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Missiles and Markets: An Investor Guide to Geopolitical Risks

Key Points
  • President Trump's surprise missile attack on Syria came on the same day as ballistic missile tests by North Korea, re-focusing markets on geopolitical risk.

  • The long history of U.S. missile strikes and NATO military operations shows us that the market impacts of these geopolitical conflicts have been small and brief.

  • Investors should avoid overreacting to geopolitical developments and stick to their long-term financial plans.

Geopolitical risk is back to making headlines. China may implement tougher sanctions in response to North Korea's nuclear weapon development, which is testing the warming relationship between the United States and China. The markets may be growing concerned that a diplomatic response may not be enough to mitigate the risk of a U.S. missile strike or broader military operation. The heightened unease stems in part from the U.S. missile strike on Syria on April 6 and the largest nonnuclear bomb ever used in combat on April 13 in Afghanistan that demonstrated President Trump’s willingness to use military force.

Looking back

Airstrikes take place almost daily as part of ongoing campaigns such as the battle against the Islamic State, but focused initial missile strikes and military operations can have an abrupt impact on markets. There is a long history of U.S. missile strikes and NATO military operations focused on regime change in the past 25-35 years we can use to assess the potential market impact of these types of geopolitical events.

In short, history shows us that the impacts of these geopolitical conflicts have been small and brief.

  • U.S. missile strikes: The stock market reaction was most often slightly negative on the first day with the market recovering the losses within five days in most instances. Larger losses of around 5% took place when the strike occurred during the Asian financial crisis in 1998 and the global financial crisis in 2008. The U.S. stock market volatility index tended to rise. Gold futures, the dollar and bond yields were little changed. Oil prices tended to rise modestly.
  • NATO military regime change operations: Stock market responses were mixed, but positive on average on the first day with further gains after five days. The U.S. stock market volatility index tended to decline. The dollar and bond yields were little changed. Gold and oil prices tended to fall.

Markets and U.S. missile strikes*

Markets and U.S. missile strikes

*excluding U.S. wars: 1991 Gulf War; 2003 Iraq War; War in Afghanistan

**MSCI AC World Index

VIX denotes the S&P 500 CBOE Volatility Index.

Source: Charles Schwab, Factset data as of 4/13/2017.

Markets and NATO military regime change operations
Markets and NATO military regime change operations

*MSCI AC World Index. MSCI World Index used prior to inception of MSCI AC World Index on 12/31/1987.

Source: Charles Schwab, Factset data as of 4/13/2017.

Fair comparison

It is important to consider whether recent developments are comparable to those in the tables above.

We believe the U.S. missile strike on the Syrian airbase responsible for the chemical attack that killed at least 88 civilians can be classified as similar to those in the table of missile strikes above including the market impact. The decision to strike only one air base signals a warning, to denounce the use of chemical weapons, and was not intended to start a major military intervention. The U.S. Navy targeted the air base, rather than Syrian surface-to-air missile sites, suggesting the strikes were not preparation for a larger campaign of airstrikes. While regime change may be a long-term objective, Syrian President Bashar al Assad was not targeted, which could have drawn the United States into a full conflict that may involve Russian forces.

Unilateral military action against North Korea would likely differ from the list of U.S. missile strikes above. A broader military campaign against North Korea could be considered similar to a NATO regime change operation, but with some differences. Unlike in Syria or Libya, the U.S. cannot assume that North Korea would not respond to an attack with an assault of their own. A North Korean attack of U.S. military bases in South Korea and Japan could turn into a broad regional conflict.

North Korean military response

A military response by North Korea to a missile strike or broader military operation would likely pose the biggest downside risk to stocks in South Korea, followed by Japan and China. A regional conflict could risk damage to economic infrastructure or activity in South Korea and Japan, two of the eleven largest economies in the world that amount to a combined 8% of global GDP, per International Monetary Fund data. The spillover effects on global consumer and business confidence could temporarily magnify the impact on world economic growth and corporate revenues.

The perceived threat reflected in the South Korean stock market, measured by the latest rise in the volatility index of the KOSPI 200, has been relatively small compared to the flare ups in recent years. The low level of concern can also be seen in the fact that the South Korean stock market has been performing well with a 6% gain measured in local currency and 12% in US dollars, so far this year.

South Korean stock market volatility index

South Korean stock market volatility index

Source: Charles Schwab, Bloomberg data as of 4/13/2017.

Geopolitical events

Thinking more broadly than the current headlines, the potential always exists for a geopolitical event to draw the U.S., or other major nations, into armed conflict. While the events are often unpredictable and the countries involved vary, the markets' reactions are often predictable. For example, we can see startling similarity between the stock market's reaction in timing, direction, and magnitude to the Cuban Missile Crisis in 1962 and the Iraq war in 2003—both conflicts involved an ideological war, concern over weapons of mass destruction, and UN inspections of weapon sites. Stocks slid as geopolitical tensions rose, but when the United States took action with a military blockade of Cuba in October of 1962 the stock market rallied. About 40 years later, the stock market reacted very similarly in the days leading up to, and in the year following, the invasion of Iraq in March of 2003.

Similar stock market performance surrounding geopolitical events

Similar stock market performance surrounding geopolitical events

Source: Charles Schwab, Bloomberg data as of 4/13/2017.

Our analysis of 37 geopolitical developments since 1980 reveals that stocks have not always declined in response to developments that heighten geopolitical conflict. But when they have, the global stock market averaged a 3% decline with an average duration of just seven days.

Path of least resistance

It has been said that geopolitics follows the path of least resistance. Applying this to the current geopolitical headlines, we could conclude that with the U.S. and China working on a diplomatic approach to the North Korean nuclear threat, a unilateral military assault is less likely at least in the near term. On April 9, U.S. Secretary of State Tillerson said the U.S. isn't planning regime change in North Korea and Treasury Secretary Mnuchin said that the administration has been working with China on new sanctions for North Korea. With the redirection of a carrier strike force to the region and the deployment of a missile defense system in South Korea, the U.S. is making it clear to China that they can either work together in stopping North Korea's nuclear weapons capability in exchange for a better trade deal or accept an enlarged U.S. military footprint in the region.

While a regional military conflict with significantly negative market impact is plausible, the long history of market response to military strikes and operations along with diplomatic efforts to contain the North Korean threat suggest most likely outcome is a negligible market impact.

Investors are best served when grim headlines are in the news by remembering that geopolitical risks are a regular part of investing and that a long history of geopolitical developments shows us that holding a well-diversified portfolio may buffer the short-term market moves that are most often the result. Investors should avoid overreacting to geopolitical developments and stick to their long-term financial plans.

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