The Red Sea Conflict and Market Reactions: Examining the Role of Military Strength in Financial Markets

1 Introduction

The world has experienced heightened geopolitical risks in the last decade compared to previous eras, and the intensity of these risks has become a significant concern for investors, especially in recent events such as the US-China trade war, the Israel-Hamas conflict, and the Russia-Ukraine war. Among these events, the financial sector is frequently negatively impacted by geopolitical risks (Boubaker et al. 2023; Chen and Sun 2024; Hunjra et al. 2024; Lesmana and Yudaruddin 2024a; Pandey et al. 2024; Polat et al. 2023; Polat, Başar, and Ekşi 2024; Shi, Wang, and Ke 2021; Vu et al. 2023; Yudaruddin et al. 2024a,b). Geopolitical risks are closely linked to the financial sector due to their significant impact on market stability and investor behavior. Events such as wars, trade conflicts, and political upheavals create uncertainty, leading to market volatility and disrupting financial markets. For instance, geopolitical conflicts can affect commodity prices, including crucial resources like oil and natural gas, which in turn influence inflation and economic growth (Babar, Ahmad, and Yousaf 2023; Yousaf et al. 2023; Yudaruddin and Lesmana 2024b; Yasmeen and Shah 2024). Additionally, these events often result in shifts in government policies and regulatory frameworks, further destabilizing financial markets. Investor sentiment tends to react negatively to geopolitical tensions, causing fluctuations in stock prices, foreign exchange rates, and bond yields (Assaf, Gupta, and Kumar 2023; Ngo, Nguyen, and Hoang 2024; Hassan et al. 2022; Jawadi et al. 2024). Consequently, the financial sector, including banking, investment, and insurance industries, becomes particularly vulnerable to the adverse effects of geopolitical risks, as seen in various recent global conflicts. This relationship underscores the importance of effective risk management strategies for financial institutions to mitigate the impacts of geopolitical uncertainties.

Recently, the US-Houthi conflict has intensified as the US and the UK have launched a series of strikes on Yemen, targeting the Iran-aligned Houthi rebels who have been attacking international shipping in the Red Sea. The Houthis, who support the Palestinian group Hamas, condemned these strikes as “barbaric” and issued a statement declaring that “all US and UK interests have become ‘legitimate targets’.”^[1] This conflict is part of a broader regional power struggle, with the Houthis receiving backing from Iran, and it has significant implications for international maritime security and geopolitical stability.^[2] The Houthis’ threats underscore the potential for further escalation, impacting not only the region but also global trade routes and international relations. Considering the escalating conflict and the Houthis’ threats against US and UK interests, it is crucial to understand the broader implications beyond immediate security concerns.

One significant aspect that warrants examination is the impact of such geopolitical tensions on the financial sector. Therefore, there are three main motivations in this study. First, several studies have indicated that the financial sector, particularly banking, is highly vulnerable to conflicts such as wars. Military deployments at border areas often serve as “bad” news for investors in the banking sector (Boubaker et al. 2023; Martins and Cró 2023; Vu et al. 2023; Yudaruddin and Lesmana 2024a). However, most of these studies focus on the Russia-Ukraine conflict, which involves financial sanctions between Russia and the European Union. This raises the question of how the financial sector market reacts to conflicts that do not involve financial sanctions, creating a research gap that needs to be addressed. Second, previous research has primarily concentrated on the banking industry, failing to provide a comprehensive view of the entire financial sector.

Additionally, factors such as military strength, which are pertinent to war, have not been thoroughly explored in previous studies. Third, the US-Houthi conflict is strategically significant due to its location along major trade routes between Asia, Africa, Europe, and America. Essallamy, Bari, and Kotb (2020) and Wu et al. (2022) highlighted the crucial role of the Red Sea route through the Suez Canal, analyzing its effectiveness and cost efficiency compared to the Cape of Good Hope route. Recently, however, tensions in the Red Sea have led companies in Asia to prefer the Cape of Good Hope route to avoid risks, resulting in a sharp decline in Suez Canal transit and an increase in Cape of Good Hope traffic. The Panama Canal has also experienced a decline, albeit less severe than the Suez Canal.^[3] Yudaruddin et al. (2025) showed that the US-Houthi conflict had a negative impact on the market in the consumer cyclical sector. This study thus seeks to assess the potential negative impact of the US-Houthi conflict on the financial sector’s stock market.

To address this gap, our study is the first to investigate market reactions to the US-Houthi conflict within the financial sector. We analyze market reactions from 15 days before to 15 days after the event, using January 11, 2024, as the event day. Our research findings address the gap in previous research by demonstrating that investors in the financial sector exhibit a “negative” sensitivity to war. This is evident from the significant negative market reaction to the US-Houthi conflict and its aftermath. These results reinforce previous findings that the financial system is highly integrated and that macroeconomic shocks increase systemic risk. Furthermore, we find that the banking industry exhibits higher vulnerability compared to other industries. Our results confirm that the banking market reacts significantly negatively to global uncertainties, including geopolitical risks, even in the absence of financial sanctions. Our findings also provide insights for companies regarding the importance of military strength and company characteristics in managing geopolitical risks. We find that while military power is not a critical factor in the absence of war, it becomes vital during conflicts, influencing market reactions to geopolitical risks.

This paper is organized into five sections. The relevant literature is briefly discussed in Section 2. The methodology is presented in Section 3. In Section 4, the data and main empirical findings are displayed. The last section concludes.

2 Literature Review

In recent years, many academics and practitioners have analyzed the impact of geopolitical conflicts particularly war events have far-reaching effects across various sectors. Tajaddini and Gholipour (2023) found that stock markets declined more in countries with strong trade ties to Russia and Ukraine during the Russia-Ukraine war, though trade openness mitigated the impact. Similarly, Boubaker et al. (2022) and Boungou and Yati´e (2022) reported that the Ukraine-Russia war caused global stock declines, hitting globalized economies, neighboring countries, and UN critics hardest, while NATO markets showed resilience. Martins and Cró (2023) illustrated this by highlighting the disruptions in flight routes caused by conflicts, which led airlines to avoid airspace near war-torn regions. Consequently, these limitations on flight routes have resulted in deteriorating aviation performance for companies operating in such areas. Similarly, Yudaruddin et al. (2023) identified a disruption in the agricultural supply chain in conflict-ridden nations like Ukraine, a significant exporter of wheat. This disruption triggered price hikes in various agricultural commodities, posing challenges for investors concerned about handling geopolitical risks. Furthermore, the real estate sector was not immune to these effects (Yudaruddin and Lesmana 2024c). Corsetti et al. (2012) emphasized that increasing sovereign risk adds new pressure to a country’s economic stability amid geopolitical pressures. As a result, investors are concerned about the level of sovereign risk that affects their business operations. Country risk, which includes legal, economic, and institutional dimensions, increasingly deters investors from engaging in business activities in that environment (Lestari et al. 2022). As a result, the level of country risk increases uncertainty, which has a major impact on financial markets in both developing and developed countries (Hoque and Zaidi 2020).

Geopolitical risks are also closely linked to the financial sector due to their significant impact on market stability and investor behavior. Investor sentiment tends to react negatively to geopolitical tensions, causing fluctuations in stock prices, sovereign wealth funds, foreign exchange rates, and bond yields (Assaf, Gupta, and Kumar 2023; Ngo, Nguyen, and Hoang 2024; Balestra et al. 2024; Hassan et al. 2022; Jawadi et al. 2024). Consequently, the financial sector often experiences adverse effects as a result of these geopolitical risks (Shi, Wang, and Ke 2021; Chen and Sun 2024; Pandey et al. 2024; Lesmana and Yudaruddin 2024b; Boubaker et al. 2023; Vu et al. 2023; Vuong et al. 2024). Shapiro, Switzer, and Mastroianni (1999) examined the response of a portfolio of defense contractors to war- and peace-related events, finding that the defense portfolio responds positively to war-related announcements and negatively to peace-related announcements. Moreover, research by Yudaruddin and Lesmana (2024a) and Boubaker et al. (2023) underscores the vulnerability of the global banking sector to geopolitical uncertainties. Past conflicts have led to the imposition of banking access sanctions on warring nations, amplifying risks within the banking. This vulnerability is also triggered by the highly integrated financial system throughout the world, the presence of external disturbances creates increased systemic risk. In addition, the existence of geopolitical risks also raises the level of bank risk which can reduce banking performance (Hunjra et al. 2022).

Moreover, several studies have examined the repercussions of war on financial markets across different regions. Abbassi, Kumari, and Pandey (2023) and Kamal, Ahmed, and Hasan (2023) focused on developed countries, while Lesmana and Yudaruddin (2024b), Yousaf, Patel, and Yarovaya (2022), Oubani (2024), Sayed (2024), Basnet, Blomkvist, and Galariotis (2022), and Oyadeyi, Arogundade, and Biyase (2024) studied emerging and frontier markets, with specific attention to Asia (Lesmana and Yudaruddin 2024b), Europe, and America (Boubaker et al. 2022). Kumari, Kumar, and Pandey (2023) found the impact of war on financial markets on the EU stock markets. Aslam et al. (2021) found that terrorist attacks, especially on certain weekdays, increased stock market volatility and negatively impacted returns in Pakistan. These investigations collectively illuminate the multifaceted impact of war on global economic systems and underscore the need for comprehensive strategies to mitigate such disruptions. Meanwhile, Rigobon and Sack (2005) Gurdgiev, Henrichsen, and Mulhair (2022), and Tee Wong, and Hooy (2023) also found a negative effect of war on US financial markets.

Recently, the US-Houthi conflict has become a focus of attention, especially for countries that use trade routes via the Suez Canal, which connects the Red Sea and the Mediterranean Sea to the European and American continents.^{[4] , [5] , [6]} The conflict has impacted the gateway to the Suez Canal, disrupting trade routes and forcing vessels to switch to the Cape of Good Hope route. This shift affects the ships’ condition and longevity. Specifically, using the Suez Canal is more time-effective, reducing sailing time to Europe by approximately 42 % and to the US by 30 % from the Middle East. In contrast, the Cape of Good Hope route results in higher damage rates, with 13 % for Europe and 5 % for America (Essallamy, Bari, and Kotb 2020). Similar research by Wu et al. (2022) analyzed the integration of trade between the Suez Canal and the Cape of Good Hope, focusing on time and fuel cost effectiveness. Their findings indicate that the Suez Canal plays a much more effective and efficient role compared to the Cape of Good Hope route. In addition, Yap and Yang (2024) found that geopolitical risks disrupted shipping networks connecting the Asia-Europe and Asia-Mediterranean trade routes. The disruption of the Suez Canal due to the US-Houthi conflict forced the service company to use an alternative Cape route with a longer route, so the company added additional ships to maintain the frequency of stops.

The US-Houthi conflict has an impact on increasing costs and shipping times, which is a “bad” signal for investors. Yudaruddin et al. (2023) stated that the impact of war can lead to an increase in commodity prices, which raises production costs and subsequently affects a company’s performance, potentially leading to a reduction in dividends. Dividends play a crucial communication role for companies and investors during crises (Hasan 2021). Subsequently, Tayachi et al. (2023) states that dividend policy also looks at several aspects other than institutional ownership and company performance. A decrease in dividends sends a negative signal to investors during times of war (Yudaruddin and Lesmana 2024c). The reaction to this can also vary based on the company’s scale, as the impact of geopolitical risk is closely associated with medium and large-scale companies engaged in international trade (Kamal, Ahmed, and Hasan 2023). Additionally, Chesney, Karaman, and Reshetar (2011) and Corbet, Gurdgiev, and Meegan (2017) demonstrated that terrorist activities drive stock market volatility.

The economic repercussions of the US-Houthi conflict extend beyond disrupted trade routes and increased shipping costs, affecting various sectors and influencing investor behavior. The conflict’s impact on maritime trade and commodity prices sends negative signals to investors, highlighting the broader implications of geopolitical tensions on financial stability. Therefore, military strength plays a crucial role in shaping investor sentiment and market reactions across various financial sectors, including banking services, collective investments, insurance, investment banking and investment services, and investment holding companies. Gurdgiev, Henrichsen, and Mulhair (2022) analyzed the effects of US military participation in both direct and indirect foreign conflicts and found that defense budget announcements have a complex and dynamic positive impact that is statistically significant on defense company stock performance.

However, military spending presents two contrasting aspects for investors depending on the prevailing situation. Tutuncu, Bayraktar, and Khan (2024) found that a bidirectional relationship between military expenditures and geopolitical risk, where both influence each other and contribute to an arms race and regional instabilit. Saba and Ngepah (2019) found that, in African countries, most arms expenditures do not have a causal link to economic growth, with only two countries showing a significant relationship. In contrast, Tsitouras and Tsounis (2024) indicated that arms spending exacerbates inequality in conflict-affected countries like Greece, leading to negative investor sentiment toward military expenditures in stable conditions. Corsetti et al. (2012) observed that substantial military power reinforces national sovereignty, thereby easing investor concerns and boosting economic stability amid geopolitical tensions. Lowering geopolitical risk can raise stock returns in both emerging and developed economies (Hoque and Zaidi 2020). Indeed, military strength heavily influences investor perceptions by fostering a sense of stability and security. A country with robust military capabilities is often perceived as better equipped to defend its interests, reassuring investors and helping to mitigate negative impacts on stock prices during conflicts. Additionally, strong military capabilities usually translate into greater geopolitical influence, deterring adversaries and reducing the likelihood of prolonged conflicts. This stabilizing effect can lead to more favorable cumulative abnormal returns (CARs), as investors anticipate quicker conflict resolutions and lower risks of escalation. Conversely, Rigobon and Sack (2005) noted that rising war risks in U.S. financial markets lead to declines in treasury yields and equity prices, widening spreads on low-rated companies, dollar depreciation, and increases in oil prices. Schneider and Vera (2006) also found that conflicts adversely impact core financial markets in the Western world, specifically affecting stock indices in Paris, London, and the United States.

Geopolitical risks (GPR) play a crucial role in shaping military expenditure policies and their subsequent impact on stock market reactions. The link between GPR and military expenditure not only affects economic stability but also triggers negative stock market reactions due to increased uncertainty and pressure on investment. For instance, Tran and Vo (2024) found that local GPR exerts a greater influence on military spending behavior than global GPR, indicating that countries adjust their defense policies based on regional threats. Menla and Dimitraki (2014) highlighted that the impact of military expenditure on economic growth is state-dependent, where increased defense spending can negatively affect growth during periods of slow expansion and high volatility. Furthermore, Khraiche, Boudreau, and Chowdhury (2023) show that GPR has a strong negative effect on stock market development, with a more pronounced impact in North America and Europe than in Asia, indicating that geopolitical uncertainty hinders investment and capital market growth.

3 Data and Methodology

We collected the daily closing prices of the leading stock indices sample firms in each country from The Wall Street Journal (WSJ) and the investing.com website (www.investing.com) for the period 1 December 2022 through 29 February 2024. We also collect daily closing composite stock price indexes of the markets from their constituent companies. We include all firms that we can match with the stock market and financial reports. After screening sample firms, the sample in this study comprised 2,339 companies in the financial sector’s stock market. The distribution of sample companies by country is presented in Table A1.

We utilized the event study approach by Fama et al. (1969). Recent studies on market reactions to the announcement of war also use the event study method (Lesmana and Yudaruddin 2024b; Yudaruddin et al. 2023; Yudaruddin and Lesmana., 2024c; Pandey et al. 2024; Boubaker et al. 2023). We also utilized multiple event windows, including 15 days prior to the invasion announcement as a pre-invasion event and 15 days after the invasion announcement as a post-invasion event. In addition, we also used the 250 trading days prior to the event window in formulating a benchmark for normal returns to improve accuracy and reduce bias in the results of this study. This research takes place at the time of the US-Houthi conflict on January 11, 2024^{[7] , [8] , [9]} as an event day. We measured the market reaction using the normal, abnormal and cumulative abnormal rates of return.

The normal rate of return is defined as:

The abnormal rate of return:

The cumulative abnormal rate of return:

for stock i on the trading day t. α _i and β _i are the regression coefficients. The expected normal return of individual stock i can be calculated when α _i and β _i remain stable during the estimation period. Furthermore, AR _i,t is the abnormal return rate of stock i on the trading day t, obtained by subtracting the expected from the actual return, and CAR i t 1 , t 2 is the cumulative abnormal return rate of stock i in the event window period (t ₁, t ₂). To test the statistical significance of cumulative abnormal returns (CAR), we employ a one-sample t-test, which assesses whether the mean CAR is significantly different from zero. The null hypothesis (H ₀) assumes that CAR has no significant impact, i.e. CAR = 0.

The objective of this study is to explore the market response to the US-Houthi conflict. To achieve this, the analysis is conducted in several stages. First, we examine the reaction of the financial sector on a global scale, stratifying the data into developed, emerging, and frontier markets. The markets are further segmented into several regions, including the Americas, Europe, the Middle East & Africa, and Asia & Pacific. Additionally, in-depth examinations are carried out based on specific industries, including Banking Services, Collective Investments, Insurance, Investment Banking & Investment Services, and Investment Holding Companies.

Additionally, we conducted a cross-sectional analysis to understand how military strength impacts market reactions in the financial sector, as represented by Equation (1):

where CAR _i,c,t is the cumulative abnormal return of the company (i) in country (c) for the event window t. Military strength is proxied by the Nation Power Index (NPI), with data collected from Global Fire Power (GFP). We also incorporated firm characteristic control variables, including profitability measured using return on assets (ROA), dividends measured by a dummy variable (0 for firms that do not pay dividends and 1 for those that do), firm size measured using the logarithm of total assets, leverage (LEV) measured using the ratio of total liabilities to total equity, and liquidity (LIQ) measured using the ratio of total current assets to total assets.

4 Empirical Result

5 Conclusions

This study investigates the market reaction to the US-Houthi conflict within the financial sector, utilizing a sample of 3,239 companies across various sub-sectors: 1,333 in banking services, 186 in collective investment, 517 in insurance, 1,039 in investment banking and investment services, and 164 in investment holding companies. Employing the event study method, a widely accepted approach for analyzing market responses to global events, including previous conflicts such as the Russia-Ukraine war (Yudaruddin and Lesmana 2024a; Yousaf, Patel, and Yarovaya 2022; Abbassi, Kumari, and Pandey 2023), this study finds that the market experienced a significant negative reaction following the event of the US-Houthi conflict. This suggests that the financial sector is particularly susceptible to geopolitical risks associated with warfare.

The study reveals that developed markets are more adversely affected by the conflict compared to developing or frontier markets. A deeper analysis of industry-specific reactions shows that the banking industry and investment banking and investment services are the most vulnerable to the conflict, underscoring a heightened sensitivity to recent wars (e.g. Russia-Ukraine, Israel-Hamas, US-Houthi Conflict). Additionally, the study examines how company characteristics and military strength influence market reactions before and after the announcement. Key findings include the significant role of company size and dividend distribution policies in shaping post-announcement market reactions, with dividends playing a crucial role in mitigating investor concerns related to geopolitical risks.

The findings of this study have significant economic and financial implications for policymakers, managers, and investors. For policymakers, the US-Houthi conflict underscores the vulnerability of financial markets to geopolitical risks, particularly in regions heavily reliant on disrupted trade routes. The additional costs and delays associated with such disruptions can lead to inflationary pressures and reduced economic growth. Therefore, beyond considering military strength, policymakers should implement risk mitigation strategies, such as diversifying trade partnerships and enhancing financial market resilience through regulatory frameworks that account for geopolitical shocks. For managers, the study highlights the importance of adaptive financial strategies, such as adjusting capital structure, liquidity management, and dividend policies to stabilize investor confidence post-conflict. Implementing strategic dividend distributions and maintaining financial flexibility can help firms navigate periods of heightened uncertainty while mitigating investor concerns over geopolitical risks. For investors, these findings emphasize the need for comprehensive risk assessment frameworks that integrate geopolitical risk factors into investment decision-making. Identifying firms with robust risk management strategies and diversified supply chains can enhance portfolio resilience in the face of geopolitical instability. By incorporating these insights, stakeholders can develop more informed strategies to safeguard financial stability and investment performance amid global conflicts.