More 'experts' are mystified

They must never have heard of the gold price suppression scheme, nor even of derivatives in the bond and oil markets.

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What Crisis? Oil, Gold, Stocks
Show Investors Ignore World Risk

By Michael R. Sesit
Bloomberg News Service
Monday, August 28, 2006

http://www.bloomberg.com/apps/news?pid=20601100&sid=agYt1SK7yvdY

PARIS -- What you know can help you -- unless you ignore it, which appears to be how investors are treating growing risks of war, terrorism, and political unrest.

Between July 11 and Aug. 10 a terrorist attack killed 182 people in Mumbai, India; Israel invaded Lebanon; two unexploded bombs were discovered on German trains; the United Nations Security Council gave Iran, which has the world's second-biggest oil reserves, until Aug. 31 to suspend its uranium-enrichment program or face economic sanctions; and British police foiled an alleged plot to blow up airliners bound for the United States.

During that period the Dow Jones Stoxx 600 Index in Europe rose 0.5 percent and the price of oil edged up 0.5 percent to $74 a barrel. Gold, traditionally a haven in times of turmoil, rose only 3.2 percent to $646 an ounce.

To Bob McKee, those price changes show that investors are failing to account for the risks of a more dangerous world.

"Markets are not taking the dangers of energy-based political flashpoints seriously," said McKee, chief economist at London-based Independent Strategy, which advises more than 100 institutions, hedge funds, corporations, and governments on investments and asset allocation. "Institutional investors are often too short-term to cover themselves for geopolitical shocks, while individual investors with their retirement accounts are often too passive and long-term."

The result may be a more severe reaction in stock, commodity, currency, and bond prices when a truly catastrophic event occurs, according to McKee.

Tensions in the Middle East -- such as Iran's nuclear ambitions and the fighting between Israel and Hezbollah, a Lebanon-based Shiite Muslim militia sponsored by Iran and Syria -- pose the greatest risks to markets, according to George Magnus, senior economic adviser to UBS AG in London.

"While financial markets are quite accustomed to periodic conflict between Israel and the Palestinians, the recent fighting in Lebanon, the bigger political goals of other countries in the region, the widening of ethnic tensions, and the repercussions of the manner in which America extricates itself from Iraq all represent an escalation of those risks," he said.

Other hotspots include North Korea, whose nuclear ambitions may accelerate an Asian arms race, and Latin America, where Venezuela, Bolivia, and Ecuador are tightening control over their oil and gas industries.

A cease-fire took effect in Lebanon Aug. 14. The standoff between Israel and Hezbollah leaves Iran emboldened to pursue its nuclear program and champion Shiite Muslims throughout the Middle East, especially in Iraq, McKee said. Iran also is in a stronger position to threaten non-Shiite regimes in Saudi Arabia, Kuwait, and the Gulf states, which account for 51 percent of the Organization of Petroleum Exporting Countries' oil output.

Meanwhile, the confrontation over Iran's nuclear program may lead to a military strike on the country next year, McKee said. That could push oil prices well above $100 a barrel, he said. "Geopolitical risk will return with a vengeance," he said.

Iran said last week it's ready to hold "serious negotiations" on its nuclear efforts. The United States and France said the offer fell short of the requirement that it halt uranium enrichment.

Even so, financial-market prices don't reflect anything close to an apocalyptic scenario. Take the Chicago Board Options Exchange's Volatility Index, which measures the expectations for volatility that are built into the prices of options on the S&P 500. It closed last week at 12.31 -- 9.4 percent below its average for the year and roughly half its 23.81 yearly high on June 13, the day global stock markets bottomed after a monthlong selloff.

It's not that investors are unaware. While they might discuss geopolitical risks in bars, restaurants, and homes, those worries don't make it to the office, said Magnus.

Investors have difficulty pricing risks with which they have little experience, such as war, he said. "And most economists can't see much further than next quarter's gross domestic product or the central bank's next monetary-policy decision."

Translating geopolitical risk into an investment strategy can be so tricky that most investors don't try. The most-feared events may not happen, or may happen at a different time than predicted, Magnus said. On the other hand, a small bet may do little to stem losses if the worst occurs, he said.

"It makes no difference if you own 3 percent or 6 percent more bonds or equities than your benchmark," said Magnus. "If your worst fears are realized, the portfolio would still drop in value like a stone. It's almost an all-or-nothing portfolio decision."

That said, investors could buy oil futures if they thought Iran would trigger a global crisis, said Eoin Treacy, a strategist at Stockcube Research Ltd. in London. In an extreme case, though, "the only hedge is precious metals," he said. Other options include holding cash or loading up on Swiss francs, another traditional political hedge.

The world has been here before. Despite obvious signs that all was not well, financial markets were "pretty much priced for perfection" in the months leading up to World War I, said Magnus.

Even so, noted Harvard historian Niall Ferguson in the February 2006 issue of The Economic History Review, for decades prior there had been speculation about the potential financial consequences of a war between European powers.

Still, it wasn't until more than three weeks after the assassination of Austrian Archduke Franz Ferdinand on June 28, 1914, that the Times newspaper in London made the first mention of the possibility that a European political crisis could be a source of financial instability. Less than two weeks later World War I erupted, and European financial markets closed for the year.

"To investors, the First World War truly came as a bolt from the blue," wrote Ferguson.

Complacency's price proved steep. British government-bond prices fell 44 percent between 1914 and 1920. French bonds lost 40 percent. Russia defaulted on its debts, while the value of German and Austrian bonds was dissipated in hyperinflation.

The lesson, according to Magnus: "This might simply tell us that markets don't price worst-case outcomes until such time as they actually happen."

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