War, AI and the stone age
Dear Friends,
This is a much longer letter than usual, its length is due to momentous changes that have occurred in the past three months.
This is a solemn spring, millions of people have been displaced and thousands have been killed in yet another war in West Asia. In our view, this war was initiated in a bout of hubris. Some in the White House and Congress appear to have believed they could assassinate the Iranian head of state in order to bring a more pliant government to power in Iran. In the first days of the war, the administration claimed this as a war of liberation for the Iranian people. The plan for a quick “regime change” appears to have been immediately dashed since many potential moderate politicians were killed in the initial surprise bombings. Four weeks later, US officials threaten to destroy Iran’s power plants, electricity, and entire infrastructure, returning it to the “stone age.” We doubt this is the sort of liberation even the most ardent internal critic of the Iranian administration would wish for. We are also increasingly unsure of the US’ objectives in this war and how it will end. One frequent refrain from our administration is that the Strait of Hormuz must be re-opened for the war to end. The Strait was, of course, open to all navigation prior to the US/Israeli bombing campaign that began on February 28. Iranians maintain that the Strait has remained open to vessels not associated with the belligerents and it has begun to charge transit fees. It is unclear as to what rules will govern during the recently announced ceasefire, and in the long-term.
This is an investment newsletter, and at the risk of seeming callous, we shall set aside our own views on this war and the humanitarian considerations, as we attempt to understand what it portends for markets and the economy. The White House appears to have underestimated the capabilities of the Iranian armed forces and government, or ignored the advice of those who cautioned them that the Iranians are a formidable adversary. Several prior administrations chose not to embark on a war with Iran based on this counsel. We believe this war will have significant medium and long-term impact on the global economy, some of which has already occurred.
Immediately after the US/Israeli attacks on February 28, Iran’s government announced the Strait of Hormuz would be closed to traffic. Over 20% of the world’s supply of oil and gas, fertilizers and other industrial products such as helium, pass through a narrow channel that lies within Iranian territorial waters. The deepest channel, used by the largest ships, is close to the Iranian coastline.
We believe Iran can keep the Strait of Hormuz closed to commercial traffic for months, if not years if it wished to. A vast ground army would be required to destroy coastal fortifications and open the Strait by force. It is worth recalling that the US reached an agreement with the Ansar Allah (aka Houthi) government in Yemen, after failing to forcibly open the Bar el-Mandeb Strait on the Red Sea. Ansar Allah possessed a fraction of Iran’s capabilities.
The Iranian government has allowed some ships to transit the Strait, subject to a transit fee. Notably, they have required the fee to be paid in Chinese Yuan. Historically, the Middle-Eastern economies have benchmarked oil sales against the dollar and this led to most other regional transactions being dollar-denominated. The Iranians are shut out of the dollar economy by sanctions, and they seem to be deliberately taking aim at the dollar’s primacy in the region (often called the petro-dollar economy). The Iranians have said the passage fees will serve as restitution for the damage done by sanctions, and the current US/Israeli bombing campaign. In this effort, they have tacit support from China and Russia. Russia has required European buyers for its gas and oil to pay in Chinese Yuan as well. Over the past 20 years, successive US administrations have imposed economic sanctions on a broad range of actors. A shift to Chinese Yuan for transfer payments would would neuter such sanctions.
The Iranians have also responded to attacks on their industrial facilities by targeting US allies in the region whose territory was used for attacks on Iran. The UAE, Qatar, Kuwait, Bahrain and Saudi Arabia have sustained damage to military bases and industrial facilities. In some cases, these oil and gas facilities will not be restored to full capacity for many years. The closing of the Strait, and damage to petro-chemical plants has begun to impact the supply of numerous petro-chemicals. Even if the cease-fire announced today were to hold, the impact of the war would be felt for months.
Our assessment is that the Iranians do not believe the US administration can be trusted in negotiations, having twice been attacked by US forces during negotiations. These breaches of trust will make reaching a long-term agreement difficult, and it is entirely possible that naval traffic in the region remains affected for many months. Iranian officials have indicated that they are prepared to continue the war beyond the US mid-term elections.
As oil and gas prices rise (and supply contracts), economies in Asia (particularly developing countries) have begun to be impacted. Some countries have moved to a four day work week, and gas shortages have impacted industrial activity. Iran has increased its exports of oil and gas, finding new buyers for its hydrocarbons, which has bolstered its finances. The same is true for Russia. Meanwhile, the exact opposite is true for US allies in the region. Most of the Gulf Cooperation Council (GCC) countries have seen revenues from oil/gas sales drop precipitously. The GCC countries run large public deficits which are funded by their state owned oil companies. As oil revenues dry up, they will face enormous economic pressures. These countries have historically invested their sovereign wealth funds in the US and Europe, we expect they will be forced to make sales as this war drags on.
Since transportation costs account for a fraction of all goods prices, the rise in oil prices will impact broader inflation. We are beginning to see early signs of this in smaller oil-importing countries in Asia. As gas prices rise in the US, we expect food and other goods prices to rise as well. This will lower US consumer spending over time. The supply chain impacts are much broader than oil or gas alone. For example, helium is critical to semi-conductor manufacturing. One-third of the world’s supply of helium comes from Qatar and is currently off-line. It’s reasonable to assume a shortage of advanced chips over the next few months. Production of other crucial goods is similarly impacted, this includes fertilizers that are widely used across Asia.
Iran’s strategy is one of attrition and economic warfare. As the subject of sanctions for decades, Iran understands how economic stress can impact a country’s capabilities. Iranian military planners have a sophisticated understanding of US domestic politics, and know the impact an economic crisis will have on the US’s resolve. Similarly, they understand the politics of GCC countries in their immediate neighborhood. Large segments of the GCC populations see this war as an aggressive move waged by the US and Israel. Sympathies for the US and Israel were already low after the heavy costs of wars in Gaza, Lebanon and Syria. Pockets of support for US/Israel do remain, primarily among the Jordanian, UAE and Saudi monarchies. Each of these governments are absolute monarchies with no tolerance for dissent. Broad public opinion does pose a threat, even to them, and there is a chance we see these monarchies backed into a corner by their populations.
This war has already lasted longer than the optimistic estimates first presented by president Trump. The US administration is clearly looking for an off-ramp, but the Iranians have very few incentives to provide one. The US and Israeli attacks on civilian infrastructure have shored up internal support for the Iranian government. Given their geography, current strengths, and past history, we do not believe the Iranians are unlikely to lay down their arms unless they extract significant concessions.
We believe the unprompted US attack on Iran was ill-advised. Though ignorance is no excuse in such serious matters, we believe a large segment of the US elite do not understand Iran, and are uninterested in learning about it. We are reminded of an anecdote where another US president, Jimmy Carter, expressed frustrations with Iranian intransigence and, in his view, an inordinate focus on the past. An American analyst in an attempt to explain the Iranian perspective remarked “Mr President, the old souq in Iran is 6000 years old, and what they call the NEW souq, is 2000 years old.”
In our estimation, this war will end only when the Iranian government is ready to have it end. At that point, it is probable that the US’s GCC allies and Israel will have been significantly weakened. After seeing the rapid retreat of US forces under Iranian missile barrages, it is entirely possible the GCC will no longer be willing to host US military bases. Iran is also likely to continue charging fees for passage through the Strait of Hormuz. If the war resumes, GCC investments in the US may need to be liquidated to help fund public sector deficits. Qatar, Saudi Arabia and the UAE invest with many large private equity and venture capital companies in the US. As the inflow of capital from the GCC slows, it will eventually affect asset prices. We are beginning to see some stress in the debt of very highly levered companies (almost all of them funded by private equity). This could easily spill over and impact other markets.
We must note that this war has already caused unimaginable losses. The initial surprise bombings conducted by the US killed over a hundred schoolchildren and seventy-five adults in a series of strikes on a school in Minab, Iran. There have been reports that the target may have been selected via AI tools, which raises another set of very troubling moral and legal questions. This was only one of many bombings that have killed civilians. We believe this and other actions taken to initiate this war have hardened the resolve of the Iranian government. It has emboldened those who insist the only way to provide security for Iranians is to impose so heavy a cost on the US and its allies that they do not think of striking at Iran again. This is part of the reason we believe the war will not have a quick and easy resolution, unless the US capitulates to Iranian demands.
Moving to the other high impact story of the quarter, over the past few months, we’ve been evaluating the new AI models released by Anthropic and OpenAI. These releases have sparked a reassessment of the investment landscape in our minds as well as that of other investors. To illustrate the significance, we will review the impact on three industries that we know well. These are technology and software services, financial services and genetic testing. All three of these are information industries in the sense that the highest value services they have historically provided involve interpreting and acting on information as opposed to manipulating physical materials. They are, from the perspective of economics, knowledge industries.
AI models and tools are furthest along in terms of software development. We can reliably say that a development or debugging task that might have taken two weeks with a prior generation of AI has now shrunk to a couple of days. High performance, specialized software using highly customized or obscure tools, remains largely unaffected. But, for the majority of software and software services, this leap in ability has taken place. The result is that the “competitive moats” many software companies were assumed to have built with large code-bases and rich feature sets have shrunk or dried up. A competitor could leapfrog an incumbent at a much faster pace than previously considered possible.
In financial services, our own development and startup experimentation has led us to the conclusion that the majority of work being done within financial services by client-facing personnel and/or researchers could be radically re-organized with this class of AI tools.
In the field of genetic testing, which we know from past association, we can see many novel applications. Physicians or genetic counselors have thus far been responsible for analyzing genome sequencing results for a particular patient. This task can now be performed by AI more efficiently. We would point specifically to Anthropic’s test results for Claude Op.4.6 which indicate the model is equivalent to human analysis 65% of the time. Similar tests have been developed for the other industries. Some of these results should be taken with a cautionary note since the tests are developed internally, and in some cases their methodology is not publicly available. All indications we’ve seen suggest that the direction of travel and approximate accuracy of the models for these tasks is roughly correct.
The shift in capabilities is so dramatic that dystopian scenarios are possible as we noted in our June 2025 letter. Many, but not all, players in the space are responsible actors. There are major AI labs that are playing fast and loose with safety. We recall that 3 to 4 weeks ago the Grok LP/xAI tool (created by Elon Musk-owned X – formerly Twitter) allowed users to generate dangerous material for many hours before it was shut down. The possibility that a loosely controlled AI may allow humans to develop a bio weapon or other doomsday scenario is not outside the realm of possibility.
What does all this mean for investors? AI is an enormously disruptive change that will percolate through the economy for the next 5 to 10 years and perhaps even longer than that. There are true outlier scenarios, for example, emerging capabilities in industrial robots and AI may give us autonomous robots that can perform a variety of different tasks at very low cost. This would be akin to going from horse-drawn carriages to a modern electric vehicle in the span of five years.
In the short term, the capital investment cycle in AI will continue. We are skeptical as to the returns from the investment and physical plan. We believe AI cloud compute capacity will be rapidly commoditized. We believe it likely that the greater part of economic benefits will accrue to firms that are effective at adopting and delivering an innovative set of products using AI technologies.
In the short term, the market is a beauty contest. In the long run, it is a measurement contest. In the immediate short term, we expect market participants to identify a series of industries that will face radical disruption from new entrance and AI companies. These industries will see increased volatility just as SaaS and software services have over the past months. In contrast, defensive sectors such as consumer staples which cannot be impacted in the same way should see investor interest increase. The same is true for certain natural resource sectors.
Over the medium term, it will become clear which new entrants have capitalized on these new capabilities to build disruptive companies. We will also see some existing enterprises adopt AI effectively and capture a larger market.
We must caution all investors that the next few years are going to be a period of immense change. This includes regulatory and social/political change as societies adapt and respond to these rapidly evolving transformative technologies.
Regards,
Louis Berger
Subir Grewal, CFA
PS: We have included a military briefing below, with the caveat that this is not our area of expertise, we are largely relying on sources we consider reputable.
Appendix: Military Briefing and Analysis
Iran is an ancient, diverse and sophisticated culture. The topography and geographical position of Iran have made it a major power for many millennia. The Iranian plateau is ringed by rugged mountain ranges that contain many peaks over 15,000 feet high. It is also vast, covering an area larger than France, Germany and Spain combined.The country has coastlines along the Persian gulf, and the Caspian sea. In a literal sense, Iran has high walls and moats protecting it. These natural defenses have long made it resistant to most foreign invaders. The Achaemenid, Parthian, Sasanian and Safavid dynasties each ruled for hundreds of years. Iranian cultural and scientific institutions have played an important role in human development over millennia. We are aware of the old quip, that war is a very expensive way to teach Americans geography.
In more recent times, the Islamic Republic of Iran has invested heavily in public education and healthcare. Literacy rates are over 90%, with virtually all children receiving a formal education. Women make up roughly 60% of university students. 40% of Iranian graduates earn a STEM degree (this is twice the US rate). University education rates overall are at 45%, only slightly below those in the US (55%).
US-imposed sanctions have forced Iranian industry to develop domestic alternatives for many goods. Iran has advanced industrial capabilities, producing over a million cars a year, and more steel per capita than the US. These industrial capabilities have allowed it to develop a domestic arms industry, with a particular focus on drones, missiles and small, nimble boats.
Military planners on both sides have assessed each other’s weapons’ strengths and weaknesses over the years. The Iranian military has been preparing for an asymmetric war with the US for at least three decades. For its part, the US has been war-gaming a war with an adversary like Iran since the Millennium Challenge 2002. That exercise demonstrated that US forces would face significant challenges and losses when confronting a capable adversary using asymmetric warfare techniques. Though US and Israeli warplanes have successfully hit many targets in Iran, it is clear that Iran’s capability to deploy drones and missiles remains intact. By launching varying barrages of older missiles early in the war, the Iranian armed forces have depleted a large portion of the US and allied missile interceptor stock. Missile interceptors are expensive to produce, and the near-term supply is finite. The Iranian armed forces have also successfully destroyed many of the US’ advanced radars, which has degraded the ability to provide timely warnings. It has also forced the US to redeploy advanced radars from bases in South Korea, reducing the effectiveness of those allies’ defenses.
Iran has also struck arms manufacturing facilities and datacenters across the middle east. It is our assessment that Iranian missile and drone stocks have not been materially depleted. Iran has built fortified missile production lines which lie deep beneath mountain ranges. It continues to launch medium and long-range missiles several times a day from multiple locations. Its naval assets include small fast craft capable of launching missiles, as well as various marine drones and mines situated in fortified installations along its coast.
Many US bases along the Persian Gulf have been evacuated or severely damaged. The US embassy in Iraq has been evacuated of non-essential personnel, and the embassy in Saudi Arabia was damaged.
The Iranian armed forces have partially succeeded in pushing the US back to airbases away from the Persian Gulf. These remote airbases, in Saudi Arabia and Israel have also been subjected to missile and drone attacks, with several aircraft reported destroyed. A US aircraft carrier, the USS Gerald Ford was damaged in a fire, there are suspicions that the damage was caused by Iranian missiles or drones. It is now in the dock being repaired. A second carrier has been forced to retreat to 1000km from the Iranian coast for the past few weeks.
The loss of several aircraft over the past week belies the US administration’s claims that Iranian air-defenses have been destroyed. Military analysts have suggested that Iran may have preserved its mobile air defenses and missile launchers in the initial weeks by placing them in hardened bunkers. Some videos released by the US military as evidence of successful strikes, may have been hits on inflatable or painted decoys, which have been widely used in the Ukraine war as well. More significantly, the US’s stock of long-range missiles is limited. For the first few weeks, US aircraft were firing guided missiles from outside Iran’s airspace. In the past two weeks, the US and Israeli air-forces have switched to flights over Iranian airspace to drop gravity bombs. This makes the aircraft vulnerable to Iran’s surviving air-defenses, and may explain the recent losses of F-15s and F-35s.
We share these military details to support our argument that the Iranian armed forces are a formidable adversary for the US. The decentralized structure of the Iranian government and armed forces was built to survive the sort of “decapitation strike” the US and Israeli air forces attempted on the morning of February 28. It is also worth noting that US officials have consistently downplayed the extent of their own losses, ascribing many of them to accidents. This includes the losses over the weekend of two C-130s and several helicopters, blamed on mishaps during a rescue operation. Military analysts believe they were lost to Iranian fire during a failed attempt by a large US and Israeli special forces team to locate and steal Iran’s highly-enriched uranium stockpile. The accidents and “friendly-fire” incidents have begun to pile up, and it strains credulity to believe that none of these incidents are the result of Iranian actions.
The Iranian armed forces have publicly said they are prepared for a long war. They believe the ceasefire agreed to last year after the 12 day war was a mistake, and the last 10 months were used by the US and Israel to re-arm, conduct deceptive negotiations and strike Iran again. Iranian officials have repeatedly made public statements that they will not permit this cycle to repeat itself.
Iranian officials have shown that they will employ the economic weapons at their disposal in this war. We believe the Iranian government possesses both the resolve and the capability to prosecute such asymmetric, economic warfare for an extended period. They have prepared for a long regional war over the course of several decades, and all indications are that they believe they are in it now. The US and its allies have sanctioned Iran for decades. The Iranian government now sees the tables as having turned, and an opportunity to deliver some of the same medicine to the US and its allies. Iran is largely self-sufficient, and has transport lines to its allies (Russia and China) via the Caspian Sea and rail networks to the north). The Russian and Chinese administrations, which have also been the subject of US led sanctions and tariff warfare, are unlikely to find American appeals to intercede persuasive. The US has also, broadly speaking, alienated allies in Europe and the GCC with its actions over the past years. Iranian military and political analysts are well aware of the fissures that exist in US alliances.