Geopolitical Risk and the Returns and Volatility of Global Defense Companies: A New Race to Arms?

When war breaks out, do investors rush into defence stocks in a "flight-to-arms"?

Zhengyong Zhang, Elie Bouri, Tony Klein, and Naji Jalkh explored this question in Geopolitical Risk and the Returns and Volatility of Global Defence Companies: A New Race to Arms?.

They examined how the daily Geopolitical Risk (GPR) index correlates with daily stock returns and volatility of 36 major defence and aerospace companies across 10 countries during the early stages of the Russia-Ukraine war.

Their observations include:

• Before the 2022 Ukraine invasion, defence stocks showed little correlation with geopolitical risk. During the war's outbreak, their performance became intensely coupled with surging GPR.
• Investors react swiftly when global tensions rise: market participants quickly adjusted positions to the new risk reality, confirming that geopolitical news can rapidly and materially reprice certain asset segments.
• At the war's onset (Feb–Apr 2022), GPR spikes led to higher returns and volatility for many US and European defence firms.
• Stock returns of companies in certain countries like China and India showed much weaker co-movement with GPR, making them potential diversifiers in a global portfolio.
• Jumps in the GPR index often preceded stock gains, as investors anticipated that higher military spending amid conflict would boost defence companies' profits.
• Facing escalating conflict, investors reallocated into defence equities, treating them as strategic bets (or quasi-safe havens) to capitalise on security spending booms.

The dynamic described in this article reflects a "flight-to-arms" phenomenon, analogous to a "flight-to-quality", with geographical disparities due to various nations' roles and involvement in the conflicts.

Geopolitical risk established is a tangible factor: in conflict scenarios, defence sector equities tend to decouple from the wider market and rally alongside rising GPR.

This study however focuses on the initial phase of a single conflict and is limited to large defence firms: it may not generalise to all geopolitical events, smaller companies or longer post-crisis periods.

Finally, while wavelet coherence reveals correlation and lead-lag patterns, it doesn't guarantee predictive power in different conditions, so caution is needed in extrapolating these results.