What do markets typically do during times of war?

The original version of this article first appeared in The Business Times. 

War and conflicts, whether local, regional or global, always bring with it a level of tension and raises anxiety in us as investors. It was first the Ukraine war and then geopolitical tensions between the US and China; later Afghanistan, and now the Israel-Palestinian situation. There has definitely been more than a fair share of geopolitical events in the past few years. Investors become anxious and markets become volatile because of the meaningful increase in the level of uncertainty. 

The science of wealth is about using empirical evidence and data to learn and understand how financial markets work. An important part of that is to look to the history of financial markets to guide and teach us about how markets react under different circumstances. We all know that while history may not exactly repeat, it certainly rhymes. 

This evidence-based approach allows us to take into account the unique context of any event and compare with other similar experiences to see how that may affect financial markets. It is intuitive to think that wars and conflicts will have an outsized negative impact on financial markets. Normally, these events are seen as shocks to the system and hence the markets. However, the way markets react to these events may not be how most people would expect. 

The bottom line is that many wars, both small and large, have had minimal impact on the underlying fundamentals or the existing trajectory of markets. However, for large wars with pervasive impact across broad regions, such as the Second World War, the financial markets fell in the period before the war but actually rose throughout the duration of the war. 

In fact, the long term study of 21 geopolitical events including terrorist acts and shock events that led to war since 1941 by LPL Research shows that typically across these 21 events that range from the Pearl Harbor attack to the many Middle Eastern conflicts to the 9/11 attacks, the market reacted on average by falling -1.2% in one day and around -5% to the bottom which normally took 22 days to reach that bottom from the day of the event but recovered that loss in 47 days on average. 

How markets have reacted to wars and geopolitical events

Note: S&P 500 index for geopolitical events. Large cap and small cap indexes in the US market for the wars. Source: LPL Research, CFA Institute, Bloomberg, Endowus Research

Furthermore, a study by CFA Institute shows that across all major wars since 1926, stocks typically returned 11.4% for large cap stocks during wartime versus an average of 10% during the whole period and 13.8% for small cap stocks during wartime versus an average of 11.6% during the whole period for the overall market. It is interesting to also note that the periods during war had an average inflation of 4.4% versus the whole period average inflation of 3%. 

So war is inflationary and also good for markets — which is a counterintuitive result. Of course, all wars are different and markets react differently to it. However, even the recent examples of the Ukraine war led to a 7% fall in the S&P 500 index in the weeks that followed but recovered a month later to above where the markets were when the war began, and we have seen a similar trend in the recent Israeli-Palestinian conflict. 

Why uncertainty, not war, is the enemy of markets     

The markets are a pricing mechanism that tries to reflect in real time all known information available to the public. This is why the market is seen as a leading indicator or a good real time sentiment gauge of underlying fundamentals of the economy or business. 

It is also why the worst thing for the market is not war or geopolitics or even a recession, but the uncertainty that creates volatility. With every news about impending war and rising geopolitical risks, the market is uncertain about the future outlook. It is another form of risk so a rising period of uncertainty is a form of rising risk. 

Normally, if that level of uncertainty rises due to war or an increased tension in geopolitics, it can lead to investors moving their money to traditionally safer assets such as gold and precious commodities or safer currencies or bonds. However, some of these traditional safe havens don’t look as safe as they used to. 

US government bonds, once heralded as the place to be whenever there was conflict or crisis as a “risk free” asset, have fallen from grace. The ongoing fiscal situation with falling credit ratings, rise in supply of issuances, high cost of servicing that debt have all led to a sense that the US treasuries is not the safe place most people thought it would be. 

Currencies such as the Japanese Yen to the Swiss Franc seem to have problems of their own. Commodities also struggle with the weaker than expected global demand especially from traditionally heavy consuming economies such as China, where growth and demand remain anemic. 

However, despite the lack of good alternatives the markets go through cycles and what seems to be a new reality can also suddenly change. We have just had the fastest pace of interest rate hikes in many decades. Despite all of the above concerns, because the market is an efficient pricing mechanism, we are likely to have priced in all these knowns in the current market valuations. What will drive interest rates and fixed income markets is likely to be things that we do not yet know. From what we do know, other things being equal, yields are closer to the peak than ever before. As a result, bonds are giving investors enough yields now to be compensated for taking the additional risk of investing in the fixed income market, whether it is treasuries or credit, regardless of where interest rates are headed. If growth slows then the likelihood of rate cuts next year as currently predicted by both the markets and the Fed is likely to give a boost to fixed income returns. 

The stock market normally prices in risks pretty quickly and then focuses back on the economic and business fundamentals of growth and earnings – the fundamentals of the markets – rather than the vagaries of geopolitical winds. Of course, in the current Middle east conflict, the uncertainty lies in whether there will be an escalation into a broader regional war that may have a longer lasting impact especially on oil and other commodities, which in turn, like the Ukraine war did, will have impact on the trend in inflation and therefore interest rate policy. These second order effects are what will be priced in over the next few weeks. Once it is priced in, then the market will reassess and move forward as it has always done. 

What history teaches us is that equity markets do not suffer as we would expect during wars and conflict. In fact, it has a decent return in that environment as long as the war does not land on its own soil. While a higher for longer interest rate environment is not good for markets, any significant rise in tensions or conflict is likely to lead to a policy response tilted towards an easing monetary and positive fiscal response initially and that is not a bad thing for markets, especially with less safe haven investments available to investors. The return of the fixed income market will be accelerated if things get worse - whether that is the economy or geopolitics.  

Samuel Rhee is Co-founder and Chief Investment Officer at Endowus, an independent wealth platform advising over S$6 billion in client assets across public, private markets and pension - CPF and SRS. He is formerly the CEO & CIO of Morgan Stanley Investment Management in Asia.

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