War, terror and the markets

One could be forgiven for thinking that markets are somewhat blasé about today's seemingly grave geopolitical threats. After all, the S&P 500 continues to set fresh all-time highs while the MSCI World Index is within touching distance of that too, despite ongoing tensions in Gaza, the alarming events Syria and Iraq, and the apparent possibility of the "worst conflict since World War Two", to quote Ukraine's defence minister.

However, bemoaning the market reaction – or the lack of it – "gets the issue precisely backward", says money manager Barry Ritholtz. The proper question to ask, he says, is, "Why should investors care about geopolitics?"

Despite the “big, bold headlines”, the global economy is not imperilled by these conflicts, he says, noting that Ukraine’s annual gross domestic product (GDP) is equal to about two days of US GDP.

That same point was emphasised in a recent JPMorgan note.

While war-torn countries represent 11.7 per cent of the world’s population, their economic footprint is much smaller, accounting for 9 per cent of total oil production, 3 per cent of global GDP, 2.6 per cent of global trade, 0.8 per cent of corporate profits, 0.7 per cent of global stock market capitalisation, and a paltry 0.4 per cent of portfolio investment inflows.

Passing impact

The current conflicts might spread, of course, thereby causing equity markets to tremble. However, geopolitical shocks tend to have only a passing impact on stock markets.

Last year, S&P Capital IQ strategist Sam Stovall examined 14 so-called "shocks to the system" since 1941, events such as the Cuban missile crisis, the Gulf War of 1990, the 9/11 attacks of 2001 and the Madrid bombings of 2004. Declines tend to be brief, indices recouping their initial losses within an average of 14 days.

In fact, stock markets enjoyed better returns and less volatility during some of the 20th century’s worst conflicts, according to New York firm Armbruster Capital Management.

Looking at returns during the second World War, the Korean War, the Vietnam War and the Gulf War, it found stocks underperformed on just one occasion – the Vietnam War – and even then, equity returns beat bonds and cash.

Reasons

There are a number of reasons for this paradoxical response. Most of the time, says Ritholtz, geopolitical conflicts do not affect corporate revenue and earnings. Often, even trade restrictions tend to cause a shift in consumption rather than a collapse, he adds.

Secondly, markets anticipate and price in conflicts. An obvious such example occurred in March 2003, markets bottoming just days before the US invasion of Iraq and almost doubling over the next four years.

Similarly, while the US did not enter the second World War until late 1941, the economic impact of war had long been priced in, with the Dow Jones having halved since 1937.

The event that precipitated US involvement – Japan's attack on Pearl Harbour – was a shock, and stocks tumbled over the following days.

Again, selling on the news would have been a costly mistake – anyone who bought after the Pearl Harbour attacks and sold at the end of 1945 would have enjoyed annual returns of 25 per cent.

Some events, like the assassination of president John F Kennedy in 1963 or the September 11th attacks in 2001, obviously cannot be priced in ahead of the event.

As mentioned earlier, however, investor shock tends to be fleeting. Markets plunged 2.9 per cent on the day of JFK’s assassination, for example, but the news, though shocking, was not economically significant. Investors quickly digested this, and stocks soared 4.5 per cent the following day.

Obviously, the 9/11 attacks were much more significant, and equities were battered in the week after the reopening of the stock exchange. Within weeks, however, investors had regained their losses and decent gains were recorded in the last months of the year.

Terrorism

The spectre of terrorist attacks is once more occupying policymakers, with Britain recently raising its terror threat level to “severe” from “substantial”, due to the rise of Islamic extremism in Iraq and Syria. As the 9/11 case exemplifies, however, the investor impact tends to be fleeting.

Take the London bombings of July 7th, 2005, and market reaction to news that 52 people had been killed in coordinated bomb blasts. UK share prices quickly fell 4 per cent but had largely recovered their losses by the end of the trading day.

Similarly, six people lost their lives during the World Trade Centre attacks of 1993 but investors were largely unmoved, stocks falling by just 0.5 per cent.

Going back much further, an anarchist bomb attack on Wall Street in 1920 led to 38 people losing their lives. At the time, it marked the deadliest terrorist attack ever seen in the US, and the marks from the bombing can still be seen on Wall Street buildings. That was its only impact on financial markets, however – stocks actually gained 1.5 per cent the following day.

These are not cherry-picked examples. One study which examined nine al-Qaeda attacks found only four moved a major index by more than 1 per cent, with most having “minimal, transient impacts”.

None of this means geopolitical tensions are irrelevant to investors. Rather, it suggests conflicts will only catalyse serious equity losses if they possess a tangible economic component. The Arab oil embargo of 1973, for example, led to oil prices quadrupling from $3 to $12 in just six months, triggering international recession and steep equity market falls.

Not priced in?

Similarly, bears can argue that, unlike previous conflicts, little if any geopolitical risk is priced into global markets.

Oil prices have dropped in recent months. Gold, supposedly a safe haven asset, has traded in sideways fashion. The Vix, or fear index, spiked higher last month but quickly retreated to multi-year lows.

And equity investors, as mentioned earlier, have been sanguine, with investors seeing the recent pullback as yet another “buy the dips” moment, driving the S&P 500 to all-time highs.

It’s not that investors are blind to the possibility of economic disruption. After all, in the most recent Merrill Lynch monthly fund manager survey, 45 per cent said a geopolitical crisis was the biggest risk facing markets today.

These fears have been evident for some time now – in March, for example, more than 80 per cent agreed geopolitical risk posed a threat to financial market stability.

In other words, investors are cognisant of today’s geopolitical conflicts, but are betting no economic repercussions will materialise.

Some see this as complacency, arguing volatility is being suppressed by the abundance of liquidity injected into global markets by central banks. Deutsche Bank, for example, has warned that while a large-scale geopolitical risk event remains unlikely, investors “should be mindful of alternative scenarios relative to the benign outcome currently expected by markets”.

If things take a turn for the worse, then, a short-term market stumble appears likely, given traders don’t appear to be prepared for any escalation in risk.

If history is any judge, however, the long-term investor has little to fear from any such stumble.