Geopolitical tremors can hit markets, but no lasting impact

Instead of trying to sort out the signals from the noise, it may be wiser to stay invested for the long term

The ominous headlines over the past few weeks in major newspapers around the world are a stern reminder that the peace we currently enjoy is a fragile one.

The horrific attack in the heart of Paris that killed more than 100 people showed terrorism remains a real and present danger today.

In the past week, the downing of a Russian jet by Turkish forces and the subsequent sabre rattling from both sides has once again conjured up images of escalating war.

These rising global tensions have been cited by many analysts as one of the key risks to markets next year.

Citigroup analysts, for instance, said that "2016 may prove to be a year in which politics, rather than economics, comes to the fore as a driver of risk in financial markets".

In particular, it cited Europe as being vulnerable to such shocks, as Britain mulls over an exit from the European Union and the refugee crisis in Western Europe intensifies. "Of course, for political risk to really impact financial markets, there needs to be an enduring economic consequence," said Citigroup.

A memorial for victims of the Nov 13 Paris attacks, on Place de la Republique in Paris last Tuesday. There is significant difficulty in trying to anticipate the effects of geopolitical tensions on financial markets, and even if the impact is real, the effects are unlikely to be long-term. PHOTO: EUROPEAN PRESSPHOTO AGENCY

"Political events may become a more important driver of risk appetite, and increased volatility may raise risk premiums, but in order to meaningfully alter return expectations across asset markets, the transmission mechanisms will likely remain in economic channels."

But does political news really move markets? It is hard to say for sure for several reasons.

For one thing, there is no clear definition of a "geopolitical event".

Wars probably count but what about flare-ups of violence such as terror attacks?

Does it matter where they happen? What about scale, or how many people died?

And then there is of course the issue of elections of the ruling government in each country. Do they really move markets?

There is a paucity of academic research in this area, probably because it is difficult to isolate political variables and their effects on stock markets.

But based on the studies that have been done, the issue is mixed at best.

A paper by authors Mei Jianping and Guo Limin at the New York University Stern School of Business looked at 22 emerging markets and the effect of elections there.

"We observe increased market volatility during political election and transition periods," noted the paper, written in 2002.

"Our results suggest that political uncertainty could be a major contributing factor to financial crisis."

A well-cited study in the United States showed that higher market returns were positively correlated when a Democratic president was elected, a strange result since Republicans tend to be more pro-business.

This was the conclusion of a 2003 article in the Journal of Finance by Dr Pedro Santa-Clara, professor of finance at the Nova School of Business and Economics, and Dr Rossen I. Valkanov, professor of finance at the Rady School of Management at University of California, San Diego.

The authors found 9 per cent higher stock market gains for large stocks in Democratic administrations since 1928.

In contrast, Germany's elections did not have a similar effect, a 2004 study by the Kiel Institute showed.

What about Singapore?

I took some of the biggest political events and checked whether the market reacted negatively to bad news events.

I used three time periods: A day after the given event, a week after and a month after.

The results are again mixed.

After Iraq moved its tanks into Kuwait on Aug 2, 1991, the Straits Times Index fell nearly 7.3 per cent to 1,157.41 points the next day.

Over the next month or so, the STI continued to sink, falling to a low of 871.11 points on Sept 27, 1991.

The other clear instance of an adverse market reaction following a negative piece of news was the Sept 11, 2001 attacks in the US.

The STI fell 7.4 per cent the day after Sept 11, following plunges in other markets that wiped off billions that day.

But other events - such as Singapore's elections in 2006, 2011 and this year, the London train bombings in 2005, the Russian invasion of Ukraine last year - did not seem to have a significant impact on the local stock market.

The list is not exhaustive, and a lot more study needs to be done to establish proper links, if any.

What this little experiment showed is that, if anything, there is significant difficulty in trying to anticipate the effects of geopolitical tensions.

But even if we assume the impact is real, the effects are unlikely to be long-term.

A JP Morgan study of major geopolitical events over the past century showed that only a handful of incidents forced a major reversal of the market. One was the Great Depression - which really is an economic and financial event rather than a political one - and the other was World War II.

That these had an impact on markets is obvious simply because it had a direct and massive impact on human society and the economy the world over.

In comparison, however, many other hundreds and thousands of events happened and did not change the direction of the market.

Even those which did seem to move markets did not have a lasting impact.

Simply put, apart from world wars or events with catastrophic outcomes, it is hard to say if geopolitical events have a true and lasting impact on stock markets.

Instead of trying to sort out the signals from the noise, it might be wiser to do what the long-term chart of the S&P 500 is clearly showing: Stay invested for the long term.

A version of this article appeared in the print edition of The Sunday Times on November 29, 2015, with the headline 'Geopolitical tremors can hit markets, but no lasting impact SmallChange'. Print Edition | Subscribe