Air Force officials say the internal bay of the B-1 Lancer could be expanded from 24 to 40 weapons. Handout.

Wars, political scandals, and natural disasters have become an integral part of our economies, and nobody can deny this fact. People deal with it in different ways, though – some prefer not to think about it, others prefer to fight it, and others to make money off it. Recently, the geopolitical tension between the US and Iran has been the central subject of interest, which is why we should analyze the potential impact on stock prices. But this, obviously, requires us to study the aggregate consequences of different conflicts throughout modern history.

The impact of political risks on stock markets depends on various factors: type of industry, the length of the conflict and how it is financed, which could lead to higher public expenditures, inflation, and disruptions of public services, as David Le Bris noted in his study “Wars, Inflation and Stock Market Returns in France, 1870–1945″ in 2012.

For example, based on a study conducted by Avni Önder Hanedar and Elmas Yaldız Hanedar of Sakarya University in Turkey, if stock investors believe that a conflict will have catastrophic consequences for their investments, then stock prices fall and volatility increases. At the same time, other stocks may even grow in value. In particular, there were falls in stock prices of export-oriented monopoly, mining, and transportation companies only for a short time during the Turco-Italian and the First Balkan wars. Thus certain sectors and firms may experience more pronounced effects because their income might grow or decrease as a consequence of a war, as Gerald Schneider and Vera E Troeger wrote in the Journal of Conflict Resolution in 2006.

However, researchers have also discovered that government bondholders were more sensitive to war-related risks, as the conflicts were highly related to government survival. Thus government bonds may experience higher volatility due to uncertainty risks and possible financial problems that may eventually lead to higher budget deficits and debt burdens. Historically, wars were important sources of solvency problems, which could explain the sensitivity of government bond prices to conflicts.

According to Schneider’s and Troeger’s paper titled “War and the World Economy,” the Dow Jones index fell 6.31% after the invasion of Kuwait by Iraqi troops in 1990, but gained 17% in the first four weeks of the US-led Operation Desert Storm. The initial stock-market reaction to the second war against Iraq was also positive, with an increase of around 2% on the main European stock markets. The authors discovered that rallies happen when the market considers a conflictive event less problematic than some alternative original scenarios in which it initially believed. Cooperation, by contrast, can entice negative reactions if investors do not trust the cooperative moves. It is worth mentioning that negative shocks have a greater impact on volatility than positive events.

In this context, Massimo Guidolin and Eliana La Ferrara in their study “The Economic Effects of Violent Conflict: Evidence from Asset Market Reactions” came to a conclusion that there are four effects of conflicts on asset markets:

  • While the reactions of other national indices are typically mixed, the US market tends to systematically react positively to the onset of conflicts rather than negatively.

Source: CFA Institute

  • International conflicts tend to have a stronger impact on stock market indices than internal ones. In addition, findings suggest that short wars tend to increase the quarterly returns from the Dow Jones Industrial Average.
  • Commodity prices are quite reactive to events in the Middle East. In particular, oil futures systematically exhibit a downturn in response to conflict onset in this region. One of the main reasons is that in the weeks (or months) preceding the outbreak of the conflict, speculative pressures drive up the price of oil futures once the hostilities actually begin, this tendency is reversed. In the two weeks after congressional authorization of Operation Desert Storm in 1991, the S&P 500 index fell nearly 5% and oil jumped 12.5%. After the United States launched an air campaign in Iraq on January 17, 1991, oil prices plunged 33% and the S&P 500 gained 3.7%. During the Iraq war, oil prices gained nearly 40%, going from $18 per barrel in early December to $25 on March 18. The S&P fell 11% during the same period. And the list continues…
  • Wars generally trigger a depreciation of the US dollar against other currencies. This is due to the safe-haven role of short-term assets denominated in the US currency, the demand of which tends to grow in periods of high uncertainty that typically precedes the dates of formal conflict onset, to subsequently disappear when tension evolves in open hostile operations.

Finally, yet importantly, in the paper “An Analysis of the Effect of War on the United States Stock Market,” Kristina Simeunovic discovered that war with prologue has a positive impact on stock prices, while surprise wars and terrorist attacks magnify a decrease in financial returns. In other words, markets do not like uncertainty. By the way, according to the findings from “The war puzzle: contradictory effects of international conflicts on stock markets,” a positive shock in the stock market can be observed when the likelihood of war increases to 100%. In other words, an increasing war likelihood seems to lower stock prices, while the outbreak of the war itself seems to increase stock prices:

In conclusion, after studying the recent increase in tensions between the US and Iran, we see that gold and oil prices have risen, while bond yields have declined and the stock rally in the US had been halted. In the foreign-exchange market, safe havens and oil-sensitive currencies jumped to their highest in months last Friday. The Swiss franc grew to a four-month high against the euro, meanwhile, the US dollar hit a one-week high versus the euro.

Igor Kuchma

Igor Kuchma is a financial adviser who is passionate about economy and the capital markets in general. He has experience working with Russian, Spanish and American financial institutions. He helped to compile a course for the Series 7 exam, while some companies he has prepared investment portfolios and macro and microeconomic models in Excel, and has studied trends and historical data.

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