How markets respond to war

This article was originally published in The Telegraph. 

IT is a statement of the obvious that the market’s response to any outbreak of war is of secondary importance. It is always primarily a distressing human tragedy. How investors react really isn’t the point - even assuming the conclusions they draw are right, which often they are not. A fact that’s less explored is that even appalling suffering and destruction can have surprisingly little impact on the long-term outlook for markets.   

Investors are generally not very good at understanding the impact of terrorism, war, or other geo-political developments, even ones that have decades of precedent from which to learn lessons. Saturday’s terrorist attack on Israel was obviously not the first. This goes some way to explaining the relatively muted reaction of most financial markets to this week’s violence. Investors accept that because they know so little about how things will pan out, they might be wise to do little too. 

The response to Hamas’s attack on Israel in the oil market - which you might have assumed would be where the impact would be most clearly felt - is instructive. The cost of a barrel of Brent crude rose by $4 a barrel to $88 on Monday and then fell back a bit on Tuesday. But in the previous two weeks, the oil price had fallen from around $97 to $84 as investors shrugged off recent supply curbs by Saudi Arabia and focused instead on weakening demand in the face of growing recession fears. 

Before that, the prospect of reduced supply had seen the oil price rally by 35% since the summer. The key driver has been supply and demand, not uncertainty, as far as investors are concerned. 

Other assets that investors typically see as safe havens when things get difficult have responded as you might expect, but without much conviction. Gold and the dollar rose but not in a way that suggested anything dramatic had happened. The usual suspects in the stock market gained some support - energy companies, defence stocks - but none of the moves were out of the ordinary. 

The broader rally in share prices this week was a response to the Fed’s hint that it was done with rate hikes and to hopes for more Chinese stimulus. Those more than outweighed any concerns about the broader market implications of a prolonged war in Israel and Gaza that has the potential to escalate but still looks more likely to be contained.  

The absence of a knee-jerk market response makes sense given the unpredictability of the lasting impact of even seemingly dramatic events. In recent years, there are many examples of markets reading the situation wrongly in the short-term and subsequently scrabbling to make good their mistake. 

The FTSE 100 fell sharply the morning after the Brexit votes were counted in June 2016 but by the end of the year, the UK’s blue-chip index had risen by 20%. Same story after the election of Donald Trump in November of the same year. By the end of 2017, the S&P 500 was 35% higher. 

More recently, and much more dramatically, the emergence of Covid in March 2020 saw global stocks fall by a third in six weeks. By the end of 2021, shares had more than doubled. While it is true that shares continued to fall for eight months after the invasion of Ukraine last year, we should remember that US interest rates moved from zero to more than 3% over the same period. 

The brutal reality of the market’s response to the invasion of Ukraine was that, from an economic perspective, the war didn’t matter as much as the recovery from the pandemic and, in the other direction, the fight against inflation. 

Another complicating factor in trying to read the market’s response to unexpected geo-political events is the fact that some assets benefit from investors’ search for a port in the storm. Sometimes, the very assets that you would expect to be negatively impacted turn out to be winners. So, the likelihood that a breach of the debt ceiling would shut down the US government has often provided the excuse for investors to load up on US Treasury bonds, the ultimate safe haven asset. 

The current war between Israel and Hamas is not without its broader risks to the global economy and markets. The first of these is the potential involvement of Iran. The US has largely turned a blind eye as sanctions have been ignored, for the good reason that Iran ships around 1.5% of the world’s oil supplies. That position may be harder to sustain now. 

The second major risk to the oil market is that Saudi Arabia is less interested in boosting supply to help secure better relations with Israel. US-brokered attempts to bring the two together look less likely to succeed than they did a week ago. 

It doesn’t seem likely, however, that either of these will lead to a 1970s-style price shock. Fifty years after the Yom Kippur war that led to the Arab oil embargo and a quadrupling of the price of crude, the world is a very different place. Markets are better supplied, more stable and better supported by strategic oil reserves. Oil is also much less important to the global economy than it was then. 

So, how should investors respond to the unexpected? At the least they should anticipate that, from time to time, bad things will happen, and they should regularly test what could go wrong with their portfolio, but also what could go right. They should ensure that their portfolios are well diversified, across both asset classes and geographical regions, to minimise the likely impact of a flare-up in any one part of the world. 

Finally, they should remember that the most important risks to their investments are not the ones that the rolling news channels cover but the invisible dangers; behavioural flaws that can make us our own worst enemies; inflation; too much caution because we are human and assume the strength of our emotional response will be mirrored in the market.

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Please be aware that past performance is not a reliable guide indicator of future returns. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.