ASSET CLASS: What Will War Mean For European Equities?
sg.biz.yahoo.com Friday January 24, 7:00 PM Of DOW JONES NEWSWIRES
LONDON (Dow Jones)--After a woeful 2002, the worst- performing year for equities since 1974, the question now facing investors is how to make money in 2003 given the likelihood of war.
Opinion is distinctly divided.
Some pundits see an outbreak of hostilities with Iraq as a likely catalyst to reverse the current grim mood. On the other hand, markets have never been particularly good at discounting political risk and recent heavy market declines could well get worse.
A view widely aired at the moment is that once war starts, a major uncertainty will be banished, giving the equities market an adrenaline shot.
Of course, central to this view is a fast win for U.S. and allied forces in invading Iraq to remove leader Saddam Hussein.
Historically, economic and political crises have been buying opportunities. Mike Lenhoff at Brewin Dolphin says that if, as seems to be happening, the increased likelihood of an invasion can push equities down, the prospect of a successful campaign can push them back up.
But many City of London brokers warn that any relief rally will amount to little more than a classic bear market squeeze.
Anais Faraj, strategist at Nomura, said that even though the outlook for 2003 as a whole doesn't sparkle, it is still wise to pepper a portfolio with a limited amount of risk in view of current geopolitical saber-rattling.
"Of course the best outcome for equities is no war at all, but I would anticipate a big spike up or a possible 20%-30% victory rally if there was a quick military resolution," he says.
However, Faraj cautions that there will be a huge surge in profit-taking once that 20% upside is achieved. He is advising clients to introduce some risk into their portfolios, since these stocks will likely see more upside, but to be aware that any rally isn't likely to be long-lived.
He prefers U.S. drugs group Pfizer Inc. (PFE) and European pharmaceuticals, saying that they look cheap at current levels, but would also hold defensive basic industries such as French cement maker LaFarge SA (LR) and aerospace group Thales SA (F.THL), which has a lot of government contracts.
Kevin Gardiner, strategist at CSFB, said his central case is that the war in Iraq occurs and will be quickly and successfully resolved. He estimates that the most responsive sectors to this scenario would include financials and cyclicals excluding the oil sector.
As a possible hedge, he highlights countries outside the euro zone such as Switzerland and Norway that are likely to have defensive currencies in the event of war with Iraq. Domestic plays in these currencies include Swisscom AG (SCM) and Den Norske Bank.
Oil Price Movements Key
Andrew Archer, oil analyst at Banc of America, believes oil price movements are key. He thinks that the war premium, which has driven the sector to record highs over the past two months, will unwind relatively quickly in the event of a war.
European benchmark Brent crude is trading above $30 a barrel after touching two-year highs in recent weeks. It spiked at $40 per barrel during the "Desert Storm" operation to liberate Kuwait during the last Gulf War in 1991.
"Governments have been building up strategic reserves in anticipation of a conflict in the Middle East," Archer said. "The release of U.S. strategic reserves on the first day of Desert Storm saw the oil price fall $10 a barrel. Hence as CNN showed pictures of burning oil fields, oil prices were falling."
U.S. strategic reserves amount to almost 600 million barrels. At the same time, any resolution to the general strike in Venezuela should drive down oil prices.
Investors may also have to grapple with the prospect of war being postponed or the Arab response if there is no United Nations mandate for a U.S.-led invasion. In this case, analysts say cyclicals would continue to underperform defensives.
Continuing strength in oil prices would then be a concern. Those sectors with the highest exposure to energy as a percentage of costs include chemicals at 60%, building materials at 20%-25%, metals and mining at 20% and cement at 25%.
Airlines would also be at risk - globally, 12%-14% of costs to the industry are fuel-related. Goldman Sachs recently cut estimates for five European flag carriers saying that, even before any war risk, 2003 is likely to see sharp capacity and cost growth against a background of stagnant demand.
Protracted War Still Possible
"What isn't priced into the market is a protracted war that disrupts oil supplies, which will have a detrimental impact on the G7 economies," said Philip Shaw, an economist at Investec Securities.
"The terrorist threat is also impossible to quantify," he added.
Khuram Chaudry at Merrill Lynch said the parallels currently being drawn in the market with 1991 are overdone. "The repercussion of a war will be far greater than the market currently anticipates and I would advise investors to remain overweight defensive assets such as bonds, utilities and oil," he said.
He favors European telecoms, which he says should continue to benefit from restructuring.
"Some perceived defensives may have a very cyclical spread around the globe. Hence investors should look to utilities that haven't grown outside their own market but should avoid pharmaceuticals," Chaudry added.
But even if there is a swift resolution to geopolitical tension, a regime change in Iraq isn't going to prove the miracle cure for European economies.
Although 2003 started off well, with the U.S. December Institute of Supply Management Survey hinting that manufacturing activity could be edging toward recovery, macroeconomic data since then have failed to live up to expectations. Overall, the global economic complexion depicted is one where growth remains subdued.
The outlook for earnings also raises questions as to whether the market can break out of its negative three-year trend. Technology giants Microsoft Corp. (MSFT), Intel Corp. (INTC) and International Business Machines Corp. (IBM) all rattled Wall Street with their lackluster forecasts.
Analysts at Dresdner Kleinwort Wasserstein say Federal Reserve Chairman Alan Greenspan's "economic soft-spot" thesis is too cuddly a description of the current economic picture. "Economic wasteland," would be more apt, they suggest.
They remain underweight equities and believe the outlook for the rest of the year is turbulent, whatever happens in Iraq.
-By Maria Daly, Dow Jones Newswires; +44-20-7842-9308; maria.daly@dowjones.com