The Cuban missile crisis – lessons for investors
By Lars Christensen, CEO & Founder Markets & Money Advisory, LC@mamoadvisory.com, @
According to the history books, one of the scariest events during the Cold War was the Cuban missile crisis of October 1962, when the world found itself on the brink of nuclear Armageddon. However, the history books might be wrong – at least if you look at what happened on Wall Street during the crisis.
If indeed we were on the brink of a nuclear exchange, one would certainly have expected the stock market to drop like a stone. Nothing of the sort happened. Instead, the S&P500 was little changed during the 13-day standoff between the United States and the Soviet Union.
This is rather remarkable given the horrific things that could have happened. Several reasons can be adduced for why we didn’t see a stock market collapse.
Some have argued that the crisis shows the effectiveness of a strategic doctrine called Mutual Assured Destruction (MAD). Both the US and Soviet Union knew that there would be no winners in a nuclear conflict, which meant that neither had any incentive to start a war. Perhaps investors realised this, and while the global media were trumpeting the risk of a third world war, they refused to panic (contrary the popular stereotype, stock markets are much less prone to panic attacks than policymakers).
Another possibility is that markets knew better than the Kennedy administration and had discounted the geopolitical risks prior to the crisis. US stock prices had already fallen more than 20% in the months before President John F. Kennedy's announcement that the Soviets were deploying nuclear missiles in Cuba.
Either way, the markets were proved right. There was no third world war and the crisis ended after a couple of tense weeks.
That does not mean the Cuban missile crisis went unnoticed by consumers and investors. But we should think about such geopolitical turbulence primarily as a supply shock. Geopolitical crises increase ‘regime uncertainty’ – in an AS/AD framework, they shift the aggregate supply curve to the left, which reduces real GDP growth and increases inflation for a given monetary policy stance.
This shift was not very visible in 1962-63, but later in the 1960s, it became clear that regime uncertainty was reducing real GDP growth. In terms of market valuation, it is important to remember that equity prices are nominal rather than real. Hence, they will not necessarily fall if the central bank keeps nominal spending/aggregate demand on track.
Obviously, stocks could drop if the risk premium increases, but we should not necessarily expect nominal earnings growth to slow. Therefore, when trying to understand how a geopolitical crisis affects stock market performance, we need to consider the monetary policy response.
Story of the 1960s: The stock market as a nominal phenomenon
Returning to the Cuban missile crisis, it is helpful to see how nominal GDP changed in the US to understand what happened in the US stock market during the crisis and afterwards. During the previous year, US NGDP growth accelerated sharply - from only 0.5% y/y in the first quarter of 1961 to 9% y/y in the first quarter of 1962.
That reflects a rather massive monetary expansion. From early 1962, however, a monetary contraction took place and NGDP growth started to slow significantly. I believe this was the real reason for what was referred to at the time as the ‘Kennedy slide’ in the stock market.
Note that this was prior to the Cuban missile crisis. However, as the geopolitical confrontation heated up, the Federal Reserve moved to ease monetary policy – initially not in dramatic fashion, but nonetheless in a more accommodative direction. NGDP growth started to accelerate towards the end of 1962 – a few months after the end of the missile crisis.
I am certain that this monetary easing helped keep a floor under US stock prices during the latter part of 1962. In fact, it is notable the extent to which geopolitics came to determine monetary policy during the 1960s. In an analogous fashion, one might argue that geopolitical concerns were to some degree behind President Kennedy’s and especially President Lyndon B. Johnson’s expansion of the US welfare state over the same decade.
During this period, the Federal Reserve actively supported the expansion of government spending by trying to intervene in the bond market to keep yields down – for example, by launching the (in)famous Operation Twist in 1961.
As the 1960s wore on, the Fed's policies became increasingly inflationary. During the decade’s early years, easier monetary conditions primarily boosted real GDP growth (in line with the acceleration in NGDP growth). But as the negative impact of spending on the Vietnam War and social welfare schemes began to be felt, US productivity growth started to slow. That led to a significant uptick in US inflation in the second half of the 1960s as nominal spending continued to expand.
The stock market closely tracked developments in nominal GDP. From 1960 to 1970, US equity prices rose by 80-90%, depending on which index you use. That closely corresponds to NGDP growth, as shown in the graph below.
The moral is that geopolitical risk is not necessarily negative for stocks, unless central banks make stupid decisions. That was certainly the case with the Fed in the 1960s.
What about now?
Today’s obvious analogue is worry over a potential military and even nuclear conflict between North Korea and the US. Jitters over this possibility have already put some downward pressure on global stock prices.
Based on the Cuban experience, investors would be well advised to ignore the geopolitical reality show. Instead, they should focus on the growth outlook for nominal earnings – in other words, on nominal GDP. The leader to watch is Janet Yellen, not Kim Jong-un or Donald Trump.
I don’t mean to suggest that geopolitics cannot influence monetary policy. I certainly would not rule out that Janet Yellen and her colleagues on the FOMC may use international tensions and heightened political uncertainty in the US as an excuse to do the right thing and postpone rate hikes. They might even start scaling back the planned ‘normalisation’ of the Fed’s balance sheet.
That would be market-moving – in a positive direction.
This is a slightly edited and updated version of a blog post that first appeared on The Market Monetarist blog in April 2014.