When dealing with geopolitical conflicts, each situation is unique, so there isn’t a predictable blueprint or roadmap to fall back on. One thing is certain: When geopolitical tension rises, so does stock market volatility.

In general, markets face uncertainties ranging from political and economic issues to inflationary and geopolitical factors. Of these, geopolitical risks tend to be the hardest to gauge as they have the widest range of outcomes. Also, these events unfortunately often involve human suffering and the loss of life, making them more painful.

Many are dubbing the Russia-Ukraine crisis as the new Cold War and a conflict that could drag on for the foreseeable future. While no one knows how this conflict will play out, an immediate solution does not seem imminent.

The direct exposure of the global market to Ukraine and Russia is pretty small, but the impact on commodity prices is of big concern.

Unfortunately, this is not the first time we have dealt with worrisome geopolitical events. While risks are not created equal, we can use history as a gauge to help assess the potential impact on financial markets.

History

As mentioned, markets are impacted by a confluence of factors, geopolitical risks being one of them. There have been 18 “acts of war” since World War II. Each of these periods was met with different outcomes.

The S&P 500’s sell-off was limited to 6.2% on average and took 30 trading days to get back to even. What’s impressive is that many of these hostilities were lengthy, yet markets fully recovered well before a resolution was struck. It should be noted that some events impacted markets for only a few days while others lasted several months.

The two larger corrections, the Arab oil embargo in 1973 and the Iraq invasion of Kuwait in 1990, were associated with major disruptions to energy markets, which resulted in longer-lasting negative economic impacts.

We are facing similarly today. If events escalate and the price of oil reaches $150 a barrel and remains elevated, the likelihood of a recession drastically increases.

While a scary thought, bear in mind that markets tend to perform better than expected during recessionary periods.

But one thing is clear: Most geopolitical sell-offs are short-lived, and markets tend to rebound when things seem bleak.

As seen above, markets have averaged a 9% return one year from various geopolitical events. Of course, there is always the fear of the unknown and its fallout, and we can’t discount the potential for this situation to be worse than past ones.

Now, this time may feel “different” because markets were already struggling out of the gates this year. Persistently high inflation is forcing the U.S. Federal Reserve to raise interest rates more aggressively than anticipated. And inflation is likely to remain elevated in the coming quarters since Russia is the third-largest oil producer and accounts for ~12% of global crude production.

With the U.S. ban on Russian energy imports, we can anticipate more inflationary pressure in the near term, which means energy prices will likely remain elevated if no resolution is struck.

In addition, there are worries that this could be a flashpoint moment for the U.S. and China, given relations were already somewhat tense between the two countries. Then add in China’s refusal to call the attack on Ukraine an invasion, their opposition to Russian economic sanctions, and a “rock solid” friendship with Russia. Establishing a mutually healthy long-term relationship with China seems challenging at the moment.

China has become fully entrenched in the global economy, and any additional friction among the U.S., Europe, and China could lead to more bumps in the road. However, an all-out trade war with China seems unlikely as the economic costs for all parties involved would be massive.

Economy

In the end, economic growth and corporate profits drive markets over the long term. While the next few quarters could be painful, the situation will eventually normalize and set the tone moving forward.

Heading into this conflict, corporate earnings, margins, and revenue showed solid growth, and bond default rates plummeted to below 1%! All this is to say that the economy was on solid ground coming into the new year. Of course, rising inflation and interest rates remain an issue—but not one that markets can’t handle.

While corrections are never the desired outcome, they are common. The S&P 500 has experienced a pullback of 10% or greater in 14 of the past 22 years (~64%), including 2022. Long-term investors should embrace them as buying opportunities.

Until we gain more clarity on Russia’s invasion of Ukraine, markets are likely to remain volatile. With geopolitical issues, there’s always the risk that the situation could drastically escalate, and if so, we are likely to see another massive spike in volatility. However, in most cases, the worst-case scenario is avoided, and market fundamentals regain control.

It is important to remember just how resilient markets are. Markets have endured countless wars, recessions, depressions and have always come back stronger.

As always, we caution against making knee-jerk investment decisions in times like this. Please reach out to our Bethesda, MD wealth management firm if you would like to discuss investment management that helps you keep your focus on the long term.

Above all else and for humanity’s sake, I hope a resolution is right around the corner.

Stay tuned …

Ara

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