Bill Jamieson: Is the Calmness in the Markets an Accurate Barometer of World Conditions?

Bill Jamieson, in the Scotsman (8-1-05):

IS THE world a riskier place? Like many who follow markets, I have been struck by the paradox between the nightly news agenda of terror and global instability and the relatively calm behaviour of financial markets."Cognitive dissonance" is the posh name for it.

I seem to be feeling a lot of it lately. There appears to be rising geo -political risk (Islamic terrorism, high oil prices) and yet diminishing risk in markets. Equity market volatility is at ten-year lows. Bond yields have tumbled. And corporate credit and emerging market bond spreads have narrowed. Have we really abolished risk? Or is there something horrible we are all missing? The good news is that those suffering from this condition are not alone. Merrill Lynch has been running a series of lectures on this theme. The latest has been given by the historian Niall Ferguson. The bad news is: Ferguson's take on this issue is not at all reassuring.

He goes back to 1914 to see how global financial markets anticipated (or, more accurately, utterly failed to anticipate) the outbreak of the First World War. In contrast to the conventional wisdom - and all the histories I have read of the war make its origins obvious from at least a decade previously - the earliest reference in the financial press to the possibility of a major European conflict was in the London Times dated 22 July, 1914.

This was a mere two weeks before Britain was to declare war on Germany and just days before world financial markets shut for the rest of the year.

Ferguson's argument, you'll be relieved to read, is not that we are necessarily on the brink of a comparably large geo-political disaster - though there are disturbing parallels between trends in international markets now and those that prevailed in the early 20th century. Rather, he argues that we need to avoid compartmentalising economic and political risk.

The biggest risks that face us today - rather as in 1914 - are not those that can be captured in financial-risk modelling. But there are risks of a great power conflict or revolution that markets in the first age of globalisation drastically under-estimated.

Few would doubt that the big talking point of the past 18 months in markets has been the seeming containment or disarming of risk. Yields on US long-dated bonds are almost as low as on two-year Treasuries. Yet commodity prices are rising. And the oil price has climbed sharply.

Ferguson, author of Colossus: The Rise and Fall of the American Empire, says today's media coverage of economic and political risks is for the most part over-done. However, we need to go back to the early years of the 20th century and ask why the first wave of globalisation came to such a sudden and dramatic end to find where the real risks lie today.

The risks, then, as now, were an over-stretched empire, Great Power rivalry, and resort to state-sponsored terrorism. Yet such was the confidence that growing international trade inspired in markets that few foresaw the risks.

From the 1880s right up until the last week of July 1914 volatility in the international bond market headed down, as did yields. The nominal yield on British government Consols - the benchmark security of the late 19th and early 20th centuries - was as low as 3.6% in June 1914. Even as late as 1 August, markets were still in denial as to what was happening. But that weekend stock markets around the world closed, and they did not reopen until the end of the year.

Had markets been allowed to reopen the following Monday, he argues, the wipeout would have been far greater than that experienced in the 1929 Great Crash. As it was, Consols opened 9.6% lower on 19 December, 1914. French bonds tumbled 15%. Austrian bonds collapsed by 23%.

Ferguson's conclusion is that globalisation then, as now, created such broad and deep capital markets that people had the illusion of a low-risk environment. We thought that market size and diversity brought security. It didn't. But how" catastrophe" risk can be priced in is no more of a certain science now than it was back then.