Anyone who follows the global financial markets will be well aware of how things like elections and wars can impact indices. Major stock market indices like S&P 500, Dow Jones Industrial Average, and Nasdaq Composite are barometers of the overall health and performance of the stock market. When times are good, the market indices are strong, but when there is turmoil in the world, the markets react accordingly.
Major geopolitical events around the world can have a significant impact on these stock market indices as they affect investor sentiment and the global economic outlook.
Some of the key ways geopolitical events influence the indices market are:
Elections
National elections, especially in major economies, create uncertainty in the markets in the run-up period as investors try to gauge the economic policies and orientation of the incoming government. Equity markets tend to favor status quo or continuity in economic policies. So, if an election result indicates a big departure from existing policies, it often leads to increased market volatility and indices declines.
For example, the unexpected 2016 election of Donald Trump led to a knee-jerk reaction and sell-off in the US indices as investors were unsure of his unconventional economic policies.
Trade Policy
Trade negotiations and tariff impositions between major trading partners create a lot of ambiguity in global trade flows and supply chains. Protectionist trade policies are viewed unfavorably by the market as they increase the costs of international trade and dampen economic growth. Trump’s trade war with China led to heightened volatility and fluctuations in US indices over 2018-19 as tough tariffs were imposed by both sides. The recent thawing of US-China trade tensions has conversely lifted equity markets.
Geopolitical Conflicts
Outbreak of conflicts, terrorism, and deterioration of ties between nations negatively impact indices as they destabilize the geopolitical environment. Stocks exposed to the affected region directly decline. Also, global supply chains, economic growth, and risk appetite are affected. The 9/11 terrorist attacks and the subsequent war on terror led to US indices falling over 10% within a week in 2001. The recent Russian invasion of Ukraine has also led to heightened volatility and corrections in indices worldwide.
Monetary Policy
Changes in interest rates and liquidity by central banks in response to economic conditions impact indices as higher rates make stocks relatively less attractive vis-a-vis fixed income. Tighter monetary policy is seen as negative for equity valuations. For instance, the US Fed’s communications on faster tapering of bond purchases and earlier rate hikes recently led to corrections in the US indices.
Energy Prices
Major changes in global crude oil prices due to demand-supply dynamics or geopolitical events in oil-producing centers impact stock markets significantly. Rising oil prices are seen as negatives for industries and the economy overall, and the indices fell sharply during the 1990 oil price spike due to Iraq’s invasion of Kuwait and the 2011 spike during the Arab Spring Revolution.
Economic Growth Outlook
Stock indices track the growth prospects and health of the underlying economy. So, geopolitical developments that impact the economic outlook like the onset of recessions, financial crises, bankruptcies of large firms, etc. get reflected in the market indices as they re-adjust to the changing fundamentals. It’s worth understanding how these developments impact the financial markets, as it will help you choose the best indices to trade.
Terrorist Attacks
Acts of terrorism create fear and uncertainty in the markets. Direct attacks on economic centers can temporarily close financial markets, as was seen after 9/11. Terrorism disrupts tourism and trade and dampens consumer and business confidence. Indices generally fall sharply after major attacks before stabilizing.
Financial Crises
Major financial/banking crises triggered by geopolitics lead to tightening of credit, losses and bankruptcies for firms, and recessions. This results in sharp equity market declines as seen during the Gulf War that triggered the 1990 recession, the Asian financial crisis of 1997, and the global financial crisis of 2008.
Cyber Warfare
Increasing geopolitical tensions also raise risks of cyber attacks and security issues for corporates, impacting their operations and earnings outlook. Equity markets price these risks and can witness volatility if major attacks or security breaches happen, impacting sentiment.
Defense Spending
Heightened global tensions and terror risks prompt nations to expand defense spending which shifts government budgets and priorities. Stock markets tend to react negatively to escalation in defense spending as it means diversion from social sectors and higher fiscal deficits, and fuels global instability.
Sanctions
Economic, trade and financial sanctions imposed on nations as geopolitical policy tools also disrupt global commerce and business environment. Sanctions drive down currency values, increase inflation, and constrain the earnings of sanctioned countries’ firms. Indices incorporating such countries decline due to sanctions.
Government Policies
In times of conflicts and tensions between rival nations, domestic policies also tend to get aligned by governments to restrict trade and finance flows to hostile nations. Equity markets witness volatility as a realignment happens away from geopolitical adversaries even if certain sectors stand to lose in the process.
Equity indices are forward-looking barometers of the economy’s health and corporate earnings growth. Major global geopolitical events can significantly influence investor psychology and change the course of the economy and business environment. So, indices tend to show enhanced volatility and directional movements during such periods of uncertainty or changing status quo. Investors need to keenly watch geopolitical developments and global economic policies as they can override company fundamentals in driving indices over the short to medium term.