‘Conflicts Of Interest’: A History Of Markets During Wartime

We’ve written a good bit this month about the possible implications for markets of a U.S. military conflict.

That topic became more relevant in August for obvious reasons. The ridiculous game of oneupmanship that saw Kim Jong-Un and Donald Trump engage in a war of words to determine once and for all whose hyperbole knob actually “goes to 11” raised concerns about a possible “miscalculation” that could plunge the Korean peninsula into armed conflict.

In “honor” of that truly absurd example of despot-on-despot propaganda crime, we brought you the following two posts that took a look back at how stocks fared during previous military interventions, wars, and nuclear brinksmanship:

Well, in light of the fact that the North Korea drama is obviously not over, and considering Trump’s Monday night speech (which certainly seemed to suggest that the new time table for a complete withdrawal of U.S. troops from Afghanistan is something that approximates “never”), we thought the following bit from Barclays might be useful…

Via Barclays

Although tensions between the US and North Korea have de-escalated somewhat from their peak and the prospect of armed conflict remains remote, tensions have ratcheted up over recent weeks and the situation remains unpredictable. To get a better sense of historical market reactions to precedents for military conflicts, we conducted a study of the SPX reaction to past US military campaigns.

Methodology

We analyse 18 military conflicts from 1914. Out of those, we focus on the eight conflicts where there was a negative stock market reaction. In Figure 9 and Figure 10 below, we plot the SPX performance during eight major conflicts involving the US. We index the price performance at t = 0 for all conflicts, which we take to be the start of the event. As there has sometimes been a market reaction prior to or after the start date, we show the market performance 100 days prior and post the start date. Figure 11 and Figure 12 plot the corresponding 1M realised volatility. Because in some conflicts (such as WW2), the US intervention occurred after the war’s initial start date, we set the day of the US intervention as the start date. In the case of the war in Afghanistan, we set the date to 11/09/2001.

Conclusions from the historic analysis of market reactions to conflicts Based on our understanding of those events, we group the dataset into two types:

Conflicts with global implications: Here we consider the First and the Second World War and the Cuban missile crisis (Figure 9). While the Cuban crisis did not result in an actual “hot” conflict, the stakes were similarly high and could have led to a global (potentially nuclear) war (although the concept of Mutually Assured Destruction may have helped ultimately defuse the situation). As a result the muted 6% sell-off in the SPX in October 1962 could be seen as rational (although it may seem low from today’s perspective). In the case of the two World Wars, the index sold off aggressively at first (-30% in the case of WW1), but then stopped its decline and recovered somewhat over the coming year. This could be because it was assumed that the war, while clearly detrimental for output in the countries where the war was fought, would ultimately not reach the US after all. On the other hand, the increased industrial production was seen as more positive for US equities after the initial panic. Realised volatility usually spikes and reaches a peak in the first two months (Figure 11).

Conflicts with regional implications: The other conflicts in Figure 10 represent regional conflicts that did not have the reach to affect the US mainland. The hallmark of those incidents is that the index sells off initially (up to 10%), but then quickly recovers. Volatility spikes immediately after the event and recovers within the following month (Figure 12).

However, the market impact of a potential conflict on the Korean peninsula could be different

Major developed economies (Japan and South Korea) could be directly affected. This would likely have major global economic implications in a world that is significantly more globalised now. It is also not clear if the US could be hit.

Developments could be rapid. This matters as today’s markets are potentially more driven by systematic flows, which could lead to outsized returns.

Lastly, any conflict could involve the use of unconventional weapons.