Opinion: Stock markets becalmed by 'war puzzle'

The price of oil has jumped by almost a third. Photo / Getty Images

OPINION:

War is being waged in Ukraine. Europe's supplies of oil and gas are running out, with rationing a possibility some time over the next few months. Basic foods are soaring in price, and shortages may spark revolutions across the developing world. With so much going wrong, you might expect the stock market to be extremely volatile — and that many investors would decide simply to get out of equities until stability had returned.

But that would be a big mistake. As a new paper from American academics points out, in times of war, the stock market is actually more stable, not less. That was even true of World Wars I and II, as well as more minor conflicts since then. It turns out that extra defence spending creates such steady profits for major companies that returns are better, and certainly a lot easier to forecast than they are during peacetime. There is no reason to expect the war in Ukraine, and the new Cold War that will inevitably follow it, to be any different. Investors can sit back and relax — the markets are going to be predictably dull for the next couple of years at least.

It is now slightly more than three weeks since Russian forces moved across the border into Ukraine. The price of oil has jumped by almost a third since then, wheat has more than doubled and nickel has gone so far off the charts that the exchange has had to be closed down. Vast amounts of analysis and speculation have been devoted to the likely impact of the war on the markets, and hedge funds have no doubt been positioning themselves to take advantage of that. And yet the main equity indices have scarcely moved in any significant way.

The FTSE 100 was at 7480 the day before the invasion and was at 7380 heading into the weekend, down a mere 100 points. The Dow Jones is up by almost 1,000 points over the same period. Germany's Dax, reflecting the major economy with by far the most exposure to the conflict, has ambled from 14,600 to 14,300. There have been a few wild trading sessions along the way, but overall it has not made a lot of difference. If you just looked at the charts and nothing else you would probably conclude that not much was going on in the world.

To anyone who cares to take a look at the historical record, there should be no real surprise about that. A paper this week from the National Bureau of Economic Research in the US, written by Gustavo Cortes, Angela Vossmeyer and Marc Weidenmier, makes the point that there is a long-established "war puzzle" in the performance of the American stock market.

First identified in the 1980s, and yet remaining true since then, equities are 33pc less volatile during periods of major conflict than during peacetime, although movements in inflation and commodity prices are far more extreme than at other times. Even during the major global wars that were true, and it held good for the more recent wars in Iraq and Afghanistan as well. True, that only measures Wall Street trading and the US suffered little physical damage in those wars. Even so, the results hold good for all the major indices outside of specific war zones.

Wars are unbearably tragic for the victims caught up in the conflict, as we are being reminded in Ukraine. Photo / Getty Images

There is a lot of debate about why that is true. The latest study suggests that rising defence spending makes the market a lot more stable, mainly because the earnings from huge government contracts are so steady and predictable that companies can make healthy margins, and, perhaps more importantly, forecast their earnings for several years ahead. True, defence contractors are not as important to the index as they used to be (although that can change very quickly — companies like Ford and General Electric weren't defence contractors at the start of World War II but quickly switched to military production). Even so, it still makes a difference and helps to create a more stable market.

More broadly, there is very little reason to think it will cause any real damage to corporate profits. Russia is only the 11th largest economy in the world and with the recession, the war will inevitably create it will soon be overtaken by Poland. Companies are pulling out, but it was not a market that made any real difference to anyone, and most of the sales lost can quickly be made up elsewhere. Sure, there may be a few shortages as Russian raw materials vanish from the market, but that can be quickly solved — we can be sure the technicians at Tesla are working overtime to replace the nickel in electric car batteries with something they can source more easily elsewhere.

Wars are unbearably tragic for the victims caught up in the conflict, as we are being reminded in Ukraine. But it is wrong to assume they are necessarily bad for the wider economy. This one will unleash a wave of new investment as every country scrambles around to replace Russian oil and gas, either by increasing their own production or by investing more in renewables and nuclear. And it will, as so often in the past, unleash a wave of innovation, as peacetime applications are found for technologies first developed with military money (at the end of this war, it seems certain that drones will be commonplace, and we may well have learnt to accept genetically modified crops as well).

Whether this is all true of Ukraine, and the new Cold War between Russia and the West that now seems inevitable, still remains to be seen. But the message from the last century of stock market history is surely clear. We will see a burst of volatility, and the prices of commodities will be all over the place, but the main equity markets will be very dull for the next couple of years — and the best thing investors can do is just leave their portfolios alone.