Billionaire Ray Dalio, founder of the world’s largest hedge fund, warned in late January that the global financial system is on the brink of what he calls a “capital war” amid rising geopolitical tensions — and that was before an actual war in Iran began.
Here’s why a capital war matters
The U.S. government has borrowed enormous sums and, unless something radical happens, borrowing will only accelerate. The deficit for the current fiscal year (beginning Oct. 1) has already topped $1 trillion dollars. We now spend more on servicing the debt than we do on defense.
This has mostly been manageable up to this point. Foreign buyers — particularly China and Europe — purchase large amounts of that debt, keeping Treasury yields relatively low. Dalio believes this could soon end.
As geopolitical tensions rise and the world moves toward isolationism, money itself may become increasingly “weaponized” through capital controls and asset freezes. U.S. Treasuries look much less attractive to international buyers when there’s a chance they won’t be repaid — that’s kind of the whole point of a Treasury.
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If that happens, the U.S. government suddenly finds itself in a no-win scenario. Fewer buyers means less demand. That means rates rise and debt becomes more expensive. The government would be forced to issue more bonds to cover rising interest payments, which would increase supply and drive rates even higher — a vicious cycle.
There is another option. The government could “print its way out” — avoiding ballooning rates by buying its own debt. But that means introducing more cash into the system, leading to currency debasement. More dollars in circulation means every dollar is worth less.
Neither scenario plays out well.
Here’s what it means for the stock market
Here’s why that matters for stocks. If the first scenario plays out, the market would get crushed. Even in a normal market, when bond yields rise, investors tend to move away from equities and toward bonds. Why take on the risk of owning a stock when you can get a more or less guaranteed return on a Treasury note? The entire equation of how stocks are valued changes.
And we’re not in a normal market. We’re in a historically valued stock market. According to the Shiller CAPE ratio — an adjusted price-to-earnings ratio of the whole market — only two times has the S&P 500 (^GSPC +0.86%) been more expensive: at the peak of the dot-com bubble, and for a brief moment during the pandemic, when corporate earnings collapsed.
Now, if the government chooses option B and tries to print its way out, you may think that would be good for stock prices. A declining dollar means corporate revenue would increase, and investors would chase higher returns and be willing to take on more risk. And you would be right, at least nominally. In real terms, stock prices may not keep pace with the declining dollar and high inflation. And add to this the fact that if international buyers are refusing to buy U.S. Treasuries, they may be hesitant to buy U.S. equities as well — reducing demand.
The war in Iran could have major downstream effects
And now an actual war in Iran threatens to impact the market in a way that mirrors Dalio’s capital war. Oil prices have surged to nearly $120 a barrel as roughly 20% of global supply transiting the Strait of Hormuz came under threat. That could spike already stubborn inflation, forcing the Federal Reserve to raise interest rates.
If this is not a temporary disruption — and there is plenty of reason to believe it won’t be — oil-driven inflation would force rates higher as the Fed tries to cool it, while the government, already running a trillion-dollar deficit, has to fund a war. That means more borrowing and more pressure on rates, or more printing, and the dollar takes a hit.
The bottom line
Now, none of this is guaranteed, but the risks are real. I’m not saying you should run for the hills — time in the market beats timing the market, after all — but what you own matters more than usual right now.
Now is not the time to invest in speculative, hype-driven stocks. You want to own shares of businesses with strong cash flows and solid balance sheets — companies that you believe can survive a down market and thrive on the other end.
