How Geopolitical Events Impact the Stock Market: Key Lessons from Recent Global Crises
Geopolitical events, such as wars, trade disputes, and political instability significantly impact the stock market by creating uncertainty and driving market volatility
Geopolitical events these days are probably exhausting to track, especially if you are a stock market participant with good investments. The reason we are mentioning this is that many events have taken place in a short time from the ongoing Russia-Ukraine war to the Israel-Hamas conflict, and now tensions between Israel and Iran.
On top of this, India's neighbouring countries are facing ongoing crises, such as the Bangladesh crisis, Sri Lankan instability, and the Pakistan issue, while the potential tension between China and Taiwan continues, even though it has not yet escalated and could start at any time. Additionally, North Korea and South Korea also have ongoing issues, which further heighten geopolitical tensions. These conflicts not only impact the countries directly involved but also affect neighbouring nations and countries engaged in trade with them.
How Geopolitical Events Affect the Stock Market
Think of a country as a shop where we buy goods from various stores, and those stores source their products from different vendors. Similarly, countries engage in trade, buying goods from different nations. For example, we import crude oil from Russia and Iran, and, in turn, we export various goods to other countries, even those currently involved in geopolitical tensions or wars.
When a country is engaged in war a major geopolitical issue these days, it not only loses resources but also faces a disrupted economy and halted daily operations, which can severely impact its ability to trade. Additionally, it brings about inflation, supply disruptions, and economic instability. Countries engaged in conflict may face defaults on payments, delays in production and so on. As a result, geopolitical instability affects not just the countries but also creates ripple effects across the global economy, influencing trade flows, supply chains, and market conditions worldwide.
Geopolitical events, such as wars, trade disputes, and political instability significantly impact the stock market by creating uncertainty and driving market volatility. When geopolitical crises occur, investors often move capital to safer assets, like government bonds or gold, causing stock prices to fall. These events can disrupt global supply chains, increase commodity prices, and inflation, further affecting the profitability of companies. Additionally, currency fluctuations and changes in central bank policies, in response to geopolitical tensions, can either stabilize or destabilize the market, influencing investor sentiment and eventually stock market.
Investors must learn from the recent crises, and here are the 6 lessons every investor should learn:
Volatility Eases Over Time: Geopolitical risk creates uncertainty, and economic activity as well as financial markets are more affected by geopolitical threats than by actual events (such as the start of wars or the imposition of any sanctions). Threats tend to increase uncertainty and downside risks, while actual events tend to resolve uncertainty and lead to actions that protect the economy.
In India, we use the India VIX, which is the volatility index, to measure the volatility in the Indian stock market. Generally, during geopolitical tensions, the VIX rises, as seen in historical instances. Before the event Russia-Ukraine war it began to rise and reach a peak, and eventually, over time, as the event is digested and becomes familiar to every investor, it gets absorbed and gradually starts cooling off, as shown in the image below.
The lesson from this point is that any geopolitical issue, whether ongoing or about to happen, will not last long and will have a limited impact. Once the events become widely known, the market starts reacting based on the country's economic performance and companies' financial results.
The market has a Tendency to Go Up: The market is born to go up. Historically, many events have occurred, such as the COVID-19 pandemic and the ongoing wars, which not only increased volatility in the stock market but also downgraded the economies of various countries. One thing is common everywhere: despite these critical challenges, the market recovered after some time and created new peaks. As we discussed, the Russia-Ukraine war began in February 2022. MOEX Index of Russia fell 20 per cent in a single day. Eventually from that day, it recovered within a year and surpassed the high recorded on the day Russia invaded Ukraine. After this, it has shown a rally of around 138%, and currently, it is trading with an actual gain of around 96%.
Not only this, the Indian market was impacted by these, the S&P BSE Sensex also experienced its biggest single-day crash in the last two years, closing with a fall of around 4.75%. However, it is currently trading much higher from that level.
The lesson investors should learn from this point is that the market has a tendency to go up. Short-term volatility, ups, and downs will always be there, but one should stick to their long-term goals and should not panic in the situation.
Act Wisely, Not Emotionally: It is very important for investors to consider how they behave and act when these situations arise. Panic buying and exiting positions can lead to significant losses. For example, when the COVID-19 pandemic emerged and the market hit a bottom, as the event was digested and the market began to recover, if you had decided to completely exit the market by selling your mutual funds, equities, and everything else, you would have lost not only your capital but also the potential returns your portfolio could have generated if you had remained invested.
Remember the second point of this explanation: "The market has a tendency to go up." While it may take some time, it will eventually rise. So, emotionally driven decisions can not only lead to forgoing your hard-earned money but also the potential returns on it.
Diversification is Important; As we know, we don’t have control over geopolitical issues, and their occurrence is uncertain they can arise at any time, even when you’re lying in bed dreaming about multibagger returns on your investments. Diversification helps reduce risk by spreading your investments across different asset classes.
Overburdening one asset class with a higher proportion of capital can lead to regret when these situations arise. While markets may recover and settle after some time, what if you had chosen the wrong company and invested heavily in it? In that case, the whole concept of "the market has a tendency to go up" would be disrupted, causing potential problems with your portfolio.
Specific Sector in Focus: Remember the COVID-19 pandemic, when there was no vaccine available. During those times, not only individuals were praying to find a vaccine to protect themselves from the virus, but governments were also urging pharmaceutical companies to develop a cure for the deadly virus. Pharmaceutical companies were working tirelessly to invent a vaccine for COVID-19. During this period, the pharma sector became the focal point, and it became a golden opportunity for investors. Look at the image below, it shows that the recovery in percentage was higher in a week when the market started recovering compared to the Nifty50 Index.
Not only did it surpass Nifty's recovery in the week when the market hit its bottom and started recovering, but it also outperformed other sectors by recovering more in that week, as displayed in the image below.
Furthermore, due to the ongoing wars in different regions around the world, countries have been focusing on defence spending to protect themselves from potential threats in the future. This shift made the defence sector another area of focus, and investors found it to be a sweet spot for investment.
The lesson investors should learn here is to identify the right sectors that have the potential for growth and opportunities, which can deliver good returns on their investments.
Adding Gold to Your Portfolio: Adding gold to your portfolio is a smart choice. As a safe haven asset, gold tends to perform well during times of market volatility and economic uncertainty. For example, during the COVID-19 pandemic, while the Nifty (red line) was falling, the Gold (black line) was rising, as shown in the chart below. While the stock market can be volatile, especially during times of crisis, gold tends to perform well when equity markets are under pressure. By adding gold to your portfolio, you can potentially offset losses in other areas and protect your investments from extreme market downturns.
Conclusion
Understanding the relationship between geopolitical events and the stock market is essential for every investor. These events can lead to sector-specific impacts, shifts in global investment flows, and changes in investor behaviour. While short-term volatility is common, markets often recover over time as clarity emerges. Diversifying investments, staying informed, and considering including safe-haven assets in a portfolio are key strategies for navigating the risks associated with geopolitical uncertainties. Ultimately, understanding these dynamics helps investors make more informed decisions and better manage their portfolios during times of crisis.
Disclaimer: The article is for informational purposes only and not investment advice.