“Illustration shows the Russian Bear with a house of cards, each card labeled a different country, ‘England, France, Germany, Japan, U.S., Austria, China, Italy, [and] Turkey’, the king on each card bears some facial characteristics of the ruler of the country, including Uncle Sam; a dove of “Peace” has landed on top of the cards, alarming the bear.”(LoC)
Visualizing History
How the Dow Jones Industrial Average Reacted to Major Events in World War II
From the Archives
The Economist (September 2, 1939)
Curious about how markets have historically reacted to outbreaks of war? This Economist article was published the day after Nazi Germany invaded Poland, triggering the start of World War II. It is remarkable reading these passages with the hindsight of knowing how grand scale the conflict would prove to be. The market was largely positive for that week, despite Germany invading Poland!
“It may be argued that the Stock Exchange has been deceiving itself this week…”
“Even with imminent apprehension of war, American and British security prices are no lower, on average, than in April and February respectively this year…”
“The market, however, would be hard put to find positive reasons for this week’s price movements.”
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We have a lot to discuss. Before diving into today’s newsletter I just want to underscore that the human toll of Russia’s invasion is obviously paramount to anything comparatively trivial like investing. As this a financial history newsletter, however, today’s focus will be on the economic and financial ramifications of previous invasions and bouts of conflict.
Economic Warfare
There has always been a close relationship between conflict and finance. Since conflicts impact economies, warring countries often try to inflict economic damage on their opponents by restricting their access to funding and/or imposing sanctions.
Counterfeiting Campaigns
During the American Revolution, for example, the British government attacked America’s currency (“continentals”) by launching a counterfeiting campaign designed to induce widespread inflation by flooding the market with paper money. Benjamin Franklin complained:
“Paper money was in those times our universal currency. But, it being the instrument with which we combatted our enemies, they resolved to deprive us of its use by depreciating it; and the most effectual means they could contrive was to counterfeit it. The artists they employed performed so well, that immense quantities of these counterfeits, which issued from the British government in New York, were circulated among the inhabitants of all the States, before the fraud was detected.
This operated considerably in depreciating the whole mass, first, by the vast additional quantity, and next by the uncertainty in distinguishing the true from the false; and the depreciation was a loss to all and the ruin of many.”
Fast forwarding to World War II, the United States conducted a similar operation against Japanese forces in places like Burma and the Philippines, in which Japan began issuing new “occupation currencies” after taking over. Working with Australia and Canada, the allied forces started printing counterfeit notes of Japan’s “invasion money” to destabilize the economies. Estimates show that allied forces printed over 70,000 pieces of counterfeit bills as part of this operation.
Restricting Access to Capital Markets
This week has underscored just how damaging economic warfare can be. Regardless of whether you think America should send troops to Ukraine, the fact that there is even an argument about whether economic sanctions will be enough demonstrates the affect that sanctions can have. Again, the concept of restricting enemy’s access to financial markets and capital is nothing new. In fact, Russia endured this exact problem during the Bolshevik Revolution a century ago. The Bolshevik’s 1905 Financial Manifesto read:
“There is only one way out – to overthrow the government, to deprive it of its last forces. It is necessary to cut the government off from the last source of its existence: financial revenue. This is necessary not only for the country’s political and economic liberation, but also, more particularly, to restore order in government finances.”
Eventually, in 1917, the Bolshevik leaders intentionally defaulted on its debts after overthrowing the tsarist regime. Bloomberg’s Tracy Alloway discusses this fascinating case study in my latest financial history course. The parallels to today are obvious, with NATO countries agreeing to remove certain Russian banks from the global SWIFT network, and sanction specific Russian leaders. In turn, there are now reports that Russian companies have stated they will not pay out dividends to investors in countries that imposed sanctions on Russia. The economic aspect of this crisis is escalating quickly.
What War Means for Investors
Much of the content in today’s newsletter will focus on how investors and markets reacted to previous episodes of conflict and invasion. For example, the chart below shows how Poland’s stock / bond markets behaved in the days leading up to Hitler’s invasion on September 1, 1939.
Polish Stock and Bond Markets Leading Up to Nazi Invasion
“The figure displays performance of Polish stock and bond market during the period between February 1938 and August 1939. In addition the performance of Polish bonds held by local and foreign investors is shown. The dashed area corresponds to periods crucial for continuation of Polish stock and bond market. The areas are numerated as follows (on top):
British Guarantee to Poland
Abrogation of German Polish Non-Aggression Pact
Britain and France declared war on Germany after attack on Poland.
By and large, however, the evidence in today’s articles shows that markets often underappreciate the significance of war-related events, and overreact to ultimately unimportant news.
Go Deeper
Before we get into the articles, I just want to remind readers that the latest financial history course is very relevant for investors trying to understand how this conflict could affect markets. Through world class content taught by experts like Niall Ferguson, Tracy Alloway and others you will learn:
How Invasions Impact Financial Markets
The Geopolitics of Debt and Economic Warfare
Historical Case Studies: Revolutions in Russia & China
There is a 24 hour flash sale on the course so that investors can obtain much needed historical context. Just enter “CONTEXT40” at checkout. Here’s a teaser:
With each day bringing new updates out of Ukraine, investors are understandably struggling to interpret what this all means for their portfolios. This paper looks at how the Dow Jones Industrial Average reacted to significant events during World War II.
Summary:
“This paper investigates which events of World War II the US investors (at that time) considered as turning points (structural breaks) of the war. The empirical study employs daily Dow Jones industrial average stock index and volatility from January 1939 to December 1945 and applies structural shift oriented test to determine endogenously the structural breaks during the WWII period. Results show that the majority of the wartime events (on and off the battlefield) labelled important by historians did result in structural breaks in both price movement and stock returns volatility (risk).“
Visualizing History:
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“Firstly, WWII events did indeed affect US stock prices and returns volatility. This is true even though most of the events took place far away from the mainland United States. Secondly, the large majority of the significant results find that any news that may indicate the prolonging of the war induce a drop in prices and a rise in volatility the day after the event and for the next five working days.”
This paper provides important context on how markets previously reacted to military invasions and other war-related events. The authors study four country’s experience during World War II, including an assessment of Poland’s financial markets leading up to the Nazi’s invasion on September 1st, 1939.
Summary:
“This paper brings together two strands of the literature: Quantifying the impact of apocalyptic risk on capital markets, and the correct computation of the equity risk premium. For the former, we use events in four countries during the Second World War to discern markets’ incorporation of information regarding the probability of an Armageddon for each country.
We then turn to analyzing the impact of a political collapse on the correct computation of the equity risk premium. Arguing that past computations did not properly account for the financial implications of political collapse on property/civil/human rights, we argue past calculations overstated the equity risk premium. We provide a correct estimate of the equity risk premium, demonstrating the important changes in this estimate over time.”
Visualizing History:
Polish Stock and Bond Markets Leading Up to Nazi Invasion
“The figure displays performance of Polish stock and bond market during the period between February 1938 and August 1939. In addition the performance of Polish bonds held by local and foreign investors is shown. The dashed area corresponds to periods crucial for continuation of Polish stock and bond market. The areas are numerated as follows (on top):
British Guarantee to Poland
Abrogation of German Polish Non-Aggression Pact
Britain and France declared war on Germany after attack on Poland.
On bottom of the figure the key events for WW2 period are highlighted:
Annexation of Austria
Munich Accord and German demands on Poland.”
Notable Quote:
“With respect to the two countries which succumbed during World War II, Poland and France, it is fair to say their respective stock markets had no inkling as to the ex-post likelihood and implications of military defeats. Polish capital markets declined 23.2%, and the French market an almost identical 22.9%, from their Feb. 1938 levels.”
How well do financial markets anticipate the outbreak of war? There were many articles written in recent months about Russia potentially invading Ukraine, but it appears that investors did not take this possibility seriously until troops finally entered Ukraine this week. Has this always been the case? This article from Niall Ferguson compares how markets reacted to the outbreak of war in late 19th century Europe and leading up to WWI. In the case of World War I, Ferguson shows that investors were blindsided by the outbreak of war.
Summary:
“This article uses price data and editorial commentaries from the contemporary financial press to measure the impact of political events on investors’ expectations from the middle of the nineteenth century until the First World War. The main question addressed is why political events appeared to affect the world’s biggest financial market, the London bond market, much less between 1881 and 1914 than they had between 1843 and 1880. In particular, I ask why the outbreak of the First World War, an event traditionally seen as having been heralded by a series of international crises, was not apparently anticipated by investors. The article considers how far the declining sensitivity of the bond market to political events was due to the spread of the gold standard, increased international financial integration or changes in the fiscal policies of the great powers. I suggest that the increasing national separation of bond markets offers a better explanation. However, even this structural change cannot explain why the London market was so slow to appreciate the risk of war in 1914. To investors the First World War truly came as a bolt from the blue.”
Visualizing History:
Notable Quote:
“Like an earthquake on a densely populated fault line, its victims had long known that it was a possibility, and how dire its consequences would be; but its timing remained impossible to predict and therefore beyond the realm of normal risk assessment. If this view is correct, then much of the traditional historiography on the origins of the war has, quite simply, over-determined the event. Far from there having been a ‘long road to catastrophe’, there was but a short slipway.”
As if there weren’t enough concerns about inflation already, another major ramification of Russia’s invasion is higher commodity prices. Stretching all the way back to the American Revolution, this article looks at the history of inflation in the United States during times of war.
Summary:
“The institutional arrangements governing the creation of money in the United States have changed dramatically since the Revolution. Yet beneath the surface the story of wartime money creation has remained much the same. During wars against minor powers, the government was able to fund the war by borrowing and levying taxes. In major wars, however, there came a point when further increases in taxes could not be undertaken for administrative or political reasons, and further increases in borrowing could not be undertaken except at higher interest rates; rates that exceeded what was considered fair based on prewar norms. At those moments governments turned to the printing press. The result was substantial inflation.”
Visualizing History:
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“For a variety of reasons war governments were loath to see interest rates rise above prewar norms. For one thing, higher rates would be a signal to the public and to friends and foes abroad that the government’s decision to wage war was undermining the economy. Increasing taxes at least to a level that promised to be sufficient to pay interest and principal on war debt was an obvious necessity for keeping interest rates in check. But raising taxes was often difficult for administrative reasons (new taxes could not be levied and collected quickly), because higher taxes were ideologically objectionable to the war party, and because higher taxes would, at some point, undermine support for the war. Given those constraints turning to the printing press was an obvious choice even though it also came with a cost: inflation that also threatened to undermine support for the war provided the public worked out the connection between the inflation and the financial policy of the government.”
The crisis in Ukraine is a piercing reminder that military conflicts have significant economic ramifications for all countries involved. In the beginning of February, for example, the Ukrainian government had issues raising funds in the debt market due to investor’s concerns that Russia may invade (which proved to be warranted).
“A local government-bond auction failed on Tuesday to raise the targeted amount when investors balked at the interest rates being offered.
The government raised around 214 million hryvnia, equivalent to $7.5 million, mostly from the sale of six-month bills. None of the one- or 1.5-year bonds that were on offer sold. Investors bought some two-year debt and dollar bonds, but they raised less than $1 million, according to data from the Ministry of Finance.” (WSJ. February 3rd, 2022)
Using three case studies, this paper covers how country’s debt markets were impacted by regime changes post-WWI.
Summary:
“We consider the effect of the three largest regime changes following World War One on the foreign debt repayments of the succeeding regimes. The Bolsheviks repudiated the Tsarist debt, both external and internal in early 1918, and could not borrow internationally until the 1970s. The Austro-Hungarian successor states, with the exception of Romania, remained on good terms with lenders, and quickly gained access to foreign capital. However, the Ottoman successor states entered into protracted negotiations before accepting responsibility for a share of the debt, which meant they faced a lengthy delay before being able to re-enter the international capital market. We analyze these events using a game theoretical model of incomplete information, whereby capital markets can not directly observe a government’s ‘type’.”
Visualizing History:
Notable Quote:
“By 1914, the state debt of Russia had grown to approximately £930 million, or 50% of national income… On the 3rd of February 1918, all state loans, internal and foreign were annulled by the new Bolshevik government, a total amount of £3,385 million. The decree for the abolition of the National Debt contained 10 points, of which three directly pertain to their debt repudiation.”
Even after soldiers’ lay down their arms and conflicts end, what are the lasting impacts to financial markets? The authors of this paper analyze how different European stock markets reintegrated after World War I. The authors find that allied stock exchanges reintegrated quickly, while exchanges in Berlin remained more isolated.
Summary:
“The pre-1914 globalized world of free capital flows and integrated markets disintegrated during World War One. Monthly data on over 7300 individual securities from 12 stock exchanges over a period of 26 years quantifies the extent to which stock market disintegration occurred as a result of the war and the restrictive government legislation introduced. I use the international arbitrage pricing theory (IAPT) to measure integration. While Allied and Neutral countries’ stock exchanges reintegrated in the early 1920s after wartime capital controls were relaxed, the exchanges of Berlin and Vienna segmented from world capital markets after the war.”
Visualizing History:
Notable Quote:
“The ongoing arguments between Germany and the victorious powers over the issue of reparations meant that foreign investors in Germany and Austria, and German and Austrian investors in the rest of the world, faced a greater risk than did domestic investors. Until the issue of reparations was settled forfeiture of securities (very liquid assets that are virtually costless to seize) was a real concern to potential foreign stock market investors. The occurrence of hyperinflation in both Germany and Austria during the early 1920s may also have a substantial role to play in explaining the fall in integration.”
This paper addresses the question of international recognition and finances after the rise of a new regime. Following the creation of the Vichy state during World War II, foreign investors had to determine whether the Vichy state was legitimate and would retain long-term sovereignty, or the original bonds issued by the French Republic were more creditworthy. Data on bond prices for bonds issued by the French Republic pre-WWII and those issued by Vichy France offer interesting insights on how investors perceived the legitimacy of Vichy France.
Summary:
“During World War II, the spread between the 3 percent rentes and the Vichy government bonds reflected French investors’ perception of the shifting fortunes of war and the willingness of future post-war government to repay the debt issued by the collaborationist regime. Structural breaks in this spread do not always match with the dates of major military events but are more closely related to the political ones, emphasizing the struggle for legitimacy by rival claimants to power.”
Visualizing History:
Notable Quote:
“By the summer of 1944 trading had encountered many problems.16 Paris could not easily communicate with the rest of the country, and orders from the provincial bourses were hard to obtain. Paris stock prices took about one day to reach Lyon, and two to four days to arrive in Bordeaux. Furthermore, many sell orders were refused because intermediaries feared that certificates would be destroyed or greatly delayed in transport. Rumors about the creation of an Anglo-American occupation currency brought back inflation fears. The quick rise of buy orders, linked with the diminution of sell orders, lead to a very limited market, with frequent intervention by the Chambre syndicale.”
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Why This is Relevant:
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