Counting the cost of war's impact on markets

What price will events in Iraq exact on the markets? Chris Johns examines the effect of previous conflicts.

Financial markets rarely handle disasters very well. We would hardly expect them to do so - earthquakes, wars and terrorist attacks are often truly catastrophic events that overwhelm our analytical abilities.

Everyone remembers how Nick Leeson brought down the house of Baring but few people realise that a major earthquake in Kobe, Japan, played a large part in that particular drama.

Making sense of madness is not something any of us do well. Yet markets almost invariably continue to function during catastrophes, although whether they can ever do so in an efficient way must be open to doubt.

Markets often do strange things during normal times. Behaviour during and immediately after dreadful events is almost always difficult to rationalise.

In the immediate aftermath of September 11th, global markets, led by the US, fell heavily. But within a couple of weeks, a sharp rally took place - largely unsupported by anything other than sentiment - that lasted almost until the end of the year.

Many US investors saw it as their patriotic duty to support the market. That sentiment-driven upswing in prices flew in the face of all sorts of fundamental indicators but it provided a powerful reminder of the ability of markets to do things that defy analysis.

Raw emotion is occasionally as powerful a driver of equity prices as is a profits announcement. The fall and rise of the Madrid stock market around the time of its recent terrorist atrocity carried more than an echo of the market's response to September 11th.

The study of market movements around disasters reveals one or two interesting patterns. And if those patterns, or some aspects of them, are currently being repeated today, we might be able to take a guess at the impact on stock prices of the war in Iraq and high oil prices.

Conventional wisdom is essentially pessimistic about Iraq and focuses on the prospect of prolonged conflict. Sensible investors need to take this on board but also need to ask about the "Iraq premium": what would happen to markets in the event of a smooth, peaceful transition of power and a swift withdrawal of coalition forces?

To say that markets don't like wars is to state the blindingly obvious, but investors are often surprised when they look back to see how stocks fared during various past conflagrations.

During the first World War, for example, German equities rose quite strongly during the first four years of that conflict, only to collapse once it became clear that there was a good chance the Germans would lose. US equities only fell when the Americans entered the war but had been rising before then and rose strongly thereafter.

American equities were weak during the onset of the second World War but began a strong rally as early as 1942 when people began to realise that US involvement in the war was inevitable, something that made the result of the war a lot more forecastable.

The period 1940-50 (a much better basis for comparison) saw US equities return 4 per cent a year in real terms; German equities lost an average 10.3 per cent a year. French stocks lost an average 6.7 per cent a year, while UK equities returned 3.1 per cent a year. Over the same period, Japanese stocks lost 26 per cent a year, effectively becoming worthless, as did many of their German counterparts.

The lesson of these and many other statistics is that war is always bad, particularly so for the loser. And even for those ending up on the winning side, it helps not to have had the war fought on your territory.

Perhaps of more immediate relevance is the extent to which global markets closer to home have been depressed by the war in Iraq. The global equity rally that began early last year essentially ran out of steam during the first quarter of 2004.

Lots of factors played a role, not least concerns about interest rates and a view that all of the good economic news is now fully reflected in asset prices. But Iraq and the war on terror have seen the world become a riskier place, which lowers the price of risky assets, particularly equities.

Of course, given the recent newsflow, it is hard to make the case that any of this is going to change any time soon. But with concerns focused on an open-ended US and British commitment to Iraq and the security of global oil supplies, it is probably reasonable to suggest that a lot of bad news is now in the price.

While things may not get demonstrably better for a good while, the worst fears of investors may not be realised.

While the "Iraq premium" may be impossible to quantify with any degree of precision, I am willing to bet that it is substantial, perhaps of the order of 10 per cent or so in terms of the major market indices. Inevitably, that is a guess but I do not think it an unreasonable one.

All of the evidence suggests that while markets - amorally perhaps - try to discount conflict and work out the winners and the losers, they do so in a haphazard fashion and with one eye fixed firmly on the possibility of catastrophe. An end to the bad news from Iraq could well see investors refocus on more familiar factors like growth, interest rates and profits, most of which still look quite favourable.

During the 20-year period from 1950-70, the best markets to be invested in were in those countries that lost the second World War: Germany returned 13.8 per cent a year and Japan a whopping 17.4 per cent.

The story here, of course, is about reconstruction and successful economic regeneration. And this might, for those of an optimistic disposition, suggest a bet on the Baghdad stock exchange.