Effects of disasters in megacities on capital markets

Major loss occurrences generally mean big claims payments for the insurance industry. Where, on top of that, a disaster in a megacity affects economic growth and the financial markets, insurers are hit twice. The interrelationships are complex, however, and short-term effects can be different than long-term effects.

A disaster that strikes a megacity not only costs lives, but also destroys, mostly directly, considerable economic assets - primarily real estate, production facilities and machinery, but also agricultural produce, energy supplies and much more. The owners of these goods and those who have to pay for the loss or damage are directly affected.

On the capital market, this is primarily reflected in the share prices of the companies concerned. Insurance companies are affected more than all other sectors because they often have to pay for most of the damage. Property companies and utilities can also be hit by an accumulation risk when assets are destroyed. Besides these direct consequences, there are also a series of indirect effects on the economy, the scale of which can far exceed the value of the assets destroyed.

Slowdown in growth and loss of confidence

Among the most important indirect losses are business interruptions and loss of suppliers or customers. With the exception of the insurance sector, it is difficult to identify a particular risk in the case of certain companies or sectors of the capital market.

Overall, restricted economic activity is likely to have a negative impact on the economic growth of the national economy in question. In turn, a weakened economy has a negative effect on the future profits of exposed companies, and thus on their share prices. The bond market, on the other hand, would tend to benefit from this scenario initially, since lower prospects for growth mean falling interest rates and thus an increase in value for an existing bond portfolio.

Key factor: Consumer confidence

The impact on consumer confidence is crucial, since in most economies consumption is the key driving force of economic activity. Where, because of a disaster, consumers lose confidence in future growth, they generally hold back on consumption. This would probably be the most significant negative outcome of a disaster in a megacity.

However, consumers do not react to every disaster in the same way. The decisive point is whether the disaster is a repeat or a one-off event, the latter having much less impact on confidence. In this case, there may even be a "we'll show them" backlash, with positive consequences for the economy. A man-made catastrophe is thus likely to have a much more negative effect than a natural disaster. Falling consumer confidence and the associated fall in consumption generally weakens almost all sectors of the stock market.

Rebuilding provides welcome impetus

On the other hand, positive economic effects are also possible, since the authorities usually set up reconstruction programmes following a disaster. Substantial additional government spending is often provided - with considerable impetus for growth. Such measures often go hand in hand with an expansionary monetary policy, i.e. lower interest rates, from which the bond market benefits.

The impact on the stock market depends on where the funding actually goes, i.e. which sectors, apart from the construction industry, receive the additional money. Naturally, usually those sectors worst hit by the disaster are on the receiving end.

Global consequences - Disruption of the capital markets

Megacities in particular are usually also important financial centres. This means that other indirect consequences are possible: for example, the operation of the capital markets could be jeopardised if a key financial centre were destroyed. The fundamental question is therefore: could just a few lost days of operation result in prolonged disruption?

It must be said, however, that this risk is confined to just a few cities and extreme disasters since, in the age of globally networked markets, hardly any financial centre is irreplaceable. Thus each of the three most important centres - New York, London and Tokyo - is able to maintain an operational market for the most important capital market products.

Furthermore, most of the major players, predominantly international investment banks, are represented in all the most important financial centres worldwide. This means that they can substitute. Moreover, the supervisory authorities require fairly comprehensive contingency plans that enable business to be resumed elsewhere within a few hours.

Whilst bottlenecks are possible with specific products that are only traded to any extent in one financial market, sustained disruption of the global markets is not very likely these days. Only if many important players were to be out of action at the same time would it lead to lasting complications. The only imaginable scenario for this would be if Manhattan were to be put entirely out of action.

Conclusion: The long-term consequences on the capital markets are uncertain

A disaster in a megacity always affects the two important factors of risk and return. Whereas with return both positive and negative effects are superimposed (with the net effect doubtful), the uncertainty, i.e. the risk, basically becomes greater and has a negative impact on the capital markets. The bottom line is therefore hard to predict and cannot be clearly attributed.

Overall, stock markets tend to lose value. How lasting this effect is largely depends on its impact on consumer confidence and thus on the nature of the disaster. A man-made disaster is far worse than a one-off natural disaster. The bond markets tend to benefit in the event of a disaster, because interest rates fall. This is positive for an existing portfolio. In the long term, however, this development leads to lower reinvestment interest rates - something that has to be taken into account in insurance premiums.