Wars and Markets
Russia’s invasion of Ukraine is an important reminder that geopolitical risk is a part of investing in global markets. But how do wars affect the economy and global stock markets? Geopolitical events like military or economic conflicts can affect stock markets in many ways. Whilst there may be a natural inclination to assume military conflicts have a negative and enduring impact on stock markets, a look back at historical conflicts suggests that the relationship between wars and market outcomes isn’t as simple as it seems. Consider the following historical conflicts:
World War I
In the six months following the onset of World War I in 1914, the Dow fell more than 30%. Because the war basically ground the business world to a halt and market liquidity all but dried up, the decision was made to close the stock market that year. This lasted for six months, the longest such period on record. Making up for lost time, the Dow rose more than 88% in 1915 after it reopened, which remains the highest annual return on record for the Dow Jones. In fact, from the start of the war in 1914 until the war ended in late 1918, the Dow was up more than 43% in total or around 8.7% p.a.
World War II
World War II had a similarly counterintuitive market outcome. Hitler invaded Poland on September 1, 1939, setting off the war. When the market opened on September 5, the Dow shot almost 10% higher that day. When the attack on the U.S. naval base at Pearl Harbor occurred in early December 1941, stocks opened the following Monday down 2.9%, but it took just a month to regain those losses. From the start of WWII in 1939 until it ended in late 1945, the Dow was up a total of 50%, more than 7% p.a.
The Korean War
The Korean War began in the summer of 1950 when North Korea invaded the South. That conflict ended in the summer of 1953. In that time, the Dow was up almost 60% in total or around 16% p.a.
The Vietnam War
U.S. troops were sent to Vietnam in March of 1965. The Dow would finish the remainder of that year up almost 10%. By the time the last of the U.S. troops were pulled out of Vietnam in 1973, the stock market was up a total of almost 43% in that time, or just under 5% per year.
History tells us periods of uncertainty, like we’re currently experiencing with Russian and Ukraine, are usually when stocks suffer the most. In 2015, researchers at the Swiss Finance Institute looked at a variety of military conflicts after World War II and found that in cases when there is a pre-war phase, an increase in the war likelihood tends to decrease stock prices, but the ultimate outbreak of a war increases them. They called this phenomenon “the war puzzle” and said there is no clear explanation why stocks increase significantly once war breaks out after a prelude. [1]
At Gilkison we believe that current market prices quickly incorporate expectations about the effects of these events on economies and companies. Our investment approach focuses on using information in current market prices rather than trying to outguess them. If markets stay open and continue to function normally, we generally continue investing our portfolios according to our usual process. We believe that the most effective way to mitigate the risk of unexpected events is through broad diversification and a flexible investment process.
The Dimensional equity portfolios we recommend for our clients typically invest across thousands of stocks. For example, as at 31 December 2021, the Dimensional World Equity Trust was diversified across more than 8,000 different stocks around the world. Similarly, Dimensional’s Global Bond Trust has exposure to more than 350 bonds from around the world and of varying maturity lengths.
Unlike traditional index funds, the Dimensional portfolios are not constrained to follow the actions of a specific benchmark during these times. Removal of companies from benchmarks in the wake of geopolitical events typically follow a similar pattern as other index rebalances. For example, the index provider announces the deletion date in advance, and index fund managers that are seeking to mirror the holdings of that index must sell the deleted securities at the market close on that date. The index provider has effectively shown their cards to the marketplace, and the index fund will have to trade with urgency along with other managers who follow the index. Since other market participants know which securities the index managers will buy and sell—and when—these managers have a trading disadvantage, which can result in higher costs and lower net returns.
Investors in global equity markets inevitably face periods of geopolitical tensions. Sometimes these events lead to restrictions, sanctions, and other types of market disruptions. We cannot predict when these events will occur or exactly what form they will take. However, we can plan for them by having well-diversified portfolios and a highly flexible investment process.
- Brune, Amelie, et al. “The war puzzle: Contradictory effects of international conflicts on stock markets.” International Review of Economics 62, No. 1. 2015. Pages 1-21.