On Geopolitics, Turmoil Isn’t Abnormal

If there were a Bingo card for sayings that encapsulate investor sentiment, we think somewhere in the scepticism column would be a square along the lines of, second-guessing the market is a fool’s errand, but … . We have seen many iterations of this amongst commentators we follow lately, usually followed by some form of that exact second-guessing. Much of the doubt we have seen dwells on the notion that the S&P 500’s trip to new record highs is whistling past mounting geopolitical risk.^[i] The supposed implication: Stocks are storing up negative surprise when the world catches fire, echoing the early 1940s’ bear market.^[ii] We see a teensy problem with this parallel, and it might not be the one you think.

That is: In our view, markets were actually pretty efficient at discounting the mounting risk of world war 85 years ago, and we strongly suspect they are just as, if not even more, efficient now.

Let us review. A Wall Street Journal editorial encapsulating today’s fears puts forth that stocks are trying to “party like it’s 1939” against the alarming backdrop of war in Europe and the Middle East and the threat of war in Asia.^[iii] But before you start nodding along, maybe we ought to review what stocks actually did in 1939 (we will use the S&P 500 index in US dollars here for its long history). Yes, the S&P 500 started that year on an up note, continuing what we think was a nascent recovery from 1937’s bear market, but it didn’t last.^[iv] A new downturn began as Hitler annexed the Sudetenland, which was Czech territory at the time.^[v] From there, it didn’t take stocks long to price in the mounting likelihood of Allied powers getting real about Hitler’s territorial ambitions and eventually declaring war—which happened about six months after the Czech invasion. On the year, the S&P 500 fell -0.9%.^[vi] This was all more than two years before Japan’s attack on Pearl Harbor and the US’s eventual entry into the war. So from our vantage point, 1939 was a year of stocks being sober about the global threat, not fiddling whilst Rome started burning.

With that context, we think it seems hard to justify the stance markets are somehow ignorant or irrational this time … or that the present is uniquely tumultuous. Yes, Putin’s war is nearing its second birthday. Yes, fighting continues in Gaza. Yes, the US and UK militaries have been drawn into the situation in the Red Sea. Yes, there are rockets flying around Iran and yes, things are tense in Pakistan. We don’t dismiss any of this. But we think the key thing to remember is that geopolitical instability is nothing new. History shows it isn’t unusual for multiple skirmishes to be happening at once. In our experience, what does ebb and flow is the amount of attention they get and how hard people in more peaceful areas look for more potential trouble spots. Right now, both seem high to us.

Examples we have seen of the latter are the focus on the Chinese government’s jawboning about Taiwan’s election and North Korean dictator Kim Jong-un’s declaration that North Korea will now view South Korea as its enemy instead of a target for peaceful reunification.^[vii] Both are getting a lot of attention from commentators we follow. We suggest not getting sucked in. For one, usually with these things, we find the target audience for these statements is domestic supporters, and the aim is usually to cultivate an image of strength at home. Westerners often miss that point, in our experience. Two, none of this seems like a change to us. China has long made its views of Taiwan’s political parties known, and verbal sabre-rattling around its elections is an old tradition. Similarly, peaceful reunification from Kim’s standpoint always meant South Korea magically turning communist and swearing fealty to the North. That unlikely scenario would never have been peaceful, in our view. We think this is all just strongman bluster.

As for the spots of actual conflict, they are still tragic and horrible for those involved, but our research shows they aren’t without precedent in world or bull market (a long period of generally rising equity prices) history. For stocks, we find there is rarely a dull moment. In 2013 and 2014, we had the Syrian Civil War, which threatened to evolve into a proxy war between the US and Russia, and Russia’s invasion and annexation of Crimea. 2012 brought Middle Eastern tensions in the Arab Spring’s wake and the attack on the US embassy in Libya. In 2006, another bull market year, North Korea tested nukes whilst Israel and Hezbollah fought.^[viii] The Bosnian War in the mid-1990s occurred during what was then history’s longest bull market—in the legendary powder keg of Europe—whilst US forces were embroiled in the Somali crisis.^[ix] All throughout, a cornucopia of other geopolitical flare-ups dot any timeline. Stocks regularly rise amidst tense geopolitical scenarios and, yes, even wars.

For the outcome to be different this time, we think there would have to be a significantly higher likelihood of several major powers getting sucked into a conflict that spanned a much larger geographic theatre. Possible? Yes. Probable? Not as far as we can see. Tinder spots like nuclear-armed Pakistan, which is unstable and not friendly with its nuclear neighbours, merit close scrutiny, in our view. But its exchange of rocket fire with usually sympatico Iran targeting militant extremists doesn’t seem like that to us.

Based on our research, the possibility of broad conflict would have to morph to strong probability for markets to begin pricing severe, widespread, long-running trouble. In our view, the usual jawboning, sabre-rattling and rocket firing isn’t a sufficient basis for arguing the likelihood of global conflict is higher. Rather, we see the heightened attention on it as a sign of prevalent investor scepticism, which we find is part and parcel of young bull markets.

Another way to look at it: If commentators we follow globally are arguing geopolitics are presently a large risk, and if we accept that markets generally deal quite efficiently with widely known information (which our research shows they do), then we think it stands to reason stocks are well aware of the alleged negatives and likely reflect them in prices. And since they are up, then we can deduce they have weighed these risks and concluded there is a strong probability things will turn out better than these headlines project, or that the likely impact just isn’t all that material to corporate profitability—stocks’ chief concern, according to our research.^[x] If things change and there is a high likelihood of conflict affecting a significant share of global economic activity, then we think stocks will price it. But for now, they seem to be concluding—in our view correctly—that the footprint is quite small.