From the frontline to the bottom line:

The crisis in Ukraine and volatility in the stock market 

This week, under the looming threat of an invasion of Ukraine global stock markets became very jittery. While the threat of conflict is not the only driver of market volatility (economic policy announcements from the US Federal Reserve were a major factor as well) it is important for retail investors, and especially those in the military, to understand some of the macro forces, like uncertainty over armed conflict, that can impact investments.  

In the last six months, Russia has amassed over 100,000 troops near eastern Ukraine and threatened a full-scale invasion of the country. Last Thursday, in response to the continued buildup of Russian forces, the Biden administration ordered an additional 8500 troops on standby for deployment to the EUCOM theater of operations in response to the escalating tensions. Fears of an imminent invasion have sparked both additional deployments and rhetorical saber-rattling between the United States and Russia. While the world watches and waits for Russian President Vladimir Putin’s next chess move, it’s clear the immediate impact is that 8500 American military families are on notice that their loved ones may be moving in harm’s way. What is less clear is what impact these geopolitical machinations will have on global markets. 

In response to the twin pressures of a potential rate hike from the Federal Reserve, coupled with the increased threat of conflict in Ukraine, global markets this week experienced high volatility compared to the historical average. US stocks opened the week sharply down dragging the major indexes into over 10% negative territory for 2022 before a late rally. On Tuesday morning the market bears prompted a similar sell-off before eventually rebounding. The nervous nellie nature of the market meant the peaks were especially peaky and valleys particularly deep, which in market-speak is known as volatility. Expected volatility is most commonly measured by the VIX index. 

The VIX index is determined by a sampling of options traded on the S&P 500 (An index of the largest 500 US companies). By looking at option pricing the VIX index measures confidence in the S&P 500 which is a reflection of the overall market expectations. On Monday the VIX index measured a shocking 38, a level not seen since the early days of the pandemic. Tuesday the VIX index opened at 35 and as of Wednesday morning was trading just below 30. This is significant because the long-term average of the VIX hovers in the mid-teens. In essence, the VIX index is like looking at a collection of insurance premiums for the stock market, just as a home insurance company might look at insurance premiums for a coastal property. If there is a hurricane offshore, insurance premiums are going to go up. Looking at the VIX index this week, investors signaled that a storm was brewing. 

 As we saw this week geopolitical instability or the threat of war, often is correlated with market volatility. Surprisingly, the actual break out of conflict itself does not historically coincide with poor market performance. This is known as the war puzzle. In the run-up to conflict, we see volatility in global markets. This is understandable. In the case of Ukraine, armed conflict could provide a serious threat to energy production and supply chains. Europe, specifically Germany, is largely dependent on natural gas from Russia to meet their energy needs. Russia is one of the world’s largest producers of oil and natural gas as well as precious metals like Palladium. Even if a ‘hot war’ doesn’t physically interrupt the supply chain it is likely that imposed sanctions, as threatened by the US government, would impact global prices. Russia would almost certainly respond to economic sanctions, providing another point of uncertainty impacting global markets. 

Paradoxically, the uncertainty of pre-crisis activities often stabilizes during the onset of the conflict itself. Take two seminal national security incidents that rocked the markets- the attack on Pearl Harbor and 9/11. The S&P 500 drawdown after the attacks on Pearl Harbor was over 19.8%. It took close to 300 days for the market to recover, but over the full course of WWII, the Dow Jones Industrial average actually increased over 50%. Similarly, on 9/11, the stock market suffered (the then) the greatest single-day point loss in its history. By the end of the next week, the Dow had dropped over 16 percentage points, the S&P 11.6%, and the overall loss was estimated to be over $1.6 trillion. This precipitous drop was actually preceded by the dot com bubble burst, meaning the market was already hurting when the attacks occurred. Similar to the aftermath of WWII, those losses were not sustained, and the market recovered to make new highs. Over the course of the next two wars in Iraq and Afghanistan, the market increased four-fold (despite the 2008 economic crisis and the global pandemic). This pattern holds for significant national security incidents over the last 75 years as outlined in the below table.