How will an India-Pakistan conflict impact the market?

In the wake of yet another terrorist attack in Kashmir backed by Pakistan, the Indian markets have experienced a surge in volatility. Just as investors began stabilising after the uncertainties surrounding Trump’s tariffs, the looming threat of tensions between India and Pakistan has made many hesitant to engage in the market, according to a recent moneycontrol news report.

Experts agree that a full-scale war is unlikely; however, how India might respond remains uncertain, leading to widespread speculation among market participants. While foreign institutional investors (FIIs) continue to invest in the Indian markets, retail investors find themselves on the sidelines, cautious and watching from a distance as the situation unfolds. 

Indian market performance 

The prospect of a clash between India and Pakistan often raises concerns, but a recent research report by brokerage firm Anand Rathi provides a more nuanced perspective. Their study reveals that equity market corrections during periods of conflict have generally averaged around seven percent, with a median correction of three percent. Interestingly, the report highlights that, aside from the notable correction following the 2001 Parliament attack, the Indian markets have rarely been affected by significant downturns—typically not exceeding two percent– during heightened tensions with Pakistan. 

Given the current context, these figures may not seem alarming. The Indian markets recently experienced a downturn of nearly 20 percent since peaking in September 2024, hitting a recent low in April. In light of this, the potential for further corrections amidst geopolitical tensions might not warrant as much concern as one might initially think.

We, however, need to learn from the history of how other markets reacted to war. 

Global evidence 

Global markets have faced numerous military and economic crises throughout history, yet they have always recovered. Even during the tumultuous days of the pandemic in 2020, when the world came to a standstill, the financial markets only felt the impact for a couple of months before beginning to bounce back. 

An intriguing observation has emerged that the mere anticipation of war often inflicts more damage on the markets than the conflict itself. A study by the Swiss Finance Institute 2015 explored US military conflicts that occurred after World War II. The research revealed a fascinating pattern: during pre-war phases, stock prices tended to decline as the possibility of conflict increased. Conversely, stock prices often rallied when war broke out following such anticipation. 

However, there was a twist. In instances where war erupted unexpectedly, the financial markets reacted in stark contrast, with a drop in stock prices. This complex phenomenon was dubbed “the war puzzle” by the researchers, who admitted that there is no straightforward explanation why markets tend to rise significantly when the reality of war arrives after a phase of anticipation. 

Ben Carlson, the director of institutional asset management at Ritholtz Wealth Management, put it in numbers by shedding light on this phenomenon by citing World War II. He pointed out that from the war’s commencement in 1939 until its conclusion in late 1945, the Dow Jones Industrial Average climbed a remarkable 50 percent, averaging over seven percent growth annually. Furthermore, during two of the most tumultuous wars in modern history, the US stock market surged a combined total of 115 percent. 

Adding to this perspective, Mark Armbruster, president of Armbruster Capital Management, conducted a study from 1926 to July 2013. His findings indicated that stock market volatility was, in fact, lower during periods of war, suggesting a surprising stability in investor confidence during turbulent times. 

The history of the stock market during times of conflict reveals its remarkable resilience and volatility. At the onset of World War I, panic swept through financial markets, leading to a staggering 30 percent decline in stocks. In response to the turmoil, markets were shut for six months. However, the Dow Jones Industrial Average experienced a spectacular rebound when trading resumed, soaring more than 88 percent in 1915. 

Fast forward to World War II, and the stock market showcased similar patterns. After the harrowing events of Hitler’s invasion of Poland in 1939, the market initially reacted with a 10 percent uptick. Yet, the most dramatic moment came following the Japanese attack on Pearl Harbor. In the days that followed, US stocks dipped by 2.9 percent but swiftly regained those losses in less than a month. Astonishingly, from 1939 until the war’s conclusion in late 1945, the Dow climbed by a remarkable 50 percent.

The Gaza war 

In more recent history, global conflicts have continued to impact financial markets. One such incident occurred on October 7, 2023, when Hamas militants from Gaza launched a brutal assault, resulting in the killing and abduction of over 1,300 Israeli civilians. The US stock markets, however, showed resilience, recovering from the initial shock within a week. Meanwhile, Israel’s benchmark index took a longer path to recovery, taking 45 days to regain its losses, all while the conflict in Palestine persisted for more than a year. 

Why are markets ignoring war? 

Although experts struggle to definitively explain how markets react during crises such as wars, David Kelly, the Chief Global Strategist for J.P. Morgan Funds, offers some insight. He suggests that a significant part of the market’s resilience may stem from psychological factors. Today’s investors have witnessed the stock market rebound after major events like the attacks on September 11 and the Great Financial Crisis, which were two of the most profound geopolitical and economic shocks of recent history. This history of recovery has led them to become more dismissive of new disruptions. 

Mohamed A. El-Erian, the chief economic adviser at Allianz, provides a more financial perspective on the issue. He points out that markets have been conditioned to avoid overreacting to political and geopolitical shocks over the past few years for two main reasons. First, there is a prevailing belief that any initial shock will not significantly escalate. Second, investors have confidence that central banks are prepared to intervene, effectively dampening financial volatility. Through these lenses, it becomes clearer why markets might not respond as dramatically to new crises as expected. 

Conclusion 

Under present circumstances, it seems likely that the ongoing conflict will be contained in both its geographical scope and duration. Should the situation persist, Pakistan, with its vulnerable economy, would bear the brunt of the consequences. 

Ultimately, it appears that as long as Trump does not introduce unexpected developments, any resulting downturn from the border conflict could offer investors a valuable opportunity to enter the market.