According to the history books one of the most scary events during the Cold War was the so-called Cuban missile crisis, where according to the history books the world was on the brink of nuclear armageddon.
However, the history books might be wrong – at least if you look at what happened to the US stock market during the crisis. If we indeed were on the brink of the third world war we would certainly have expected the US stock market to drop like a stone.
What really happened, however, was that S&P500 didn’t drop – it flatlined during the 13 days in October 1962 the stand-off between the US and the Soviet Union lasted. That to me is pretty remarkable given what could have happened.
There might be a number of reasons why we didn’t see a stock market collapse during the stand-off. Some have argued that the crisis was an example of what has been called Mutual Assured Destruction (MAD). Both the US and Soviet Union knew that there would be no winners in a nuclear conflict and therefore neither of them had an incentive to actually start a nuclear war. It might be that investors realised this and while the global media was reporting on the risk of the outbreak of the third World War they were not panicking (contrary to popular belief stock markets are a lot less prone to panic than policy makers).
Another possibility is of course that the markets knew better than the Kennedy administration about the geopolitical risks prior to the crisis. Hence, the stock market had already fallen more than 20% in the months prior to the Kennedy administration’s announcement that the Soviet Union was putting up nuclear missiles in Cuba.
And the market was of course right – there was not third World War and after 13 days of tense stand-off the crisis ended.
That said, the Cuban missile crisis did not go unnoticed by consumers and investors. However, we should think about such geopolitical shocks as primarily supply shocks. A geopolitical crisis increases “regime uncertainty” – in an AS/AD framework this shifts the AS curve to the left, which reduces real GDP growth and increases inflation for a give monetary policy stance. This was actually not very visible in 1962-63, but later in the 1960s it became very clear that regime uncertainty was reducing real GDP growth.
In terms of stock market valuation it is important that we remember that equity prices are nominal rather than real and therefore it is not necessarily given that stock prices should drop if the central bank keeps nominal spending/aggregate demand on track. Obviously stocks could drop if the risk premium on stocks increases, but we should not necessarily expect nominal earnings growth to drop.
Therefore, we need to think about the monetary policy response to a geopolitical crisis to understand how it is impacting the stock market performance. This of course is highly relevant for what is going on right now in regard to the Ukrainian-Russian conflict.
The horrors of Russian and Ukrainian central banking
The recent sharp rise in geopolitical tensions is a significant negative supply shock to both the Russian and the Ukrainian economy – visible in the sharp weakening of both countries’ currencies. However, unlike in the case of the US stock market in October 1962 the Russian and Ukrainian stock markets have sold off dramatically.
Given the amount of regime uncertainty it is not surprising that investors have become a lot less happy to hold Russian and Ukrainian stocks. However, central bankers in the two countries are not making life easier for anybody either. Hence, the Russian central bank (CBR) has reacted to the sharp sell-off in the Russian ruble by intervening heavily in the currency markets and thereby tightening monetary conditions and the CBR has also increased its key policy rate by 150bp to prop up the ruble and more rate hikes might be in the pipeline. And this week the Ukrainian central bank followed the (bad) example from the CBR and hiked its key policy by 300bp.
So what both of the central banks are doing now is to tighten monetary conditions in response to negative supply shock. Obvious page 1 in the central banker’s textbook tells you not to respond to supply shocks in this way. Unfortunately most central bankers never read the textbook and hence are happy to make things worse by “adding” a negative demand shock to the negative supply shock.
And this of course is going to be negative for stock markets. Monetary tightening causes nominal spending to drop and hence causes a contraction in nominal earnings growth and that of course is bad news for stocks.
Paradoxically we can also on the other hand imagine a situation where a geopolitical crisis can be good news for stocks (measured in local currency). Imagine that central bankers freak out about the possible negative growth consequences of a geopolitical shock and respond to this by easing monetary policy. Actual that might be what is happening in the euro zone at the moment (on a small scale). Or at least judging from comments from ECB-chief Mario Draghi the ECB thinks that the Ukrainian crisis potentially could have significant negative ramifications for European growth and it seems like the ECB has become somewhat more dovish after the Ukrainian crisis began. The Polish central bank has similarly become more dovish in its rhetoric since the outbreak of the crisis.
Central banks should not react to negative (or positive) supply shocks, but if they do ease monetary policy in response to a negative supply shock then it will increase nominal GDP growth (but not necessarily real GDP growth). That is positive for stocks (whether or not real GDP growth increases). I am not arguing that that is what is happening now, but I am using this as an example to illustrate that we should not necessarily assume that geopolitical shocks automatically will lead to lower stock prices. It all comes down to the monetary policy response.
The story of the 1960s: The stock market is a nominal phenomenon
Returning to the Cuban missile crisis it is helpful to have a look a the development in nominal GDP to understand what was going on in the US stock market during the Cuban missile crisis and in the aftermath.
In 1961 US NGDP growth had been accelerating significantly – with NGDP growth going from only 0.5% y/y in Q1 1961 to 9% y/y in Q1 of 1962. That reflects a rather massive monetary expansion. However, from early 1962 a monetary contraction took place and NGDP growth started to slow significantly. This I believe was the real reason for what at the time became to be known as the Kennedy Slide in the stock market. This was prior to the Cuban missile crisis.
However, as the geopolitical crisis hit the Federal Reserve moved to ease monetary policy – initially not dramatically but nonetheless the Fed moved in a more accommodative direction and NGDP growth started to accelerate towards the end of 1962 – a few months after the end of the Cuban missile crisis. I am certain this helped keep a floor under US stock prices in the later part of 1962.
In fact it is notable to what extent geopolitics came to determine monetary policy during the 1960s and we might of course equally argue that geopolitical concerns to some extent were a driving force behind president Kennedy and particularly president Johnson’s expansion of the welfare state measures in the US in the 1960s. The Federal Reserve during the 1960s actively supported the expansion of government spending by trying to intervene in the US bond market to keep bond yields down for example through the (in)famous operation twist. The Fed’s policies became increasingly inflationary during the 1960s.
During the early period of the 1960s the easing of monetary conditions primarily boosted real GDP growth (in line with the acceleration in NGDP growth), but as the negative impact of war spending and spending on social welfare schemes started to be felt US productivity growth started to slow significantly and as a result the continued expansion of nominal spending led to a significant increase in US inflation in the second half of the 1960s.
In regard to the US stock market it notable to what extent the development in the stock market follows in the development in nominal GDP. In fact from 1960 to 1970 US stock prices rose 80-90% – more or less in line with the development in NGDP. This is illustrated in the graph below:
This illustrates that higher geopolitical risks are not necessarily negative for stocks, but it might make central banks make stupid decisions. That is certainly the case of the Fed during the 1960s. Whether that is any guide for what will happen to global monetary policy today if we continue to see an escalation of geopolitical tensions is certainly not easy to say.