Geopolitical risk and Niall Ferguson's The War of the World

The low level of risk premium in many markets has been a disturbing theme in 2007. Starting with the The Financial Times editorial by Lawrence Summers arguing that risk premiums did not reflect the geopolitical uncertainty in the world, there has been a growing cry for what we may call risk compensation sanity.

The increase in the VIX index last month was viewed as a signal that risk has reentered the global markets but after a short correction there again seems to be a complacency with respect to geopolitical risk. The "wall of worry" is not very high in today's markets and those who restructured their portfolios during the recent market decline have been paid back with under performance. So what should investors do? Follow the signals of the market which are the aggregation of all market opinions or prepare for a sell-off of the riskiest markets?

A recent reading of Niall Ferguson's new book The War of the World suggests that the biggest geopolitical event of the 20th century was wholly unanticipated by the world bond markets. (See http://www.niallferguson.org/ for more details on Prof. Ferguson.) Prof Ferguson examined the bond prices for the sovereign debt of the leading countries to be embroiled in WWI. Given the war would have to be financed through the debt markets, these bonds should be the most sensitive markets to any hostilities. He found that for the prices available right before the beginning of the war in August 1914, there was little decline in value of bonds for any of the major combatant countries. This was even after the assassination of Duke Ferdinand which was the root cause of the war. Historians have often suggested that war was inevitable in Europe at that time but the bond markets at that time thought differently. The signs may be present in hindsight, but that does not mean we can see them before the fact.

Perhaps markets have a hard time discounting a large event which had a low probability, or perhaps the markets were overly optimistic that diplomacy could save the day. We cannot say why there was not a strong reaction, but it is food for thought that we can be in a similar period.

Markets may not be able to effective discount those low probability geopolitical events we are seeing around the world. Certainly, there is little historical data which will point to what the markets will do during some geopolitical risks. We just do not know. So how do you prepare for these types of events? Most important is the realization that markets are less likely to discount what has not occurred regularly so that there should be less confidence in markets properly discounting these events. Low risk premiums do not mean that there are low risks. It may only mean that the risk we are facing have not been properly priced.

History provides us with many lessons. The greatest lesson may be that we will be surprised by those events which are unique and not generally countable even if they are reported on every day.