Are we heading for a 1914-style collapse?

Kathryn Cooper Sunday Times, London

A top historian sees parallels between today and the first world war — and he is not alone
THE FTSE 100 may be trading close to three-and-a-half-year highs, but some City analysts see storm clouds ahead and are even drawing parallels with 1914.

Niall Ferguson, professor of history at Harvard University, thinks that today’s investors have a great deal to learn from the events that led up to the first world war — and his ideas are gaining followers in the City.

Ferguson’s argument is that while analysts usually look to the Great Depression of the 1930s or the oil shock of the 1970s to understand impending crises, they should in fact be looking back almost 100 years.

While he does not suggest we are heading for another world war, he sees remarkable political and financial parallels between today and the period before the outbreak of hostilities in 1914. Then, as now, geopolitical risks were mounting against a benign economic backdrop of low and stable inflation.

The risks sound familiar: an overstretched empire; rivalry between two great powers, manifested in simmering tensions over trade; a rogue regime sponsoring terrorism. “The risks back then were like the risks today,” said Ferguson.

However, investors in 1914 largely ignored the rising political risks, and stock-market volatility remained low — as it is today. In fact, the financial press of the time did not even entertain the possibility of war until July 22, 1914, three weeks after the assassination of Archduke Franz Ferdinand and just days before war was declared.

When, in early August, investors finally appreciated the risks, the stampede for the exit was so great stock markets round the world were forced to close. The London market did not open again until the end of the year.

Ferguson believes that if the markets had remained open, the collapse would have been more serious than the Wall Street crash of 1929. He said: “That is one of the most important, but least understood, facts of financial history. Everybody assumes that 1929 was the big one, but 1914 was far, far worse.”

Although he does not suggest we are heading for another crash of that magnitude, he believes investors today are as complacent as their great-grandfathers.

Jeremy Batstone of Charles Stanley, a stockbroker, is one of a growing band of City analysts who share Ferguson’s concerns. He said: “We find it paradoxical that, in a world of rising, geopolitical tensions, financial markets have sailed to new highs with apparent insouciance.”

Stock-market volatility, measured by option prices, is at a nine-year low. The difference between yields on emerging-market bonds and US Treasury bonds — called the yield spread — is at its lowest since the mid-1990s, suggesting investors are happy to take on extra risk for little additional return. Inflation expectations remain low, despite soaring commodity prices. Oil hit a record $62.50 in New York last week, before settling back to $61.38 on Thursday.

Ferguson thinks this benign backdrop is at odds with the severe economic and political risks. One of the biggest economic dangers, he said, is the revival of protectionism in America in response to the influx of cheap goods from China. Politicians in the US have already proposed blanket tariffs on Chinese imports.

This risk has diminished in the short term after the Chinese revalued their currency relative to the dollar last month, making their goods less competitive, but tensions are expected to bubble up again.

There are also big political risks, according to Ferguson. He thinks the US, which he calls an “empire in denial”, is overstretched at a time when anti-Western extremism is proliferating.

Ferguson said: “There is a conflict between the financial signs — lower volatility and declining risk premiums — and all of this evidence that the world is as risky as it has ever been.”

The same kind of optimism abounded before the first world war. The period between 1880 and 1914 is known as the first age of globalisation, when improved communications and transport led to an unparalleled integration of global trade.

Volatility in international bond markets declined from the 1880s right up to July 1914, with the exception of Russia in 1904-5. Spreads between emerging-market bonds and consols, which were the benchmark gilts of the time, were also narrowing. And, in another echo of today’s conditions, yields were remarkably low despite rising commodity prices. The price of coal — the oil of the day — went up steeply between 1880 and the eve of war.

Against this optimism, political and economic risks were on the rise. There was growing rivalry between Britain and Germany, which manifested itself in tensions over trade. The British denounced German imports, just as American politicians complain of cheap Chinese goods today.

In another parallel, the British empire was overstretched, at a time when tensions in the Balkan states were mounting.

Ferguson said: “About 100 years ago, conditions were remarkably similar in financial terms to those we see today. It has become almost commonplace to say we live in the second age of globalisation, with the first being 1880 to 1914. Then, as now, there seemed many reasons not to worry. But that optimism in the financial and media worlds turned out to be catastrophically wrong.”

However, investors should not panic. There are more democracies in the world now, and warfare is less common. And even if there were a crash, investors with staying power could still make decent returns. While UK equities delivered a paltry 0.4% in real terms between 1915 and 1924, they gained 9.2% in the following 10 years — the second-best decade in the century despite the 1929 crash, according to the Barclays Equity Gilt study.

Even so, it is always worth having some exposure to gold and other commodities to hedge against geopolitical risk. You can get exposure to commodities indirectly through funds such as Merrill Lynch Gold and General or JPMF Natural Resources. Alternatively, you can buy shares that directly track the gold price through Gold Bullion Securities.

While Ferguson’s theory may seem extreme, there are plenty of analysts who fear that the current equity rally is looking long in the tooth.

Henry McVey of Morgan Stanley, the American investment bank, pointed out last week that the current rally, which started in March 2003, is the fifth-longest bull market since 1928. It is beaten only by the rallies of 1990-97, 1962-66, 1984-87 and 1950-53.

McVey’s research is based on America’s S&P 500, but David Schwarz, a stock-market historian, said the London market generally followed Wall Street: if the US rally is past its prime, the chances are that the FTSE 100 index is too.

McVey also points out that the current bull market has been driven by rising company earnings, and 60% of such rallies end with a recession. “When growth does turn south, investors should run — not walk — for cover because price performance after earnings-led bull markets is generally nastier than usual,” he said.

Alex Scott of Seven Investment Management also sees storm clouds on the horizon, although he does not think it is time to reduce equity holdings — yet.

He said: “As we drift through the lazy days of summer, it is easy to be lulled into a false sense of security over the progress in equity markets, particularly as we are close to four-year highs. In the bond markets, there is a greater sense of reality — yields remain low, pointing to slower growth ahead. As the economic cycle ages, it will become necessary to switch some equity holdings into bonds. While we are not there yet, we are on the lookout.”

He recommends a balanced portfolio of equities, bonds, cash and commodities, with increased bond holdings when the economic cycle finally turns.

 

Thanks for posting that. Everytime an economist/historian says something about the stock market, do the opposite.

Anyone remember Didier Sornette and his 'crash' predictions in 2003?

The fact that he was getting so much attention and even published a book was the biggest sign to go long.

Mea culpa: I myself was a cynic at that time for a long (and painful) time.

 

And add in there Gross, Fleckenstein, Grant... and let's not forget, as always, Alan Un-Ableson!

 

well there are several possible major macro events on the horizon-----if we can't see them, then we are currently looking in the wrong direction.

some of these issues are national and many are international that will pressure markets going forward--------

* Energy Costs/Shortages

* Currencies/Debt/Trade

* Geopolitical/Regional Instabilities

* Food/Water Quality/Shortages


just to name a few

 

great article. thanks.

 

Ahh... bliss.

fxskalper

 

every blue sky gets to see some rain once in a while----that is just the cycles of life.

 

Nothing new under the sun.......

 

This is called " takin a shot...why not " play....

This is an old time trick....find second party history parralels...sell to a nucleus of readers...if it hits...you appear to be smart...

In the brokerage industry....you are as good as your last trade...

Look how long Elaine Garzarelli played off her 1987 call....

People are so gullable....

 

everything is well.
no problems.
buy
buy