History sheds some important insights on how the market fares during times of war, but are the risks different this time?
As the world looks on at the devastating scenes unfolding in Ukraine, many of our worst fears of a war have come to light after recent months where conflict loomed as a distinct possibility.
For all the likelihood of a war breaking out based on surveillance intelligence, recent events have still been a shock for the global community.
In the wake of the recent crisis, there is now a significantly heightened element of uncertainty on a number of fronts.
This ranges from the outcome of the conflict and peace talks, Russian control of nuclear facilities in Ukraine, the global economic impact of sanctions introduced by countries around the world against Russia, how inflation might respond as commodity prices soar, and whether more countries find themselves directly involved as participants in a wider war.
The initial reaction for markets pointed to grave concerns across these areas, with stocks falling sharply. Since then, however, global indexes have been recording volatile swings, with markets staging a relief rally, but large negative sessions are still a common sight.
What does history suggest occurs during times of war? Let’s take a closer look at what this might mean for the market.
How does the stock market perform during times of war?
History tells us that beyond an initial ‘shock’, wars tend to have little sustained impact on the stock market, nor growth in corporate earnings for that matter.
There are caveats of course. First, past performance is no indicator of future performance, especially when things appear to be sitting more on a knife-edge at the moment in terms of the conflict escalating into a broader international war involving NATO nations.
There has also been an unprecedented level of cooperation and implementation of sanctions directed towards Russia in response, and its status as a major commodities player is a curveball given the inflationary impact.
Nonetheless, if we consider the current conflict to be among the biggest, if not the biggest threat to global peace since the Second World War, it is worth noting that the Dow Jones actually increased 50% during World War II.
In this respect, it is incorrect to assume that geopolitical crises will inevitably result in market crashes. In our view, that shouldn’t exclude the need to act with prudence, which is one reason why we are currently holding higher cash balances across all of our Portfolios at this time.
There are also other strategic reasons for this caution. This includes: flexibility to deploy funds into more attractive opportunities that have been sold down; and to ensure we have appropriate exposure to the sectors that we see outperforming.
If World War II is considered perhaps an anomaly in terms of stock market performance, what about other results? Well, research from the Swiss Finance Institute shows a surprising phenomenon when it comes to military conflicts involving the US since that date.
During ‘pre-war’ phases, the increasing prospect of a war breaking out has weighed on sentiment and typically yielded negative returns. But stocks have often rallied once a war does break out, with the exception where wars were started by surprise.
Another piece of research comes from Armbruster Capital Management. It looked at data spanning 1926 right through to 2013, and it came to the view that, with the exception of the Gulf War, volatility in the stock market was lower during periods where a war was active.
Why might stocks continue to rally during times of war?
It seems almost incomprehensible that a war could have little impact on the stock market. After all, there is untold chaos, destruction and grief, let alone the economic fallout and the hit to sentiment.
However, as we have learnt from various other black swan-like events, the market is not necessarily an indicator of the real world. It is only a reflection of the constituents that make up the key indexes.
And on that point, over the years, our markets have shifted in terms of their composition and the way the economy is also built on these names.
Reflecting on the current war, alongside the impact on exports out of Ukraine itself, the role of sanctions on Russia has sparked a sharp increase in a number of commodities, including oil, coal, gas, precious metals, base metals, and even agricultural staples as well.
This is because Russia is a global supplier of: 8-10% of oil supply; approximately 30% of natural gas; about 20% of palladium and 12% of platinum; about 8% of aluminium; and with the inclusion of Ukraine, roughly 27% of wheat and 15% of corn. Furthermore, supply constraints in the shipping waters around the region could also play a role.
While historically these commodity sectors have had an influence over US markets - it is easier to say they hold a bigger influence over the ASX - there has been a seismic shift in what other companies have contributed to the market in that time.
So while rallying commodity prices, and other sectors like defence become more prominent amid expected government spending, this is more of a catalyst for individual stocks. The reality is that the overall market will still be subject to the biggest drivers, which are the mega-tech stocks.
This is another reason why we have exercised some caution and sold down our holdings in some growth names during February, as these assets are more likely to face challenges in the current environment.
But that doesn’t mean other sectors from energy to food and defence are not poised to rise during the current circumstances. In fact, that is principally why we have freed some capital across our Portfolios.
The other consideration at hand is the impact to global growth, with the potential for a domino effect. Soaring commodity prices are expected to feed through to inflation, and this is a barrier that central banks will need to contend with at a time when preparing to lift rates. That timing may sound aligned, but it raises further question marks and uncertainty over the pace at which rates increase.
Do central banks risk raising rates as quickly as they were preparing to, noting the uncertainty stemming from the war in Ukraine? On the contrary, do central banks risk raising rates slower than anticipated, and failing to quash inflation?
In our view, there is no doubt the current war has become a point of concern for the stock market in the near-term. However, if the war is somewhat contained and does not spiral into a broader conflict dragging in other countries, we would expect stock prices to resume their upwards trend. The historical data also suggests this is more likely than not.
The unprecedented nature and juncture of several themes at the moment is something that necessitates flexibility when it comes to decision-making.
Our lesson here is that you can never be too rigid with your investment thesis, you must be prepared to adapt and take into account new information and risks.
At the same time, uncertainty and fear is also the catalyst for opportunities, so being prepared and tailoring one’s investments to the current climate is far more important than worrying about the day-to-day movements in the market.
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