How Conflict Affects Financial Markets

War and geopolitical tension have a strong impact on the economic performance of nations, as well as risk sentiment in global and domestic financial markets. However, the extent of the effect on price action varies and is not usually as pronounced as one might think.

For instance, the Paris attack in November this year triggered a sharp knee-jerk reaction from French equities and European assets initially, but the selloff wasn’t prolonged. EURUSD also suffered a selloff in the same week and during market open on the following Monday, but the pair was quick to recoup its losses and even enjoyed a strong post-ECB rally a couple of weeks later.

The 9/11 attack in the United States also had a limited impact on financial markets, as currencies and equities were able to shrug off the shock in just a few days and resume trading on fundamentals. Perhaps what’s of particular interest to investors is whether or not the conflict would be significant enough to affect monetary policy biases or overall business performance.

A review of other terror attacks in the past few years yields a similar conclusion. The Charlie Hebdo attack in January spurred a 2-day market reaction while the July 2005 London bombing’s effect was muted after a couple of days as well. The March 2004 Madrid bombing had a 3-day market reaction before equities rebounded.

The 9/11 attack and ensuing tension was a bit more prolonged, as it prompted speculations on defense spending and what it might imply for the rest of the economy. US equities were already in a downtrend at that time and the US dollar had enough bearish momentum in play, with USDJPY bottoming out nearly a week later after a 5% decline.

Looking much further back reveals that this pattern has been observed in earlier conflicts in the US. In Adam Shell’s article on “What Wall Street is Watching in the Ukraine Crisis” published on USA Today, he noted that the median one-day decline was at 2.4% in the last 14 market shocks dating back to the Pearl Harbor attack in 1941. He also noted that the market was able to recoup its losses a couple of weeks afterwards.

In addition, during times of prolonged conflict, the market typically prices in expectations ahead and starts declining before any actual shocks or attacks occur. Around that time, sharp drops are usually seen in a few days before profit-taking and recovery occurs.

In a nutshell, short-term shocks such as terror attacks or one-off conflict tend to spur a large initial reaction but these moves are usually reversed later on. However, other types of conflict that can affect trade and supply, such as that of crude oil, usually take a while to kick in, with commodity prices being more sensitive to the conflict.

Once any war spending starts making an impact on the government budget or inflation, markets start to favor stronger trends. For instance, the prospect of spiking inflation could lead a central bank to pursue monetary policy tightening, which is actually good for the country’s assets and currency.

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