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Financial Times: Unfathomable task of getting to grips with geopolitical risk

Published: September 12 2006 03:00 | Last updated: September 12 2006 03:00

Five years on from the World Trade Center atrocity, it might be thought investors have a handle on geopolitical risk. The markets are in broad equilibrium, and talk is of humdrum matters such as growth and interest rates. There may be all kinds of menaces out there, from Iran to bird flu. But they are in the price.

Not necessarily. In those five years, I have sat through my share of lunches and conferences on geopolitical risk. The pattern is familiar. First, people argue over what the most likely or imminent threats are. Then, perhaps, they talk about how each individual disaster might play out. And then – nothing.

That is, there is no discussion of what practical steps investors might take right now in response to those threats. They cannot assign any useful probability to them, let alone a time. So they have nothing in their toolkit with which to address them.

There may be a psychological element here. The historian Niall Ferguson has examined government bond yields across Europe in the decades before the First World War*.

He found that investors’ sensitivity to geopolitical risk fell sharply in the period, and that spreads of Continental bond yields over UK gilts – the risk-free benchmark of the day – narrowed as the war approached.

This was in spite of warnings from financial commentators on the ruinous effect war would have on bond prices. It is also rather at odds with the fact that in the early summer of1914 the UK Treasury set up its first ever Cost of Living Index, on the explicit premise that war was imminent and its inflationary effects had to be measured.

Why investors should have remained like deer in the headlights is an interesting question. Perhaps it was the herd instinct, or the sense that the game was up, whatever they did. But the subsequent 40 per cent plunge in bond prices reminds us that an event need not be in the price just because it is in investors’ minds.

Need it be like that? Let us look at a couple of other industries which might do it better – insurance and oil.

Insurers are in the business of quantifying risks andpricing them. But when weturn to geopolitics, the results are meagre. Lloyd’s of London recently thought it worth a press release that one of its member firms was offering a policy against avian flu. On closer inspection, it covers US farmers for having their flocks slaughtered – not quite the cataclysm one had inmind.

Or look at catastrophe bonds, which cover events such as hurricanes. But the point about such events is that they recur, and thus present a claims history against which risks can be priced. When it comes to one-off geopolitical risk, it seems, the insurers are asmuch in the dark as the restof us.

What about the oil industry? Ever since the first oil shock of 1973, oil companies – with Shell in the vanguard – have drawn up scenarios incorporating geopolitical shocks to help them in their planning. But over the years there have been dissident voices, even within Shell, suggesting that whereas brilliant minds may have been bent to the problem, little has emerged in terms of concrete decisions.

Some would say this is not the point. Rather, oil executives make up stories about the future not because they are true, but because they are a form of mental preparation. That way, you can respond quickly to an event with some assurance that you have thought the consequences through.

Self-evidently, that should have attractions for the professional investor. But there is one key difference. Oil executives have a short menu of choices. In the end, oil must be found, wells must be drilled and refineries built. The only question is where.

Some portfolio investors, by contrast, have the option of doing nothing. Cash under the mattress may be the correct strategy. Others have no choices at all. What is the point of concluding you should sell all bonds, if you are running a global bond fund?

If this is a depressing conclusion, it is not meant to be. The awkward fact is that geopolitical risk is running at a high level, and the investment industry is not best set up to deal with it. The problem, it seems to me, should not be insoluble. If there are people out there with the answer, I would be glad to hear from them. Apart from anything else, I might want to hand them some of my savings.

*Economic History Review, LIX, 1 (2006), pp.70-112

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