- A quick note before I start,
the unprovoked aggression currently happening in Ukraine
is unacceptable and heartbreaking.
War in general is horrific
and above all else a human tragedy.
I'm not minimizing that
by talking about the financial, economic impacts.
Wars and financial markets have coexisted
and often been intertwined for hundreds of years.
Countries that have lost major wars
have had their financial markets decimated,
while global markets have been relatively resilient,
even to major conflicts.
Despite their relative resilience of global markets,
crises and wars tend to reduce global market returns
and increase their volatility.
Some of the most extreme historical stock
and bond market returns both positive and negative,
have been concentrated around wars.
But drawing predictive conclusions from past wars
is a dangerous task.
Historically the relationship between wars
and financial markets has differed from war to war
and through time.
So attempts at timing the market
or making tactical asset allocation decisions
is as usual likely to be a losing game.
I'm Ben Felix, portfolio manager at PWL Capital.
I'm going to tell you about the historical relationship
between financial markets and war.
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There are enough historical examples
of war's devastating individual financial markets
to make war a scary prospect for investors.
In two of the most extreme cases,
the Russian Revolution in 1917,
and the Chinese Civil War ending in 1949,
investors assets were expropriated,
resulting in effectively total losses
for foreign and domestic investors
in the stocks and bonds of those countries.
Interestingly, investing in the companies
listed on the St. Petersburg's Stock Exchange
from 1865 to 1917, yielded returns nearly twice as high
as those on the New York Stock Exchange.
But that all changed quickly
as a result of the Russian Revolution,
reminding us of the importance of diversification.
This is a stark reminder of the role
that relative domestic peace
and success in foreign wars over the last 100 years
has played in the exceptional ex-post results
of the US financial markets.
Whether we can bet on US exceptionalism continuing
for another 100 years is an open question.
German stocks took a beating during and after World War I,
dropping more than 90% in real returns
measured in US dollars by 1922.
During the war, from 1914 to 1918,
German stocks dropped 67% cumulative.
US and UK investors also lost in World War I,
but not nearly as bad as Germany.
US stock investors lost 18% in real returns,
while investors in the UK lost 17% measured in US dollars,
void by an appreciation of the pound relative to the dollar.
Japan had a massive increase
in the value of their stock market
over the 1914 to 1918 period,
gaining a real 63% in US dollars.
The world index lost a real 31% measured in US dollars
over this period.
Germany was again hit with large losses
during and after World War II.
Again, dropping more than 90% from 1939 to 1947.
Japan was even worse,
with their stock market losing nearly 99%
of its real US dollar value during and after World War II.
Investors in US and UK stocks
who tried to learn from World War I
by getting out of stocks before the war,
lost out on positive real returns
with the US delivering 22% and the UK 34% cumulative
in their respective currencies during World War II.
A global equity investor lost
about 15% real measured in USD.
Exposure to multiple risk premiums paid of in this period.
US small cap value stocks beat the US market
by an annualized 12% from 1939 to '47,
and US value stocks beat the US market
by 6% of over the same period.
As historian Niall Fergusson explains
in "Earning from History,"
financial markets and the approach of world wars,
"In short, there is no simple recurrent pattern.
Investors did try to learn from history in the late 1930s,
but they mainly learned how to make new mistakes,
since the lessons of the previous war proved
to have only limited relevance to the next one."
This is nothing new.
Financial markets are inherently uncertain,
random, and difficult to learn from.
On average though, it should not be terribly surprising
to see declining stock markets during times of war.
Stock prices theoretically reflect the present value
of expected cash flows,
discounted at a rate that is based on risk.
If times of war serve to decrease expected cash flows
or increase risk, which are both plausible,
drops in prices are to be expected.
The other side of that coin though,
is expected returns may increase after a fall in prices.
A higher discount rate means a higher expected return.
On that point, despite the dramatic drops for Germany
and Japan in World War II,
the years fall following are some of the most extreme
positive returns in stock market history.
From 1949 to '59, the German stock market increased
at a rate of 61% per year, adjusted for inflation,
measured in US dollars.
An investor who got into the German market in 1939,
had lost nearly everything by 1947,
but had they stayed invested
and maintained the ownership of their property,
they nearly tripled their initial investment by 1952.
Similarly, Japanese stocks appreciated at 28% per year
from 1949 to 1959,
but the previous losses were severe enough in that case,
that it took another 10 years, until 1969
to recover the USD purchasing power
of an initial investment made in 1939.
To contrast the difficult experience
for investors in Japanese and German stocks
over these periods,
globally diversified investors fared much better,
losing only about 15% in real terms measured in US dollars.
It is important to note
that investing in the global market
was much more challenging at that time,
but the results remind us why diversification is worthwhile
now that it's readily available.
So far these events have been extreme,
deep in the left tails of stock market history.
Taking a broader perspective, the 2006 paper,
"War, Peace, and Stock Markets,"
looks at 440 international political crises over the period,
1918 to 2002,
using the International Crisis Behavior Database.
Based on these data, on average,
an international political crisis
starts almost once every two months.
The authors find that international crises
reduce world stock market returns by about 4% per year.
They find large negative stock market reactions
from world markets in the first month of a crisis,
followed by lower than average returns
during the remaining months
and a partial recovery when they end.
The reaction from stock prices is stronger
when a crisis involves basic values,
like a territorial threat, a threat of grave damage
or a threat to existence.
Reactions are also stronger when a superpower
is involved on both sides of the conflict
and when the conflict starts with violence.
Confirming what we have seen anecdotally at the extremes,
this paper demonstrates that investors in stock markets
of countries involved in an international crisis
see their markets drop about 2% when a crisis starts
and then additional 1% per month
as long as the crisis lasts.
Importantly, these losses are only partially recovered
when the crisis ends on average.
Countries not involved in the crisis
only tend to see significant negative returns
at the start of the crisis.
International crises have a strong impact
both on average returns and volatility,
with volatility increasing by slightly more
than a third at the onset of a crisis
and decreasing by slightly less than a third
when the crisis ends.
The author suggests that political uncertainty
may help to explain the volatility puzzle.
The question of why stock market volatility changes
so much through time.
We have seen that stock markets do tend to react negatively
to political crises and in particular wars.
Bond markets have fared even worse,
flipping the conventional wisdom of bonds is a safe asset.
Over the last 121 years
five trees have experienced negative real bond returns
for the full period,
largely associated with wars and their aftermath
in the first half of the 1900s.
German bonds lost all of their value
during the hyper-inflationary period of 1922 to '23.
Even the US bond market has had major periods
of long term under-performance in and around war time.
Starting in December, 1940,
US long term government bonds lost 67%
of their real value
and did not recover in real terms until 1991.
Similarly, UK long term government bonds started dropping
in October, 1946, losing 74% in real terms by 1974
and not recovering fully until December, 1993.
This is not a cautionary tale about not owning bonds.
It is a reminder that diversifying across stocks and bonds
and diversifying bonds globally makes a lot of sense.
Remember US and UK stocks had positive real returns
over the same periods.
Stocks and bonds have generally been imperfectly correlated.
And despite their substantial real drawdowns
over sometime periods,
bonds are usually less volatile than stocks.
Well, wars can be devastating
particularly for individual countries on the losing end.
An important point for globally diversified investors
to understand is that the worst
historical global stock market returns
have occurred in peace time.
And those peace time crashes have occurred more frequently
than major wars.
Global stocks lost 31% in real terms in World War I
and 15% in World War II,
but they lost 54% in the 1929 Wall Street crash,
47% in the 1973 oil shock and recession,
44% in the 2000 internet bust
and 41% in the 2008 global financial crisis.
In other words, if you can't handle the volatility
and drawdown related to wars,
you can't handle stocks, plain and simple.
Finally, the last lesson to remember
is that while stock returns
have been volatile throughout history,
they have been reliably positive in the long run.
And for a globally diversified investor,
the ride has been relatively stable
compared to investors concentrated in individual countries.
Global stocks have returned a real 5.2%
or about 8% in nominal terms for the last 121 years
despite two large scale global wars,
the cold war, civil wars, revolutions,
depressions and pandemics.
In total there are 487 crises from 1918 to 2017
in the International Crisis Behavior Database
and here we are.
A common response that I hear to these long-term data
is that people don't have 121 years to wait,
but remember diversification between stocks and bonds
across countries and across multiple sources
of expected return, like small cap and value stocks
has dampen volatility, reduced extreme drawdowns
and increased recovery times after crises.
In investing, we are faced with risk,
which can be quantified with probabilities and uncertainty
which cannot be quantified.
The prospect of political risk
and war falls on the side of uncertainty.
In "Earning from History,"
financial markets and the approach of world wars,
Niall Fergusson finds that changes in military technology
and government regulation
ensured that one could never be certain
that the next war would have the same financial impact
as the previous war.
But that doesn't mean there are no lessons to be taken
from the history of financial markets in major wars.
Fergusson explains, major wars can arrive
even when economic globalization is far advanced,
the longer the world goes without a major war,
the harder one becomes to imagine.
And when a crisis strikes complacent investors,
it causes much more disruption
than when it strikes battle scarred ones.
About how to respond to uncertainty, Keynes wrote in 1937,
"We largely ignore the prospect of future changes
about the actual character of which we know nothing.
We assume that the existing state of opinion
as expressed in prices and the character of existing output
is based on a correct summing up of future prospects.
Knowing that our own individual judgment is worthless,
we endeavor to fall back on the judgment
of the rest of the world, which is perhaps better informed,
that is we endeavor to conform with the behavior
of the majority or the average."
In other words, only take as much risk as you can handle,
even in, or especially in bad times.
Don't forget that bad times will come
and that you plan for them
and diversify globally in low cost index funds.
Thanks for watching, I'm Ben Felix,
portfolio manager at PWL Capital.
If you enjoy this video,
please share it with someone who you think could benefit
from the information.
We also discussed this topic in a special episode
of the "Rational Reminder Podcast."
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