Cannons and Tickers - Part II

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Understanding that markets have historically been resilient to war is only the first step. To build a robust analytical framework, one must move beyond historical correlation to dissect the specific causal mechanisms at play. War does not impact stock prices in a vacuum; it triggers a complex chain of psychological, economic, and political reactions that ripple through the financial system. This section deconstructs that chain, examining the roles of investor psychology, economic mobilization, and sector-specific disruption.

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The Psychology of Fear and the "War Puzzle"

The immediate market reaction to the outbreak of war is almost always driven by human emotion, not cold calculation. The primary driver is a surge in uncertainty, a condition that market participants fundamentally abhor. This psychological response manifests in predictable patterns of behavior, yet it also gives rise to a counterintuitive phenomenon that helps explain the market's surprising resilience.

Uncertainty, Volatility, and the Flight to Safety

War shatters the predictable future upon which investment theses are built. It introduces a massive level of uncertainty regarding its potential scope, duration, cost, and ultimate economic consequences. This uncertainty is poison to markets. It causes risk premiums to soar, leading investors to demand greater compensation for holding risky assets like stocks.

This is visibly reflected in market volatility gauges. The Cboe Volatility Index (VIX), often called the market's "fear gauge," tends to jump on news of conflict, signaling that traders are bracing for wider daily price swings. In response to this heightened uncertainty, a classic "flight to safety" or "risk-off" rotation occurs. Investors sell equities and pile into assets perceived as safe havens. These typically include physical gold, the government bonds of stable nations (like U.S. Treasuries), and currencies seen as stores of value, such as the U.S. dollar and the Swiss franc.¹ This initial, fear-driven sell-off is the most consistent and predictable market reaction to the outbreak of hostilities.

The "War Puzzle" Framework

While the initial reaction is one of fear, the market's behavior becomes more complex as a conflict unfolds. Groundbreaking research from the Swiss Finance Institute in 2015 identified a key paradox they termed "the war puzzle". Their study of U.S. military conflicts after World War II found a distinct pattern:

• In cases where there is a pre-war buildup phase, a rising likelihood of war tends to decrease stock prices as markets discount the growing risk. However, the actual outbreak of war often causes stock prices to increase.

• Conversely, in cases where a war begins as a surprise, with no significant buildup, the outbreak of war causes stock prices to decrease.

The 2003 invasion of Iraq is a perfect example of the first case, where markets sold off in the months of diplomatic wrangling and then rallied strongly once the invasion began. The attacks of 9/11 are a perfect example of the second case, where a complete surprise triggered an immediate and sharp market drop.

The most compelling explanation for this puzzle lies in the market's preference for certainty—even a grim certainty—over ambiguity. During the pre-war buildup, the market is forced to price in a wide range of potential outcomes, many of them catastrophic. Once war is declared, the ambiguity is resolved. The conflict becomes a known quantity. Investors can then recalibrate their expectations based on the actual scope and nature of the conflict, which is often less destructive than the worst-case scenarios they had imagined. The market can now price them known war rather than the unknown threat of war.

Quantifying Geopolitical Risk

This psychological dynamic can be systematically measured. Economists Dario Caldara and Matteo Iacoviello developed the Geopolitical Risk (GPR) Index, a novel tool that quantifies risk by tracking the frequency of words related to war and geopolitical tensions in the archives of major international newspapers.² The index spikes around major conflicts like the Gulf War, the 9/11 attacks, and the 2003 Iraq invasion.

Crucially, the GPR index captures a dimension of risk distinct from other common gauges. Analysis shows it is largely independent of the VIX. The VIX tends to spike during purely financial crises (like the 2008 collapse of Lehman Brothers) when the GPR index might remain stable. Conversely, the GPR index spikes during geopolitical events (like terrorist attacks or war threats) that may not immediately rattle financial volatility. This demonstrates that geopolitical risk is a unique factor that requires its own analytical lens.

The GPR index can be further decomposed into two sub-indices that align perfectly with the "war puzzle" framework: a Geopolitical Threats (GPRT) index and a Geopolitical Acts (GPRA) index. The GPRT captures the pre-war buildup of tension, while the GPRA spikes when conflict actually begins. Academic studies confirm that high levels of geopolitical risk, as measured by the GPR index, are associated with lower equity returns, lower investment, and higher market volatility.

Sources:. Note: Index values are approximate peaks around the time of the event and are for illustrative purposes to show the differential responses of risk gauges. VIX reflects market volatility, GPR reflects geopolitical threats, and EPU reflects uncertainty about government economic policy.

This table illustrates that different crises manifest in different risk gauges. The Global Financial Crisis was a VIX and EPU event, not a GPR event. Conversely, the geopolitical shocks of 9/11, Iraq, and Ukraine registered strongly on the GPR index, demonstrating its unique value in capturing this specific type of risk.

The market's behavior during wartime is not just a simple reaction to fear; it is a dynamic process of discounting future probabilities. The collective judgment of millions of investors often anticipates crucial turning points with a "wisdom of crowds" effect that can be more accurate than contemporaneous expert opinion. The market's bottom before the Battle of Midway and the German market's peak before the tide turned against Hitler are powerful examples. This suggests that for a discerning analyst, the market's own price action can be a valuable signal. A market that stubbornly refuses to sell off in the face of escalating headlines may be collectively signaling its belief that the conflict will not escalate into a systemic, economy-damaging event.

The Economics of Mobilization and Disruption

Beyond the initial psychological shock, war's lasting impact on markets is determined by its fundamental alteration of the real economy. The immense resources required to wage war, coupled with the profound disruption it causes, trigger powerful economic forces. The ultimate direction of the stock market hinges on the net effect of three primary channels: the inflationary pressures and subsequent monetary policy response, the scale and nature of fiscal stimulus from government spending, and the disruption to critical commodity markets and global supply chains.

Inflation and Monetary Policy: The Ultimate Arbiter

A near-universal consequence of major conflict is inflation. This is driven by a potent combination of factors: a surge in government demand for goods and services, production bottlenecks, and supply chain disruptions that create shortages. A study by the CFA Institute covering major wars since 1926 found that the average inflation rate during wartime was 4.4%, significantly higher than the 3% average for the entire period.

Persistently high inflation is generally toxic for stock market valuations. It erodes the real value of future corporate earnings and dividends, and it can squeeze corporate profit margins through higher input costs. Historically, the worst real returns for equities have occurred during periods of high inflation.

The most critical variable, therefore, becomes the central bank's response. If a war's inflationary impact is severe enough to force the Federal Reserve into an aggressive cycle of interest rate hikes, it creates a powerful headwind for stocks by increasing the cost of capital and slowing economic growth. This was a key factor in the difficult market environments during the Vietnam War and the initial phase of the Russia-Ukraine conflict.⁵ Conversely, if a conflict occurs during a deflationary period and the resulting fiscal stimulus is seen as a welcome boost to demand without triggering immediate inflation fears, the monetary policy environment can remain accommodative, which is bullish for stocks.

Fiscal Stimulus and Government Spending: The Keynesian Boost

War is an expensive enterprise, invariably leading to a massive expansion of government spending. In the United States, spending on the post-9/11 wars was estimated to have reached $8 trillion by fiscal year 2022, a sizable portion of GDP. This firehose of government expenditure can act as a powerful Keynesian stimulus, boosting aggregate demand, GDP growth, and the revenues of companies that are direct or indirect beneficiaries of government contracts.

Intriguingly, research has shown that periods of rising U.S. defense spending are correlated with lower, not higher, aggregate stock market volatility. The logic is that large, multi-year government contracts make the future revenue and earnings streams of a wide swath of companies—from prime defense contractors down to their smallest suppliers—more stable and predictable. This reduces uncertainty about future profitability and thus dampens the volatility of their stock prices. Analysts' earnings forecasts for defense-related firms tend to become more uniform and less dispersed during conflicts, reflecting this increased predictability.

Commodity and Supply Chain Shocks: The Global Contagion

For most modern, regional conflicts, the most direct and potent channel for global contagion is through commodity markets and supply chains. A conflict's location is often more important than its scale. Conflicts centered in or affecting major energy-producing regions, such as the Middle East or Russia, will inevitably have an outsized impact on global oil and natural gas prices.

History is replete with examples. The 1973 Yom Kippur War led directly to the Arab Oil Embargo, a quintessential supply-side shock that quadrupled oil prices, caused a deep global recession, and contributed to a staggering 40.9% drop in the S&P 500 over the following year. The 1990 Gulf War was preceded by a sharp oil price spike that helped trigger a U.S. recession. More recently, the 2022 Russia-Ukraine war caused a surge not only in energy prices but also in the prices of food commodities like wheat and corn, and industrial materials like palladium, creating broad and persistent inflationary pressures worldwide. The threat of disruption to critical shipping chokepoints, such as the Strait of Hormuz, through which over 20% of the world's maritime oil trade passes, remains a potent source of risk that could send energy prices soaring in any regional escalation.

A sophisticated analysis of a war's market impact requires weighing the inherent tension between these economic forces. The bullish impulse of fiscal stimulus (defense spending) works in direct opposition to the bearish impulse of war-driven inflation and supply shocks. The ultimate market direction depends on which force proves stronger, a dynamic that is almost entirely dependent on the economy's starting conditions.

Consider two scenarios. First, an economy in a deep depression, like the U.S. in 1939, with massive unemployment and idle industrial capacity. In this context, the fiscal stimulus of war spending is incredibly powerful and not immediately inflationary. The bullish impulse from government spending and re-employment dominates the negative effects, leading to a strong market rally. Second, consider an economy already at full employment and grappling with high inflation, like the U.S. in 2022. Here, additional fiscal stimulus is less impactful and more likely to be inflationary. The negative supply shock from the conflict becomes the dominant force, pushing inflation even higher and compelling the central bank to slam on the monetary brakes. The bearish impulse dominates. This framework explains the divergent market outcomes of WWII and the Ukraine War and provides a more nuanced tool for analysis than simply concluding that "war is good" or "war is bad" for stocks.

Sector Performance - Winners, Losers, and Surprises

The aggregate performance of the stock market during a war masks significant divergence at the sector and industry level. Conflict fundamentally reorients economic priorities, creating a clear set of winners and losers. While some of these outcomes are predictable, a deeper historical analysis reveals surprising results that challenge simplistic assumptions and highlight the complex interplay of economic forces during wartime.

The Predictable Winners and Losers

Certain sectors have a clear and direct relationship with military conflict, making their performance relatively easy to anticipate.

• The Winners - "War Babies": The most obvious beneficiaries are companies in the Defense and Aerospace sectors. Increased government budgets for military hardware, technology, and services flow directly to their top and bottom lines. Stocks of defense contractors who build munitions, aircraft, tanks, and ships—sometimes referred to as "war babies"—are consistent outperformers during periods of conflict. Similarly, the Energy sector often benefits when conflicts disrupt supply or occur in major oil and gas producing regions, leading to higher commodity prices and wider profit margins for producers. Increased demand for industrial production and the strategic stockpiling of resources can also boost companies in the Materials and Commodities sectors.

• The Losers: On the other side of the ledger, the Airlines and Travel industries are typically hit with a double blow: higher jet fuel prices squeeze their already thin margins, while the uncertainty and potential danger of conflict can depress demand for travel. The Consumer Discretionary sector also tends to suffer, as the combination of war-related inflation and general economic uncertainty squeezes household budgets, leading consumers to cut back on non-essential goods and services.

The Surprises of World War II: A Cautionary Tale

A more granular analysis of sector performance during World War II, however, yields highly counterintuitive results that serve as a crucial cautionary tale for investors. Research analyzing the performance of 49 U.S. industries between 1941 and 1945 found that the sectors one might expect to be the biggest winners were not.³

While defense-related industries certainly saw a massive increase in production, their stock performance was often mediocre. The Steel, Chemical, and Aircraft industries, for example, did not number among the top performers. Instead, the best-performing sector during the war was

Printing & Publishing. It was followed by Alcoholic Drinks and Personal Services. At the other end of the spectrum, the worst-performing industry was Tobacco, another surprising result.

What explains this paradox? The answer lies in the unique economics of a total war effort. The U.S. government became the primary, and often sole, customer for the output of heavy industry. To prevent "war profiteering," the government implemented price controls, excess profits taxes, and structured procurement contracts in ways that capped the profitability of these firms. While their revenues soared, their margins did not necessarily follow suit. Their production was dictated by the needs of the state, not the dynamics of the free market.

Meanwhile, companies outside the direct war machine, such as beverage makers and publishers, may have faced fewer regulations. They were able to sell their products to a fully employed civilian population that had steady income from war-related jobs but a limited supply of durable goods (like cars and appliances, whose production was halted) to spend it on. This left more disposable income for small luxuries and entertainment, driving the profits and stock prices of these consumer-facing industries higher.

This historical example provides a profound lesson: it is not enough to simply identify which goods and services a war will require. An investor must also analyze how the government will procure those goods and what the resulting profit landscape will look like. The "obvious" thematic play can often be a trap if the political and regulatory environment is not fully understood.

Sources: Note: WWII data reflects total returns for specific industries from the Kenneth R. French Data Library. Performance for later conflicts is characteristic, as specific index return data is highly variable. The table illustrates the shifting nature of sector leadership and the counterintuitive results seen during WWII.

Investing in the Arsenal: A Strategic Consideration

Given the direct link between conflict and military procurement, a common question is whether investing in defense stocks is a worthwhile strategy during wartime. The intuitive answer is yes, and historical data often supports this view, but the reality is more complex, fraught with unique risks and ethical considerations.

The Bull Case: Predictable Spending and Performance

The primary driver for defense sector outperformance during conflicts is straightforward: wars lead to massive increases in government spending on military hardware, technology, and services. This surge in demand translates into large, stable, multi-year government contracts that make future revenues and earnings for defense firms more predictable. This increased predictability can, counterintuitively, lead to lower stock volatility for the defense sector compared to the broader market during periods of conflict.

This pattern has played out in recent conflicts:

• Post-9/11 Wars: During the war in Afghanistan, an equally-weighted investment in the top five U.S. defense contractors (Boeing, Raytheon, Lockheed Martin, Northrop Grumman, and General Dynamics) would have outperformed the S&P 500 by 58%.

• Iraq War (2003): In the four years following the 2003 invasion, the S&P Aerospace and Defense index nearly tripled, significantly outpacing the gains of the broader S&P 500 as defense spending soared.

• Russia-Ukraine War (2022): In 2022, while the S&P 500 fell nearly 20%, the Invesco Aerospace and Defense ETF (PPA) gained 8.6%, with some individual defense stocks seeing double-digit increases. European defense stocks have seen even more dramatic surges as nations rush to meet new NATO spending targets.

The Bear Case: Peace Dividends, Politics, and Principles

Despite the strong performance during conflicts, investing in the defense sector is not without significant risks:

1. The "Peace Dividend" Risk: The flip side of a wartime spending boom is a post-conflict "peace dividend," where governments cut defense budgets and reallocate funds to domestic priorities. This can lead to a sharp downturn for the sector. After the Cold War, for instance, defense spending was cut significantly, leading to a protracted down cycle for the industry. While the end of a conflict can bring a broad market rally, it can signal the end of peak earnings for defense firms.

2. Political and Regulatory Risk: As seen in WWII, governments can impose price controls or excess profits taxes to prevent "war profiteering," which can cap the upside for defense contractors even as revenues soar. Furthermore, the industry is highly dependent on the political process, and contracts can be subject to cancellation or changes in administration priorities.

3. Ethical and ESG Headwinds: A major modern risk is the rise of Environmental, Social, and Governance (ESG) investing. Many sustainable and ethical funds explicitly exclude companies involved in manufacturing weapons, particularly controversial ones like cluster munitions or nuclear arms. This can shrink the potential investor base and limit access to capital. While the war in Ukraine has prompted some European institutions to reconsider these blanket exclusions, the ESG framework remains a significant headwind and a source of reputational risk for the industry.

In conclusion, while defense stocks have historically been a profitable tactical play during periods of rising geopolitical tension and active conflict, they are not a simple "buy and hold" investment. The sector's fortunes are tied directly to the cycles of war and peace, subject to intense political and regulatory oversight, and face growing scrutiny from ethically-minded investors. A successful strategy requires not only an assessment of the conflict itself but also a deep understanding of the political, regulatory, and ethical landscape that will shape the industry's profitability long after the fighting stops.

1  How War Affects the Modern Stock Market - Investopedia, https://www.investopedia.com/solving-the-war-puzzle-4780889

2  Geopolitical Risk (GPR) Index - Matteo Iacoviello, https://www.matteoiacoviello.com/gpr.htm

3  Sector and Factor Performance in Wartime | CFA Institute Enterprising Investor, https://blogs.cfainstitute.org/investor/2022/11/01/sector-and-factor-performance-in-wartime/