Nuclear weapons and stock prices
The second moment in stock prices, military Keynesianism and whether war is scarier than the Fed
Analysts have been contemplating the potential for low yield/tactical nuclear use in Ukraine. As Tim Snyder argues, this is exactly what Putin wants us to contemplate. But just because Putin wants us to, doesn’t mean we shouldn’t. It is far from clear nuclear use would buy Putin very much in the battle space, or the diplomatic-political space for that matter. Tim makes a persuasive case for prospective regime change in Russia as one war termination scenario, although freely concedes other scenarios are possible.
The war has so far made a very good case for epistemic humility in approaching international relations. Many analysts thought Putin would not invade Ukraine because it was not in his interests, although Western intelligence actually did a good job of calling it closer to the event. Those who correctly thought a war would go badly for Putin were more inclined to think he would not go there.
Putin obviously had a theory of success in Ukraine. It may looked flawed in retrospect, but it was a theory substantively shared by most Western analysts and governments, who also expected a rapid Ukrainian collapse. It should be recalled that one of the first US responses to the invasion was to offer to evacuate Zelenskyy.
Where both Putin and the west went wrong was to under-estimate the extent to which Russia’s state capacity has been hollowed out by corruption. It is entirely fitting that Putin’s efforts to re-create the Soviet empire have been brought unstuck by some of the same weaknesses that were endemic to the Soviet system. If anything, Putin has underperformed relative to the Soviet era. The Warsaw Pact was at least a serious conventional as well as nuclear threat. That said, I had a Czech defector as a social science teacher in the 1980s who claimed that when he was a conscript, his unit’s agreed plan in the event of conflict had been to shoot the political officer and surrender to the first NATO forces they could find.
Nuclear weapons were the basis for the world’s first financial market event study in 1954 by Armen Alchian, 15 years before FFJR (1969). Alchian studied capital market reactions to the Operation Castle series of nuclear detonations to infer the fuel material used in the manufacture of the hydrogen bomb. The paper was seen as a threat to national security and was confiscated and destroyed rather than published. Joe Newhard has since replicated the study in a paper published in 2014, confirming Alchian's results.
The 1962 Cuban missile crisis is perhaps the closest analogue we have for thinking about the market implications of escalation potentially involving nuclear use. The crisis came on the back of the ‘Kennedy slide’ in US stocks in 1962 and so amplified an existing trend, which was itself a reflection of rising tensions. This old FT story helpfully shows the crisis decline in the context of the broader slide:
While the 7% decline in US stocks during the crisis looks modest given the gravity of the situation, one study has inferred from the limited market reaction ‘that the existential risk associated with the crisis was exaggerated. Unlike genuinely new threats whose impact is entirely unknown, the doomsday scenario associated with nuclear weapons was more than familiar to market participants of the 1960s.’ In other words, doomsday risks were already in the price before the crisis, to the extent such risks can be meaningfully priced. That could also be the case in relation to Ukraine. However, the same study found more pronounced negative price action in the 1% left tail of the distribution of stock returns.
Dario Caldara and Matteo Iacoviello’s geopolitical risk index is notable for showing more pronounced economic and financial market effects from the threat rather than the reality of hostilities. It’s the uncertainty that matters. Their index shows that while the Ukraine war has led to elevated levels of geopolitical risk, those risks have moderated since the onset of hostilities, suggesting the war has faded into the background for many:
The impulse response functions to a two standard deviation shock to their index are as follows:
The IRF’s seem modest compared to those from the literature on economic policy uncertainty, particularly given that these are two rather than one standard deviations shocks. In my own modelling for a USSC paper that never saw the light of day, I found that geopolitical risk index shocks seem to work largely through an economic policy uncertainty channel.
This would seem consistent with the war volatility puzzle. US stock volatility is 33% lower during wartime and periods of conflict. This has been explained in terms of increased defence spending acting as something of an automatic stabiliser. The second moment in stocks seems to like military Keynesianism.
None of which is to downplay the gravity of the current situation and its potential to escalate into a broader conflict. The financial market reaction to these events is in many ways the least significant aspect of the war, but financial markets may nonetheless provide insights into its broader significance. For now, markets appear more worried by the Fed than war. Remember pre-pandemic when people said monetary policy was irrelevant and ineffective? You’re hearing it less and less.
US September payrolls and unemployment rate
US September non-farm payrolls came in at 263k, which was a little better than the market expectation of 250k and our own forecast of 240k. This was the softest jobs growth since April 2021, although still leaves total employment 514k higher than in February 2020.
The unemployment rate fell back to its lowest level since the late 1960s at 3.5%, better than the 3.6% the market had expected and our own expectation for a steady unemployment rate. We had hoped for a continuation of the supply-led easing in labour market conditions seen last month, but in the event, the labour force declined by 57k. There is not much here to deter a further 75 basis point Fed tightening in November.
ICYMI
Interesting study of the role of the media in holding the BoE accountable.
A remembrance of Axel Leijonhufvud.
Substack now has an Android app:
Memes and themes: