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| 07/03/2011
Something skyrockets. The markets' reaction to war

Something skyrockets. The markets' reaction to war

STOCK MARKETS ON AVERAGE REACT POSITIVELY TO THE ONSET OF A CONFLICT ACCORDING TO A STUDY BY BOCCONI PROFESSORS GUIDOLIN AND LA FERARRA ANALYZING 101 CONFLICTS IN THE 1971-2004 PERIOD. THE EVIDENCE FOR OTHER ASSETS' MARKETS IS MIXED

Maybe markets don’t love war, but they undoubtedly hate the uncertainty usually preceding a conflict and when the war finally breaks out they react with a collective sigh of relief, which on average boosts stock markets, Massimo Guidolin (Department of Finance) and Eliana La Ferrara (Department of Economics) find in The Economic Effects of Violent Conflict: Evidence from Asset Market Reactions.

Through an event study approach they analyze 101 internal (72) or international (29) conflicts for which onset can be attributed to a precise week in the period 1971-2004 and measure their effect on the MCSI (Morgan Stanley Capital International) stock indices for the World, the USA, UK, France and Japan, the trade-weighted exchange value of the US dollar versus major currencies and the prices of oil, gold and the Goldman Sachs general commodities indices. The goal of the study, which uses weekly financial data, is first to spot abnormal returns in correspondence to the week of the onset of the conflict and then to “investigate whether the effects of conflicts on key financial variables could have been used to produce abnormal investment profits from strategies that systematically buy or sell assets based on their average reactions to typical conflict events”.

“On average”, the scholars write, “national stock markets are more likely to display positive than negative reactions to conflict onset. The US stock market is the one that displays the strongest reactions, producing positive abnormal returns in correspondence to 12% of the conflict events investigated (...). We find that in general the fraction of significant results is higher for international than for internal conflicts”.

But not all conflicts are born equal and the stock markets of countries that depend on foreign supplies of raw materials or energy sources can be badly hit by conflicts localized in countries which are net exporters of such goods, especially when the conflicts are not anticipated and markets have not yet discounted the uncertainty preceding the outbreak. That’s the reason why Italian stock exchange crashed at the news of the violent clashes in Libya after similar situations had solved in a smoother way in neighbouring countries.

As for commodities markets, the evidence is mixed. The reaction of an overall commodities index is positive in 6.9% of the cases and negative in 4.9% (as the authors use tests of 5% size, the coefficients under 5% might be imputed to chance), but there are many exceptions, including the strong reaction of oil futures prices to the onset of conflicts in the Middle East, which is negative in the 45.5% of the cases and positive in the 27.3%. The result, the scholars write, “confirms a generalized tendency of market participants to hoard in the face of uncertainty regarding future oil supplies. When the conflicts in the Middle East are actually initiated, the excess demand motivated by speculative pressures disappears and oil futures prices fall”. The dollar exchange rate follows a similar pattern because dollar cash reserves are frequently built up as a response to the increased ambiguity that precedes the outbreak of a conflict.

All the impacts on assets markets are stronger for the more intense conflicts, both in terms of duration and of casualties.

Guidolin and La Ferrara run a portfolio simulation comparing the returns of an investor who systematically exploits market reactions buying or selling assets in the weeks a conflict starts according to their average response to conflict and the returns of a naive investor who passively buys the world market portfolio in the same weeks. At the end of the 1971-2004 period, the wealth effect is weak for investors in the US stock market (they would be only 4% richer than their naive counterparts), but strong in the case of UK stocks (27% higher wealth). The most significant wealth effect derives from the systematic investment in oil futures, with a wealth gain 80% in excess of a passive strategy. 

 

Fabio Todesco

E-mail fabio.todesco@unibocconi.it
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