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Don't Expect War in Iraq to Trigger a Market Rally
Last uploaded : Saturday 5th Apr 2003 at 14:48
Contributed by : A.Kim Fustier



By listening to the stock market gurus in late March, the temptation was great to think that all we needed to get badly battered stock indices back on the upswing was a quick war. War with Iraq would finally lift the uncertainty that had been heavily weighing on the markets for months, and would also spark a decline in oil prices, a big boost for Western economies, they argued.

Indeed, the initial market reaction in the days following the breakout of the long-awaited Iraqi conflict was a strong rally, as investors were betting on a quick and easy war. Both the Dow Jones and the S&P 500 surged on an eight-session streak, while weekly gains for the Dow were the biggest in more than 20 years. Many analysts and economists were already optimistically drawing comparisons to the gains made during the 1991 Gulf War. But as the grim realities of the war suddenly hit home on the first weekend of the war, stocks saw the year?s biggest slide, wiping out all gains from the recent run-up. Skeptical traders took advantage of the short-lived bear-market rally and went back to profit-taking, thus causing the ?war euphoria? to vanish just as rapidly as it had appeared. Although this return to sanity felt like reality-check time for some, it ought not to have come as a major surprise.

One reason is that the ups and downs of the war with Iraq have little to do with the actual state of the world economy. There are still poor economic fundamentals to overcome. Japan has been teetering on the brink of recession for a decade and the outlook for recovery does not look good. The Eurozone -and especially Germany, which accounts for a third of the Euroland?s GDP-has run out of steam and consumer confidence there remains shaky. Forget about increased government spending in the EU, since the stability pact limits the scope for fiscal expansion. The other lever of economic policy, i.e. monetary policy, is already bumping against the buffers: consumer price inflation is rising, which could deter central banks from further cutting interest rates.

In a slow-growing global economy, U.S. companies won?t be able to count on demand in Europe and Japan to compensate for a weaker domestic market. Investors and lenders are still worried about the reliability of corporate governance and accounting statements, which has made capital more scarce. Therefore, business sentiment remains soft, and executives continue to cautiously hold back investment. Moreover, many U.S. companies are still trying to reduce their debt, a strain that has discouraged new capital spending.

Another reason is that current market valuations don?t leave much room for hope, as the excesses of the Internet bubble still have to be worked through. Weak corporate profits do not make for attractive deals, either. Price-earnings ratios are hovering around 15 in Europe and 22 in the U.S., and those ratios are considered to be only fair value, about their long-run average.
True, oil prices -the only variables affected by the war in Iraq that can have a significant impact on the global economy and financial markets- are likely to fall. Thus far, Iraqi oil fields have not been seriously sabotaged and oil production has not been disrupted. However, swapping the ?war premium? for a ?victory discount? may be somewhat premature. Strikes by oil workers in Venezuela and political unrest in Nigeria have cut supplies.

At the same time, demand remains strong, spurred in part by higher imports from Japan, which has had to shut down some nuclear-power plants. OPEC does not have enough spare capacity and inventories are not sufficient. This will not offset the positive effect of the unwinding of the war premium, but it can mean that crude-oil prices will not drop as sharply as expected.

So if the strike on Iraq will probably not result in a quick rebound in the economy and the stock market, how can the impact of the war be characterized? While strategists continue to stress that the focus should not stray from the fundamentals, it is nearly impossible to get the war out of investors? minds. Plus, with trading volume light on many days, daily swings can be amplified and stock prices have less to do with usual business fundamentals. At some point, they will notice that Iraq does not have much to do with companies? earnings and the overall business picture. They will see that the ?uncertainty? and fears of a terrorist attack have not caused consumer spending to fall off a cliff.

But that point hasn?t arrived yet. For now, waiting dominates the market mood, as investors prefer to wait and see how Iraq turns out. This lack of direction explains why each relief rally has faded even more rapidly than the previous one. Stocks nowadays seem to be moving in sync with the latest news from the battlefront, with a nervousness that reflects the underlying fear of getting left behind.

What we are seeing these days are short, sharp moves in the market, not a sustained rally. We should not anticipate a return to a bull market anytime soon -war or no war.

A. Kim Fustier is a student at the HEC School of Management in Paris.


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