Prepare for financial meltdown

Investors need to wake up we may be heading for a financial meltdown. So says Niall Ferguson, the Scottish professor of history at Harvard, who draws an ominous parallel between today's markets and conditions prior to the financial collapse triggered by the outbreak of World War I in 1914. It was the "first great age of globalisation", he says in Time. Trade was expanding rapidly, growth was steady amid low inflation and interest rates, commodities were up, emerging markets were booming and volatility was historically low. "Sound familiar?"

Stock and bond markets barely budged when Archduke Franz Ferdinand was assassinated on 28 June. Only three weeks later, when Austria demanded access to Serbia to investigate alleged Serbian sponsorship of terrorists, did financial markets twig that war was not just possible, but certain. The selling happened so suddenly, and on such a scale, that only by closing stock exchanges could a complete meltdown be avoided; the London exchange was shut until January 1915. It should have been clear to investors what damage war could do to stocks and bonds, but "it's as if investors didn't want to factor in [the likely war between Germany and Britain] until it was upon them", Ferguson told Barron's.

And just as the smart money of 1914 was blind to looming disaster, so the smart money of 2007 seems to have tuned out geopolitical risk. Ferguson points to buoyant stockmarkets, minuscule spreads between US Treasuries and junk and emerging market bonds, and the recent trend of declining volatility in stock, bond and foreign exchange markets as signs of complacency.

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While a world war may be unlikely, a major conflict in the Middle East is a possibility, given the disintegration of Iraq and ongoing tension between Iran and the US. A withdrawal from Iraq by the US today's overstretched global policeman, a role Britain was playing in 1914 could make the country as violent and unstable as central Africa in the 1990s, reckons Ferguson. A geopolitical shock, such as conflict in the Middle East, could well cause such a liquidity crunch that stockmarkets would have to close. Investors today are as complacent as their great-grandfathers. "We might one day look back and say God, the origins of the great Middle Eastern War of 2007 were very obvious'."