War’s impact on markets – decent returns

WAR and conflicts – whether local, regional or global – always arouse tension and anxiety in us as investors. First, there was the Ukraine war; then geopolitical tensions between the US and China; Afghanistan; and now the Israel-Palestinian conflict. Markets have weathered more than their fair share of geopolitical events in the past few years. Investors have become anxious, and volatility has surged alongside the rise in 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 repeat itself, it certainly rhymes.

This evidence-based approach allows us to take into account the unique context of any event, and compare it 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 a shock to the system. However, the way markets react may not align with most expectations.

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, in the case of large wars with pervasive impact across broad regions – such as World War II – financial markets fell in the period before the war, but rose throughout the duration of the war.

LPL Research conducted a long-term study by of 21 geopolitical events including terrorist acts and shock events that have led to war since 1941. It showed that typically across these events – ranging from the Pearl Harbor attack to the many Middle Eastern conflicts and the 9/11 attack – the market on average fell by 1.2 per cent on the first day of the event. From the first day to the trough – which normally took 22 days – the loss was 5 per cent. The loss was recovered in 47 days on average.

A study by CFA Institute showed that across all major wars since 1926, large-cap stocks typically returned 11.4 per cent during wartime versus an average of 10 per cent during the span from then till 2013. Small-cap stocks returned 13.8 per cent during wartime versus an average of 11.6 per cent during the period. It is interesting to also note that wartime periods had an average inflation of 4.4 per cent versus the whole span’s average inflation of 3 per cent.

So, war is inflationary and good for markets – which is a counterintuitive result. Of course, all wars differ and markets react differently to them. However, here is a more recent example. The Ukraine war led to a 7 per cent fall in the S&P 500 index in the weeks that followed, but the index recovered a month later and surpassed the level it was at when war began. We see a similar trend in the recent Israeli-Palestinian conflict.

Enemy of markets – uncertainty, not war

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. News about impending war and rising geopolitical risks raises uncertainty about the future outlook.

Normally, rising uncertainty due to war or geopolitical tension may cause investors to shift their money to traditionally safer assets such as gold and precious commodities, currencies or bonds. However, some of these traditional safe havens do not look as safe as they used to.

US government bonds, once heralded as risk-free assets and the place for funds in times of crisis, have fallen from grace. The US’ ongoing fiscal challenge; falling credit ratings; rise in issuances; and high debt servicing cost have all led to a sense that US Treasuries are not the safe haven that people thought they were.

Currencies such as the Japanese yen and 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 anaemic.

However, markets go through cycles; what seems to be a new reality can suddenly change. We have just had the fastest pace of interest rate hikes in many decades. Despite all the concerns, the market is an efficient pricing mechanism; and current market valuations are likely to have priced in all the known factors. What will drive interest rates and fixed income markets are likely the things that we do not yet know.

Based on what we do know, other things being equal, yields are closer to the peak than ever before. As a result, bonds now give investors enough yields to compensate for 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 boost 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, rather than the vagaries of geopolitical winds. Of course, in the current Middle East conflict, the uncertainty lies in whether the conflict will escalate 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, would impact on inflation and interest rate policy.

These second-order effects will be priced in over the next few weeks, after which the market will reassess and move forward as it has always done.

What history teaches is that equity markets do not suffer as we would expect during wars and conflict. Instead, returns are decent in that environment. 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 of monetary and positive fiscal response initially.

That is not a bad thing for markets, especially with fewer safe haven investments available to investors. Returns of the fixed income market will accelerate if things get worse – whether that is the economy or geopolitics.

The writer is co-founder and chief investment officer at Endowus, an independent wealth platform advising more than S$6 billion in client assets across public, private markets and pensions (CPF and SRS)