The Historical Impact of Crises on Financial Markets

With the terrorist attacks on the World Trade Center in New York and elsewhere in the United States took place on September 11, 2001, there were immediate concerns about their impact on world financial markets. Although this event is without precedent, by looking at military and political crises of the past, we can hopefully learn what to expect from this horrible event.

The general pattern we have found is that there is initially a flight to safety in financial markets, producing a decline in stock markets and volatility in commodity markets. The impact of the crisis itself is short-term. After a brief period of time, calm returns and markets return to their situation before the crisis. Although financial markets react quickly to all news, they can also process the information and quickly incorporate the news into the market to reflect the long-term impact of these crises on the markets. Financial markets are only impacted if the crisis creates a long-term change in the fundamental nature of the economy.

Let’s see how markets reacted in the past.

The assassination of Archduke Francis Ferdinand on June 28, 1914 precipitated a series of events that led to Austria-Hungary declaring war on Serbia on July 28 and war throughout Europe within a week. All the world’s financial markets were closed by August 1, 1914. In New York, there was large selling on the New York Stock Exchange in the last days of July 1914 to raise money and return it to Europe. The selling led to the closure of the exchange. The New York Stock Exchange remained closed until it was reopened on December 12, 1914. London’s stock market remained closed until January 1915, and allowed only limited trading during 1915. The Paris Stock exchange reopened in 1915 and the Berlin Stock Exchange reopened in 1917.

Although the New York Stock Exchange itself did not reopen until December, curb trading in New York began in September. The prices of stocks actually hit their lowest point in October of 1914, and by the time the market reopened in December, stocks had returned to the level they had been at before World War I began. The market continued to rise until November 1916. World War I provided an important lesson for financial markets. Closing them does not solve any problems. It is best to let markets digest the information and allow financial prices to reflect the change in circumstances.

Currency market were initially disrupted by the war, with the British Pound rising 20% against the US Dollar as people tried to repatriate money to England, but within a week of the beginning of the war, currency exchange rates returned to their pre-war levels. Bond markets were generally unaffected by the war. Interest rates only began to rise once inflation began to build up later in the war.

This pattern, as we will see, was consistently followed in other crises. Initially, there is a flight to safety, leading to declines in the market and increases in the value of commodities. Once the long-term impact of the crisis is understood, markets return to their conditions before the crisis. Thereafter, markets move up or down as investors perceive that the crisis will be resolved.

There were several phases to how markets reacted to World War II. There were a series of crises during World War II: the attack of Germany on Poland in September 1939, the attack on France and the collapse of France in May 1940, and the attack on Pearl Harbor on December 7, 1941.

Surprisingly, the New York Stock Market rose when Germany attacked Poland on September 1, 1939, primarily because investors thought the United States would benefit from the demand for goods generated by the war. The market barely moved until the collapse of France in May 1940. The collapse of France and Dunkirk precipitated a 25% decline in the market in May 1940 in a massive sell-off. But again, the market jumped back quickly. The market first bottomed on May 22 and hit its final bottom on June 11, 1940. As the news got worse in the war, markets gradually declined throughout 1941, and when Pearl Harbor was attacked, the market declined around 10% in the next two weeks. The market bottomed in April 1942, and moved up after that for the rest of the war as the war moved in the favor of the Allies.

Unlike World War I, the New York Stock Exchange did not close during World War II. The London Stock Exchange was closed for only one week in September when Germany attacked Poland. The New York Stock Exchange remained open throughout the war. In fact, the NYSE was open on Monday, December 8, the day after the attack on Pearl Harbor. The Stock Exchanges found that people will find a way to trade stocks and other financial assets outside of the exchanges if people cannot trade stocks on open markets. Moreover, the quicker markets are allowed to process news, the quicker markets can adjust to the economic and financial changes that have occurred.

During the Gulf War, the market followed the pattern shown in World War I and World War II. Stock markets sold off and oil prices rose when Saddam Hussein invaded Kuwait. Oil prices were at $17 a barrel at the end of June 1990, and peaked at $40 on October 9, 1990. The price then proceeded to decline to $20 a barrel by January of 1991, and continued to decline throughout most of the 1990s.

The stock market had been rising prior to Saddam Hussein’s invasion of Kuwait. The market topped out on July 17, 1990 and declined 20% until the market bottomed on October 11, 1990. When the attack on Iraq finally began, the market jumped up, rising almost 20% over the next month. The war was over with in a few days and despite a recession in the United States that followed the Gulf War, the market did not decline and stayed within a trading range for the rest of 1991.

During the Gulf War there was a reduction in airplane travel, which did affect the airline industry. But the long-term impact on stock markets and even oil markets was minimal, even though it was followed by a recession in the United States. In fact, the price of oil continued to decline after the war was over with.

The World Trade Center was bombed on February 26, 1993. This attack had virtually no impact on the stock market. In fact, the Dow Jones Industrials moved up on that day.

A similar situation occurred in August 1991 when there was an attempted coup in Russia. European markets sold off over 10% within one day, but recovered all of their losses within a week after the coup attempt collapsed. As in other crises, the market quickly recovered and never looked back once it was clear the crisis was over with.

As could be expected, world markets sold off as soon as news of the attack was heard. The London Stock market was down 5%, Germany 8% and Paris 5%. US Stock Markets never opened because the attack occurred before 9:30.

What will be the reaction of financial markets to this crisis?

This event is different from the other crises because it was a direct attack on the financial center of the United States. The World Trade Center houses many of the most important financial firms in the world, including the New York Mercantile Exchange, which physically no longer exists. This raises important concerns because many of the people who operate financial markets in the United States probably died.

But as we have seen, markets bounce back from these crises and bounce back quickly. The reason is that markets are efficient at processing information. They both overreact initially when the crisis occurs, and quickly bounce back once markets have determined the impact of these crises on the economy will be minimal.

The primary way in which this attack could impact financial markets is if it materially impacts the economy. In and of itself, the attack is unlikely to do this. It all depends upon how the government reacts to return the economy and the market to normal in the next few weeks. One fear would be that the attack might lead to greater isolationism in the world economy, but this would be exactly the wrong reaction. Globalization of markets and trade has provided immense benefits over the past decades and in many ways was responsible for the growth in the world economy during the 1990s. If anything, this attack should make provide us with an even greater commitment to free trade to defeat the goals of the terrorists.

Although many people worry that the integration of the world’s stock markets could cause a ripple effect through the world’s markets, and that their integration makes them all vulnerable to attack. The technology that is currently available can also help markets to bounce back. Markets such as Nasdaq and the London Stock Exchange require no physical location. One result of the terrorist attack may be to quicken the move of financial markets into cyberspace. Exchanges with a single location where stocks or commodities can be traded are likely to become rarer in the future. Experience of previous crises shows that people find ways to buy and sell financial assets regardless of whether markets are officially open or not.

To conclude, markets quickly assess the impact of crises. The quicker markets are allowed to digest news, the quicker markets can recover from the crisis. The consistent pattern in past crises is a sell off when the news breaks, a short period of evaluation, and a bounce back in financial markets once investors realize that the crisis, in and of itself, will not have a long-term impact on financial markets. The key to making sure that this crisis does not impact the rest of the economy and the global economy, and push an already weak global economy into recession is to keep financial markets open and promote international trade.

Dr. Bryan Taylor
Global Financial Data
September 12, 2001

Reprinted with permission from Global Financial Data (www.globalfindata.com).