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Terrorism: economic consequences, implications for investors

In Focus

The attacks of September 11, 2001, like the bombing of the World Trade Center in 1993, were designed to produce mass casualties and significant economic damage. For those who lost loved ones in those attacks, the costs were beyond measure. And there were, indeed, dramatic economic consequences — and implications for investors.

The initial reaction of financial markets was a flight to quality, reflecting a decrease in risk tolerance and an increase in perceived risk. Although there was an immediate drop in stock prices, as in earlier wartime periods, stocks soon recovered — in many cases well above their September 10 levels. For the most part, the initial turbulence in financial markets was transitory. Not so for the insurance industry.

The Organization for Economic Cooperation and Development (OECD) estimated insured losses to be between $34 and $58 billion, dwarfing the $21 billion incurred in 1992 from Hurricane Andrew, then the largest insurance event in history. The U.S. Government Accountability Office, formerly the General Accounting Office, concluded that total losses for New York through 2003, both direct and indirect, were approximately $83 billion. On a national level, the impact was much greater, but was mitigated by government action.

Much to their credit, the Federal Reserve, the Bush Administration and Congress took steps to safeguard the financial system and protect business through aggressive easing of monetary policy, an emergency spending package of $40 billion, $5 billion in direct grants, plus $10 billion in federal loan guarantees for U.S. airlines. Despite these efforts, the economy took a sizeable hit. According to the OECD, the implied impact of 9/11 on the nation’s gross domestic product through 2003 was five percentage points, or half a trillion dollars.

In addition, government spending on homeland security escalated significantly, directing resources away from more productive uses. Civitas Group, a D.C. based strategic advisory and investment services firm, recently reported that federal spending on homeland security more than tripled from FY 2000 to FY 2004, going from $13.2 billion to an estimated $41.3 billion. Civitas observed that, “States, counties, towns and cities joined (the federal government) and spent billions more in federal grants and from their own resources on protective equipment, communications tools and training.” Considering recent events, this was money well spent.

On August 1, as a result of arrests of al Qaeda militants in Pakistan and detailed evidence uncovered, the Department of Homeland Security raised the alert level for the Washington, D.C., area from “elevated” to “high” and issued specific warnings for targets in Washington, D.C., New York, already on high alert, and Newark, N.J. Targets mentioned in the warning were major financial institutions: Citigroup, Prudential, the World Bank, the International Monetary Fund and the New York Stock Exchange.

Concurrent with continuing terrorist threats and other potential disasters, policymakers and the financial services sector have taken steps to protect the nation’s critical infrastructure, including those elements vital to the resilience of securities firms and markets. Rules NYSE 446, NASD 3510 and 3520, for example, require securities broker-dealers and clearing firms to implement Business

Continuity Plans, which must address certain business elements:

• Data back-up and recovery,

• Mission critical systems,

• Financial and operational assessments,

• Alternate communications between firms and their clients, employees, and regulators,

• Alternate physical locations,

• Critical business constituent, bank and counter-party impact,

• Client access to funds and securities in the event the firm is unable to continue operating.

Many investors will receive information with their September brokerage statements regarding their firm’s Business Continuity Plan. These measures provide additional protection for the nation’s financial infrastructure, not only against terrorist attacks, but also from other disasters — natural or man-made. If you are concerned about investment risk, here are three steps you can take to further protect your financial assets.

First, examine your needs for cash reserves, favoring insured deposits and government-backed cash equivalents. Increasing your cash reserves may protect you from having to sell during a market decline if unexpected expenses occur. Needs for cash vary depending on whether you are employed or retired. If employed, needs vary by profession, industry, alternate sources of income and type of assets owned; that is, how difficult is it to convert those assets to cash. If retired, your assets may be inaccessible due to long-term commitments; therefore, needs for cash may be higher. In either case, avoid using rule-of-thumb multiples of monthly income or expense. A detailed examination of your personal circumstances is the best approach.

Second, evaluate your investment risk management strategies. Since terrorist acts and other potential disasters pose considerable risk for specific industries or companies, investors reluctant to accept risk should avoid investment concentrations in one industrial sector or company. Therefore, diversify your investments using conservatively managed, sector-neutral mutual funds or similar products. If you are unwilling or unable to avoid investments in one company, perhaps due to employment, consider using options or other hedging strategies to protect those assets.

Third, review your asset allocation and the quality of your holdings. Studies have shown that as much as 93.6% of the variation of quarterly investment returns can be attributed to the asset allocation decision; that is, how one is invested among stocks, bonds and cash. During periods of increased uncertainty, markets favor quality over the potential for growth or income. Strong earnings history and asset quality directly affect the performance of a company’s stock. Credit quality, yield and maturity, on the other hand, impact bond performance; however, as with stocks, quality wins in times of worry. Therefore, appropriate decisions regarding asset allocation and investment quality are extremely effective in reducing risk.

Clearly, the above are not exhaustive treatments of these subjects, and many strategies are available. Investors concerned about risk should meet with a financial planning professional to determine the strategies appropriate for their circumstances.

The future holds many uncertainties. Yet, uncertainties can be addressed, the risks of uncertainty reduced. More importantly, investment confidence can be achieved — no matter what the future holds.

Thomas Howard, CFP, is president of Trustmark Securities Inc. in Jackson. Contact him via e-mail at “thoward@trustmark.com.

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