The calm of the market shows that times of war do not mean volatility

War is cruel. In their own way, so are the markets. When Russia invaded Ukraine last month, global stock markets initially fell amid investor shock. The US benchmark S&P 500 fell 15 percent from its peak, while the Nasdaq Composite fell more than 20 percent.

Since then, US equity markets have recovered and even European indices have rallied. What is most noticeable and counterintuitive is that traders are acting as if calmer times are ahead.

For example, look at that arcane corner of the derivatives world known as the Vix futures curve (a benchmark indicating future volatility risk expectations). At the end of February tMarch Vix futures price it jumped above that for contracts expiring between April and November. This is highly unusual: investors tend to pay more to cover distant risks than close ones because the long term is inherently more uncertain.

But in March things returned to a more normal pattern. The Vix index, which indicates current volatility, also fell, with traders using fewer options to hedge tail risks, after a struggle earlier in the year. In plain language, the panic has subsided.

Why? One explanation could be that investors think the war will prompt Jay Powell, chairman of the US Federal Reserve, to delay his plans to raise rates. That hope is probably misplaced: This week Powell warned that the Fed needed move “quickly” to combat skyrocketing inflation, with a possible 50bp hike in May. However, the OECD also said this week that Russia’s invasion it would cut world output by 1.1 percent this year. If this slows rate hikes, that could help stocks.

There is another possible explanation for the surprising calm: traders are reading their history books; more specifically, looking at the evidence from the last two centuries of financial history, it seems silly to assume that war is bad for stock prices or volatility.

Consider some analysis from the Ned Davis research group, which looked at more than 50 crisis events over the last 100 years, such as the Covid-19 crash and World War II. It found that while the Dow Jones Industrial Average tended to fall at the start of a crisis, by an average of 7 percent, it then recovered to gain an average of 4.2 percent three weeks later and 9.6 percent afterward. 18 weeks.

There are exceptions to this pattern, mostly “while the Fed bursts a bubble,” NDR says. When the JPMorgan office was bombed in 1920, markets did not lastingly recover after the initial crash, nor did they after the Suez Canal impact in 1956, the US invasion of Grenada in 1983, or the Russian invasion of Georgia. in 2008. This caveat might be relevant again now given Powell’s recent comments.

If you want another historical reason to stay calm, look at volatility. A trio of American economists (Gustavo Cortés, Angela Vossmeyer and Marc Weidenmier) have just published a paper titled “Equity Volatility and the Puzzle of War” which calculates that, over the past century, the level of US stock market volatility has been on average 33 percent lower during times of war than in peacetime.

This seems strange, given that war usually triggers geopolitical uncertainty and inflationary spirals of the kind we are facing now. But the authors say this “puzzle of war,” identified by economist William Schwert, reflects in part the fact that the United States has not fought a war on its own soil in more than a century.

Furthermore, when war breaks out, governments tend to implement tighter controls on trade and invest in military resources. This “massive public spending” means that corporate profits are “easier to forecast during times of war,” economists argue, since bureaucrats’ budgets are more predictable than free markets and military spending can represent a significant part of the overall index.

“Sector-level regressions show that defense spending predicts lower volatility in the stocks of companies that produce military items,” they add, noting that this applied not only to both world wars, but that “forecasts of defense company earnings by stock analysts [also became] significantly less dispersed after 9/11 and the invasions of Afghanistan (2001) and Iraq (2003).”

Could this pattern play again today? Most likely as I noticed, The events in Ukraine are contributing to a pre-existing, albeit subtle, reset of the relationship between business and government that began during the pandemic. Industrial policy is no longer a taboo concept and defense spending will almost certainly increase as well.

What makes this crisis different from previous ones is that tech giants, not industrial groups, dominate the US stock market now. It may be foolish to assume that this war will not be fought inside the US: even without physical shootings on national soil, a major cyberattack could do economic damage, as President Joe Biden has explicitly stated. warned this week. Then there is the (hopefully unthinkable) possibility of nuclear war; we are still at an early stage of this conflict.

Still, at the moment the reality is that traders do not seem to be pricing in such tail risks. Instead, the pattern appears to be returning to the historical norm.

Does this leave markets heartless? Yes. Could it make traders look naive about long-term tail risks? Quite possibly. But it is also yet another example of how events in Ukraine have not unfolded as the pundits in the salon might have predicted. It is unlikely to be the last.

gillian.tett@ft.com

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