Market Insight: Terrorism another factor to price in

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When events occur such as Thursday’s blasts in London, market participants have to set aside consideration of the human dimension and perform an unsentimental calculation. How does this event change the relative risk-return scenario? What is the proper historical equivalent: September 11? Bali? Madrid? Or something else?

Whether they were a few blocks away in the City or just waking up on Wall Street, investors scrambled to answer these questions and trade accordingly. Historical market reactions to terrorism and military acts suggests that markets stumble and remain weak after major events, according to a study by Andrew Chen at Southern Methodist University and Thomas Siems at the Dallas Federal Reserve.

The researchers found that US stocks fell between 6 per cent and 20 per cent in the 11 days of trading after the September 11 attacks, the Iraqi invasion of Kuwait, North Korea’s invasion of South Korea, the bombing of Pearl Harbor, Germany’s invasion of France in the second world war and the sinking of the Lusitania. Events such as the Kent State shootings, the first World Trade Center attack and the US embassy bombing in Kenya caused smaller declines.

Of course, these historical comparisons are probably not apt in this instance. First, since September 11, market participants have been obsessed with the notion of “pricing in” the risk of terrorism. While Londoners were caught unaware in this specific event, in general the markets have been prepared for such an event.

Carl Astorri, head of investment strategy at Barclays Wealth Management in London, said the most appropriate comparison was the Madrid bombing in March 2004. In that case, stocks in Madrid fell 8 per cent in three days, remained sluggish for a few days then took 14 trading sessions to recover to pre-bombing levels. “The initial impact is quite swift,” Mr Astorri said, adding that such events “can in due course provide a buying opportunity.” Mr Astorri also found an interesting response from the global markets: the further away the market, the less severe the market response. Japan even managed to rally in the session immediately after the Madrid bombing.

This time investors may be even quicker to shrug off the impact of the explosions. As the scale of the tragedy became clearer, many investors concluded it would have little effect on the markets overall. Indeed, even the broad sell-off that sent most indices off more than 3 per cent seemed to present a buying opportunity. Later in the session, European bourses recovered a good deal of their losses.

“On balance, I’m pretty encouraged by the market reaction today,” said Tim Price, senior investment strategist at Ansbacher & Co in London. “Terrorism is terrible, but it’s not going to keep people from eating and drinking. Not to be unduly blasé, but London has seen this before. This is life these days.”

Meanwhile, some New York investors sensed the market’s initial negative response was an overreaction, and positioned themselves accordingly. “I won’t be an outright buyer into the panic today, but I will be actively covering short positions to get more long exposure in this market.”

It could be that the market recovers all the ground it lost yesterday in the coming days, but that is a premature response. Initially, one trader expressed the hope that this would spell an end to the Federal Reserve’s interest rate increases, but that seems unlikely. In any case, if yesterday’s London blasts are followed by further events, the impact on markets will be much greater.

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