What happens to the market if America goes to war?

Let’s look at how the markets responded to the previous round of North Korean missiles test earlier this month.

“It is tempting to blame this week’s 1.1% decline in the Dow industrials on the belligerent exchanges between North Korean leader Kim Jong Un and US President Donald Trump,” Spencer Jakab wrote.

“An analysis of 80 international incidents involving North Korea and its nuclear program since 1993 shows little connection between tensions on the Korean Peninsula and financial markets.”

Prashant S. Rao had a different spin on the matter. He looked to the global markets and saw the accelerating sell-off as the result of the escalating tensions between the two countries.

“Asian stock markets closed lower and European indexes opened sharply down, on fears that the verbal back-and-forth between Washington and Pyongyang had raised the risk of actual conflict,” he wrote.

Lewis Krauskopf and Rodrigo Campos also claimed that the fall in global stocks earlier this month was the result of the rising geopolitical tensions.

Wallace Witkowski and Mark Decambre observed, “All three major equity benchmarks finished sharply lower on Thursday for their worst day since mid-May, with the trifecta of indexes all tumbling for a third straight session for the first time since mid-April, amid a persistent war of words between the U.S. and North Korea.”

With repeated tweets by President Donald Trump vowing to “rain fire and fury like the world has never seen” down on North Korea if it threatened the United States, and that “military solutions are now fully in place, locked and loaded, should North Korea act unwisely,” is it any wonder markets are jittery?

So how have historical capital markets performed during times of war?

We looked at returns and volatility leading up to and during World War II, the Korean War, the Vietnam War, and the Gulf War. We opted to exclude the Iraq War from this group, as the Iraq War included a major economic boom, and subsequent bust, that had very little do with the nation’s involvement in a war.

As the table below shows, war does not necessarily imply lacklustre returns for domestic stocks. Quite the contrary, stocks have outperformed their long-term averages during wars. On the other hand, bonds, usually a safe harbour during tumultuous times, have performed below their historic averages during periods of war.

Capital Market Performance During Times of War

The full period of study, 1926 through July 2013 is shaded in blue and provides a “control” group for comparison. Periods of war are highlighted in red. All of the individual wars we considered are listed below.

Interestingly, both large-cap and small-cap stocks outperformed with less volatility during war times. The Vietnam War was the one exception, where stock returns were worse than the full period average. Even then, though, the returns were positive and above those of bonds and cash.

It is interesting to note that stock market volatility was lower during periods of war. Intuitively, one would expect the uncertainty of the geopolitical environment to spill over into the stock market. However, that has not been the case, except during the Gulf War when volatility was roughly in line with the historical average.

Capital market returns during the Gulf War were different from other wars. This war was very short, spanning less than a full year. This period also coincided with an oil price spike that helped push the economy into a brief recession.

The idea of recession during war time was fairly new, and reflected the changing US economy. During previous wars, the economy was more exposed to capital goods and natural resources, which experienced greater demand to feed the war.

However, by the 1990s, the economy had shifted away from heavy industry and toward the current “knowledge-based” economy. Thus, military demand had less of an impact, for better or worse, on economic growth.

Bonds generally underperformed their historical average during periods of war. This is likely, at least in part, because inflation has been higher during war times. Bond returns have historically been negatively correlated with inflation.

Another explanation is that governments borrow more during wars, thus driving bond yields up and bond prices down. With the higher inflation and increased government borrowing associated with war time, investors seeking safety may want to think twice before shifting assets from stocks to bonds.

There are many economic and fundamental factors that impact security prices. Occasionally, a single event is powerful enough to dominate these other factors to singly influence capital market returns. However, historically speaking, this has not been the case with wars.

“None of this means that what happens in Northeast Asia is irrelevant. The threat of conflict there is real, and it is hard to imagine even in the current buy-the-dip market that outright military confrontation would be very good for stocks and corporate bonds that already are widely perceived to be richly priced,” Jakab concluded. “For now, the current dispute — despite its unusually strident tone from the U.S. side — remains one of words....Something, some day, will end the current bull market, but mere words from North Korea probably won’t suffice.”

Economic growth, earnings, valuation, interest rates, inflation, and a host of other factors will ultimately decide the future direction of the stock and bond markets.

While a knee-jerk decline is possible if war breaks out between the United States and North Korea, history suggests that any market decline should be short-lived.

Disclaimer: The full article can be viewed on CFA Institute under the blogs section. Please click https://goo.gl/z7U92n to view. The views and investment tips expressed by the investment expert on moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.