The Long View: Not the time to panic

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The return of terrorism to the streets of London is a reminder that geopolitical risks have not gone away.

It is almost a surprise, given Britain’s close alliance with the US and its involvement in the Iraq war, that attacks had not occurred in the UK before. It was becoming tempting to believe that the focus on terrorism had shifted to Iraq and that groups al-Qaeda were now incapable of mounting attacks in the west.

That illusion has now been dispelled. But the attacks, terrible as they were, did not match the scale of destruction of September 11. Nor did they involve chemical or biological weapons, as had long been feared.

The key issue for investors is whether these attacks will be a one-off, followed by another long pause, or whether they will herald a series of assaults on the transport system of the UK, or indeed of other countries.

The economic impact of a one-day attack will probably be limited. Some consumers may be deterred from making shopping trips to London for a while; some tourists may cancel their UK trips. This could make some of the economic data for July look rather depressing.

But most people will probably take the philosophical view that an attack could occur anywhere, at any time, and there is little to be gained from attempting to avoid them. That would change, of course, if the attacks turn out to be part of a series. As the latest retail sales surveys have shown, UK consumer sentiment is already fragile.

However, global investors may have to get used to the idea of the occasional terrorist atrocity, just as Britons got used to IRA bombs in the 1970s and 1980s and tourists to Spain have not been put off their beach holidays by ETA attacks. Barring any further attacks, markets will probably regain their composure within a few days.

Terrorism is the classic example of an “exogenous shock”, a threat that emerges from outside the system. These events are almost by definition impossible to predict (if they were expected, they would not be a shock). But it is still worth considering some of the other possibilities.

At the end of last year, I thought a potential shock for 2005 would be a US attack on Iran. This was because anti-Iranian rhetoric was stepped up in the aftermath of President Bush’s re-election.

It has not happened – yet. The US has left the task of dealing with Iran to the Europeans, perhaps because it has its hands full in Iraq. But the underlying problem still remains. Iran is unwilling to abandon its nuclear programme, especially after the election of a hardline president; the US does not want Iran to develop the atomic bomb. This could still be a problem in 2006 or 2007.

And while we are in the Middle East, a further danger is revolution in Saudi Arabia. King Fahd is in poor health; there are large numbers of unemployed young men in the kingdom; there is a tradition of religious fundamentalism; and the government is a specific target for Osama bin Laden.

The potential for conflict in Iran or Saudi Arabia leads directly to another possible shock – a spike in the price of oil. Had you told people a year ago that oil would be hovering around $60 a barrel, they would have predicted much more adverse economic effects than we have seen. But that is not to say that economies would not struggle were oil to reach, say, $100 a barrel. Such a spike could occur were supplies to be disrupted in either of those two huge Middle Eastern producers.

While we are in worrying mode, there are concerns about the potential for a global pandemic, particularly of bird flu. The Sars panic in Asia showed the potential economic disruption that can be caused when only a limited epidemic occurs. Some even say we are overdue a flu pandemic, given the attacks after the first world war and in the 1950s. I am no epidemiologist but I would be careful about taking this analysis too seriously. If one wanted to devise conditions in which disease could spread – an exhausted, starving population, mass exodus by refugees – then the conditions of 1918-19 could not be bettered. History is not doomed to repeat itself.

A more man-made shock could come from a resurgence of protectionist sentiment. US senators keep complaining about China’s “unfair” exchange rate and there are still rumbling disputes between the European Union and the US over issues such as aircraft subsidies.

A trade war would be disastrous, as the 1930s made abundantly clear. At the moment, it looks as if politicians realise this but are still inclined to make nationalistic noises to impress their constituents. Let us hope it stays that way.

There is always something to worry about. Each of the risks mentioned above has only a small probability. And it is worth remembering that markets and economies surmounted two world wars, a great depression, stagflation and all the rest of it during the 20th century.

For the moment, it looks more likely that the greatest threats to the market are endogenous, in other words within the system.

The US house price bubble might pop, leading to a slump in consumption in the world’s largest economy. The same result could occur if the Federal Reserve tightens monetary policy too far. If the Chinese economy (which is highly export-dependent) slowed at the same time, we could be pushed into global recession. And the E, faced with sluggish productivity growth and dismal demographics, could slip into deflation.

All of these risks mean that investors should own a healthy dollop of cash (which now earns a decent return in the UK and the US) and some government bonds (both index-linked and conventional) despite their low yields.

But the worst may not happen. Usually it does not. So this is not the moment to be abandoning the stock market in panic.

philip.coggan@ft.com

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