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CA-EN Advisors

A Portfolio Manager’s Guide to War and Conflict

April 26, 2022
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With Russia’s recent invasion of Ukraine, institutional investors are once again questioning the historical relationship between war and capital markets. In response, Steve Shepherd, Director and Portfolio Manager with BMO’s Multi-Asset Solutions Team (MAST), offers a practical roadmap to managing geopolitical risks within portfolios.

Between two groups of people who want to make inconsistent kinds of worlds, I see no remedy but force.

Oliver Wendell Holmes Jr.​

Lessons from history​

War is a tragedy, from beginning to end. The human toll, paid in lives lost and horrors witnessed, exceeds any calculation that we as investment professionals can hope to make. As asset managers, our role is to manage risk and navigate through uncertain times on behalf of our clients, many whom themselves carry a similar fiduciary duty to protect capital within the portfolios they manage. In that spirit, this article will examine:

  1. the historical impact of war on capital markets, and
  2. the broad framework we use to consider a conflict’s disruptive power.

We look at 22 major events that took place from 1941 to 2021 (chart 1), measuring the percentage drop in the S&P 500 from the inciting event to the bottom of the market, and also how many days it took to recover. The data reveals a clear pattern: markets often react quickly when conflict arises, selling off at the first tremors before eventually rebounding as the initial shock wears off. In fact, our research shows the average time from the market reaction to recovery is approximately 42 days. (Source: LPL Research, S&P Dow Jones Indices, CFRA)

Chart 1 – Impact of War on Equity Markets

A chart that takes a look at 22 major events that took place from 1941 to 2021, measuring the percentage drop in the S&P 500 from the inciting event to the bottom of the market, and also how many days it took to recover. The data reveals a clear pattern: markets often react quickly when conflict arises, selling off at the first tremors before eventually rebounding as the initial shock wears off. In fact, our research shows the average time from the market reaction to recovery is approximately 42 days.
Source: LPL Research, S&P Dow Jones Indices, CFRA.

Another takeaway is that conflicts come in different forms, and from different origins. For instance, the Boston bombing is not a sufficient proxy for understanding the nuances of the Yom Kippur War, and vice versa. Even when the underlying characteristics are similar, it’s helpful to remember that the analogy only goes so far. Russia’s recent invasion of Ukraine may be reminiscent of the Iraqi invasion of Kuwait, for example, given that both are territorial land grabs instigated by autocratic leaders in oil-rich regions of the world. But Russia is not Iraq, and Ukraine is not Kuwait. Russia plays a much larger role in the global economy than Iraq did at the time, and Ukraine’s export profile differs significantly from that of Kuwait, not to mention that the world looks very different now than it did in the early 1990s.

That being said, there are common parameters for all geopolitical conflicts. The questions we ask ourselves at the outset of any conflict allow us to put the event in its appropriate context, and hopefully help cooler heads prevail in our tactical decision-making.

Question 1: What was the prior sentiment in markets?​

Headline events such as the war in Ukraine are so startling and disruptive, that they can often cause investors to forget the prior trajectory of markets in favour of the immediate. There can be a tendency to view the event in isolation rather than as a single data point in a longer series, which, of course, is the case with any new macro development. Markets always react based on a pre-existing narrative. If the global economy is doing well, the blow is softened. If asset prices are slipping, the decline becomes part of the trend. Investors’ reactions to war are never free of context; conflict merely amplifies the sentiment that was there to begin with.

Consider chart 2, which shows the market drawdown before and after the 9/11 attacks. The pullback in the S&P 500 in September was marked by a sharp decline in equity prices that were already trending down. U.S. shares had been declining since July, when the Dot Com Bubble burst and exposed systemic issues with technology issuances on the stock market. In fact, the broad market was down nearly 50% from its peak when the attack took place. Similarly, investors’ response to Russia-Ukraine was characterized as severe, but the S&P was never down more than 3% on a daily closing basis. Was it too harsh? Certain asset classes were harder hit, such as Russian bonds and equities, but otherwise the oft-quoted year-to-date numbers included losses from January that preceded the invasion.

Chart 2 – Drawdown from Peak (%)

Drawdown from Peak (%)
Source: Refinitiv, Capital Economics.

Question 2: How vital are the countries to the global economy?

Another unfortunate reality of conflict is that not all countries have an equal impact on the global economy. Broad divisions exist between developed and developing nations, and going further still, each country has its own unique footprint on the landscape of international trade. For example: if an economy has the entire global supply of an asset—say, neon that’s needed for computer chips—the outbreak of war in that region would have a severe impact on technology supply chains. This was the case in Ukraine. To make matters worse, the European energy network is heavily dependent on Russia, which accounts for more than 40% of the continent’s oil and natural gas needs (Source: International Energy Agency), as well as being a major exporter of wheat and nickel. (Source: Douglas Broom) Once the conflict began in earnest, it became clear that much of Europe would need to find alternate sources of electricity or else cope with extreme energy inflation.

When evaluating the ripple effects of a conflict, size also matters. Countries with large populations and landmass are more worrying given the sheer scale of potential warfare, as opposed to smaller nations that are both geographically and economically remote.

Question 3: What’s the worst potential outcome?

Finally, we put ourselves through grim thought-experiments to see what the tail ends of the possibility curve look like. Short of nuclear war, the worst scenario imaginable is one in which the U.S. and China begin a full-scale military conflict (an eventuality which we glimpsed during the trade war initiated by President Trump). Most conflicts will not be on this scale, however; they will likely be confined to territorial disputes whose fallout is limited to the region. Nonetheless, the exercise helps us set goalposts with those outlier probabilities in case the situation does get out of control.

While the initial market reaction can be emotional, the final calculation must be based on tangible damage. Money is only lost when capital is destroyed, so ask yourself: what real assets are being destroyed? Beyond the physical, we do also have to consider the knock-on effects of financial sanctions, such as those that have crippled the Russian economy and tried to destabilize Putin’s control from within the country. Although those sanctions are meant to be temporary in order to incentivize a Russian withdrawal from Ukraine, individual companies have taken it on themselves to stop doing business within Russia. Take, for example, the decision by British Petroleum to exit its 19.75% stake in Russian energy giant Rosneft at a cost of up $25 billion (Source: BP Corporate Website, February 27, 2022), McDonald’s closing its 850 locations inside Russia (Source: McDonald’s Corporate Website, March 8, 2022), or banks like Société Générale, Goldman Sachs and Deutsche Bank winding down their business in protest of the war. (Source: The New York Times, March 9, 2022) These actions must be viewed as permanent rather than transitory.

Investors’ reactions to war are never free of context; conflict merely amplifies the sentiment that was there to begin with.​

Finding signals in the noise

It’s exceedingly rare that investors know the true impact of war immediately after it begins. Uncertainty causes the initial shockwave, but after the dust settles it’s only the material changes to the world that determine long-run valuations. Whether through physical destruction or financial sanctions—or even the mere existence of heightened uncertainty—we need to identify the economic consequences that will seep into the broader world and influence intrinsic value, because those factors will determine returns. Ultimately, we must actively manage our natural impulses, and ask the question: what will this change about the world?

About the Author

Steve Shepherd, CFA, Portfolio Manager & Investment Strategist, Multi-Asset Solutions, BMO Global Asset Management

Steve has over two decades of experience in the investment industry, and currently serves as portfolio manager and investment strategist, focussing primarily on the asset allocation of BMO Asset Management Inc.’s fund of fund solutions. Steve has held senior roles in sales and product development, most recently as Vice President, Equity Strategies with BMO Investments Inc., where he was responsible for the oversight of the bank’s equity mutual funds, including manager due diligence, portfolio construction, performance analysis and market commentary. Steve holds an HBA from the Richard Ivey School of Business at the University of Western Ontario, and is a CFA charterholder.


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