual end to the crisis and weaker oil prices. We believe investors will need to confront the following issues in the coming months:
- Higher-for-longer oil price and rising central bank hawkishness
- Rising equity-bonds correlations and the need for new safe havens
- The new capex supercycle
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