While markets tend to absorb military clashes quickly, the world’s complex web of financial ties makes the economic clashes a greater source of risk.
August 4, 2022
Vice President, Portfolio AnalystPortfolio Advisory Group – U.S.
Increased tensions between the U.S. and China over House of Representatives Speaker Nancy Pelosi’s controversial trip to Taiwan have renewed concerns about the potential for geopolitical risks and military clashes to weigh on major developed equity markets.
Taiwan and the ongoing Russia-Ukraine conflict are not the only major sources of such risks, however.
In recent days, clashes have flared up in two regions where the U.S./NATO and Russia have opposing strategic interests: in the Balkans between Serbia and self-proclaimed Kosovo, and in the Caucasus between Armenia and Azerbaijan regarding the disputed territory of Nagorno-Karabakh (aka Artsakh). Amid the Ukraine crisis – which we view as a proxy conflict between NATO and Russia – it’s not at all surprising to us that risks are rising in the Balkans and Caucasus.
In recent months, tensions have also escalated between Iran and Israel due to the potential for Iran to fully achieve nuclear weapons capabilities.
Historically, military clashes have had limited impact on equity markets both in magnitude and duration – even when the U.S. and Soviet Union were embroiled in the dangerous Cuban Missile Crisis.
The S&P 500 fell 6.3 percent, on average, in 19 major post-WWII military conflicts or hostilities that we evaluated. While that level of decline is nothing to dismiss, it’s well within the bounds of a typical, modest pullback in many scenarios that often confront markets, including those that have nothing to do with military risks.
Our study of previous geopolitical conflicts indicates the market’s reaction lasted an average of only 29 days before it was able to climb back to even. This occurred despite the fact that many of the actual events lasted longer – sometimes much, much longer.
The Russia-Ukraine conflict is a textbook example. We estimate the S&P 500 began to price in the military hostilities after Feb. 10, and the S&P 500 sank 7.4 percent soon thereafter. But the military operation’s impact on the market had run its course by March 22 when the S&P 500 had recouped all of its lost ground from the initial hostilities. The U.S. market then went on to worry about domestic economic growth, inflation, and earnings growth, along with the Fed’s aggressive rate hike cycle.
Certainly the Russia-Ukraine conflict could generate another equity market selloff if NATO escalates its involvement meaningfully and/or if the fighting spills beyond Ukraine’s post-2014 boundaries to another country in the region. But for now, markets seem unfazed by the ongoing hostilities in Ukraine.
In general, when it comes to wars and serious geopolitical risks, our long-standing advice is that investors should assume that such events can push the equity market into a temporary five percent to 10 percent pullback or, in rarer cases, into a longer-lasting correction of greater magnitude. It’s simply one of the many risks that go along with equity investing.
* The date attempts to capture any material pre-event equity market impact. Actual event start dates may differ.
^ Other economic and monetary policy factors negatively influenced the number of days it took the market to get back to even; this is not counted in the average number of trading days back to even.
Source – RBC Wealth Management, RBC Global Asset Management, Wikipedia, National Security Archive at George Washington University, U.S. Naval Institute
Military clashes are one thing, but the economic consequences associated with geo-economic clashes can be quite another. We think this needs to be considered in the context of Taiwan, and also what has played out recently with Russia.
We live in an era when unprecedented economic levers are being pulled in an attempt to prevent countries from taking certain actions or to punish countries for their behavior.
The U.S., UK, and EU have used these levers more and more frequently over the past two decades, culminating in thousands of sanctions against Russia, the world’s largest commodity producer, and the seizing of hundreds of billions of dollars of the country’s foreign currency reserves.
Western leaders and policymakers misjudged the potential impact of anti-Russia sanctions. They have damaged Russia’s economy much less than what was intended, and they also have had a negative boomerang effect on the very countries that imposed the sanctions, especially on European economies and businesses.
The European energy crisis, which has been exacerbated by the anti-Russia sanctions and Russia’s asymmetric responses to those sanctions, has yet to fully run its course. Winter is coming, and Russia has more economic counter-levers it could pull, including those outside of the natural gas sector. If the sanctions crisis persists and high energy and power prices linger for many months in Europe, not only could economic conditions in the region become more strained, we think Europe could be at risk of experiencing a wave of deindustrialisation.
We believe that over time sanctions have the potential to bring forth greater risks for economies and financial markets than military clashes, especially when they are directed at countries that have critical linkages in the global economy.
In our view, this is where the bulk of the economic and market risks related to Taiwan are concentrated. If tensions continue to escalate between the U.S. and China in relation to Taiwan – regardless of whether a military conflict occurs on the territory – we think the risks of a damaging tit-for-tat sanctions war between the two economic giants could escalate meaningfully. And such a confrontation could impact America’s allies if they follow along.
Markets tend to absorb military clashes rather quickly, but economic clashes have the potential to play out over many months or even years.
In its World Economic Outlook update in July 2022, the International Monetary Fund (IMF) stated the obvious. It warned that there are “serious medium term risks” that the world economy could become fragmented “into geopolitical blocs with distinct technology standards, cross-border payment systems, and reserve currencies.” While the IMF cited the military hostilities in Ukraine as the source of this risk, we think they directly stem from the related sanctions war between the West and Russia.
If the U.S.-China confrontation regarding Taiwan escalates on the economic plane, we think geo-economic fragmentation risks would increase exponentially.
If the COVID-19 crisis taught us anything, it revealed that countries are deeply linked through trade ties and supply chains. And we know from other crises in prior decades that countries are also linked by a complex web of financial ties. This is how the global economic system has evolved – like it or not – and damaging those links can have unintended negative consequences.
This publication has been issued by Royal Bank of Canada on behalf of certain RBC ® companies that form part of the international network of RBC Wealth Management. You should carefully read any risk warnings or regulatory disclosures in this publication or in any other literature accompanying this publication or transmitted to you by Royal Bank of Canada, its affiliates or subsidiaries.
The information contained in this report has been compiled by Royal Bank of Canada and/or its affiliates from sources believed to be reliable, but no representation or warranty, express or implied is made to its accuracy, completeness or correctness. All opinions and estimates contained in this report are judgments as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. This report is not an offer to sell or a solicitation of an offer to buy any securities. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Every province in Canada, state in the U.S. and most countries throughout the world have their own laws regulating the types of securities and other investment products which may be offered to their residents, as well as the process for doing so. As a result, any securities discussed in this report may not be eligible for sale in some jurisdictions. This report is not, and under no circumstances should be construed as, a solicitation to act as a securities broker or dealer in any jurisdiction by any person or company that is not legally permitted to carry on the business of a securities broker or dealer in that jurisdiction. Nothing in this report constitutes legal, accounting or tax advice or individually tailored investment advice.
This material is prepared for general circulation to clients, including clients who are affiliates of Royal Bank of Canada, and does not have regard to the particular circumstances or needs of any specific person who may read it. The investments or services contained in this report may not be suitable for you and it is recommended that you consult an independent investment advisor if you are in doubt about the suitability of such investments or services. To the full extent permitted by law neither Royal Bank of Canada nor any of its affiliates, nor any other person, accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein. No matter contained in this document may be reproduced or copied by any means without the prior consent of Royal Bank of Canada.
Clients of United Kingdom companies may be entitled to compensation from the UK Financial Services Compensation Scheme if any of these entities cannot meet its obligations. This depends on the type of business and the circumstances of the claim. Most types of investment business are covered for up to a total of £85,000. The Channel Island subsidiaries are not covered by the UK Financial Services Compensation Scheme; the offices of Royal Bank of Canada (Channel Islands) Limited in Guernsey and Jersey are covered by the respective compensation schemes in these jurisdictions for deposit taking business only.