Sensex dip: In the short term, markets are always nervous during terror attacks or conflict

The Sensex crashed 500 points on Thursday during intra-day trade following the announcement of surgical strikes by the Indian Army on terror launch pads along the Line of Control. Interestingly enough, the KSE30 Index at the Karachi Stock Exchange also fell today and saw a steep correction last week, following the Uri attack on September 18.

Just like India-Pakistan tension is not new in politics, geopolitical risk is not new for the markets either.

To put things in perspective, global markets have survived two world wars, the Gulf War, the September 11, 2001 attacks in the US, and many other military conflicts around the world. No one likes a war, including markets. But they are part of reality and markets eventually learn to live with them.

Short-term impact

How do markets behave during war?

Each war is different and no one can predict the fallout. In a brilliant paper on financial markets and the approach of world wars, Niall Ferguson of Harvard University wrote:

“Investors try to learn from history, but the very different financial impacts of the two world wars and the Cold War reveal the tendency of military technology and regulatory regimes to shift significantly, reducing the relevance of past experience. Any lessons investors might take from the last war could have limited relevance for the next – or be forgotten after a generation of relative peace has led to complacency.”

Historical experience shows us just one thing: markets get jittery at an unexpected geopolitical event, and when investors get nervous, they sell. In the past, the Sensex dropped 3%-8% in the days following a major event.

1. In April-May 1998, following the nuclear tests the Sensex fell 8% (or 450 points) in a month, from 4007 on April 30 to 3,686 on May 29.
2. In May 1999, during the Kargil war, within two days of the air strikes by India, the Sensex fell 5% (or 180 points), from 4,060 on May 25 to 3,862 on May 27.
3. In December 2001, after the attack on the Indian Parliament, the Sensex fell 8% (or 280 points) in two weeks from 3,412 on December 12 to 3,132 on December 27.
4. In November 2008, during the terror attacks in Mumbai, the Sensex fell 3% (or 280 points) from 9,027 on November 26 to 8,747 on December 3.

Viewed in that historical context, the Sensex’s nervous sell-off reaction today makes sense. However, during the Kargil war, the Sensex actually rallied after the first nervous reaction following the air strikes. Thus, by the end of July that year, the Sensex had risen 1,200 points (a whopping 37%) to 4,542 on July 30, from its close of 3,326 on April 29.

But before you think wars are good for the Sensex, keep in mind that 1999 was also the global tech boom that eventually ended in the dot-com bubble bursting in 2000.

Long-term impact

Markets follow economic trends and react to political events by guessing their impact on the overall economy in general, and sectors and companies in specific. As long as the current standoff between India and Pakistan has no major impact on the Indian economy, markets should recover eventually, as they did during earlier conflicts.

India’s economy is chugging along at 7% growth, with both current account and fiscal deficit broadly in control. Low crude prices are keeping inflation low and while weak industrial production is a concern, the strength in consumer demand is a positive. The Indian government has passed the Goods and Services Tax Bill and the investment sentiment around India is generally positive.

However, a prolonged standoff with Pakistan, accompanied by a heavy cost of waging war could result in a strain on government finances. In the face of GST implementation, a new tax or cess to fund the war would be bad news. Worsening economic news would only lead to sell-offs across the currency, government bonds, and equity markets. This is the worst-case scenario and it is difficult to predict what Indian markets would look like in this scenario.

Remember that the US economy suffered many blows in 2000 and 2001: the collapse of the dot-com bubble, the attacks of 9/11, and corporate scandals such as Enron and Worldcom. All of these events contributed to a mild recession during 2001, which ended, coincidentally a few months after 9/11. By 2003, a new bull run was about to begin that lifted stocks, commodities across the world, including India, till the crash of 2008.

It is tempting to extrapolate past wars and predict the course of the Sensex in the next few weeks or months. But markets have a way of proving people wrong and charting a course of their own, as events shape out. Therefore, leave markets to figure their way out. They follow no one’s advice.