Threat of war weighs heavy on the markets

news.ft.com By Lauren Foster and Julie Earle Published: February 26 2003 20:21 | Last Updated: February 26 2003 20:21

These are unsettling times. US investor optimism fell to the lowest level in at least seven years this month and consumer confidence dropped to a nine-year low, both on fears of war with Iraq.

Last month, nervous equity fund investors withdrew $1bn more than they invested - the first January outflow for equity funds in more than a decade.

Adding fear to already jittery war nerves, Iraq released new information on its weapons of mass destruction, including a biological bomb. The disclosure further divided the United Nations Security Council over whether to back a US-led war against Iraq, which Washington is expected to be preparing for mid- to late-March.

Many investors are wondering if they should head for the exits. Vanguard, the second largest mutual fund firm, says it has had a significantly higher number of calls in recent weeks from investors worried about war and the economy.

So what could happen in the markets if war breaks out?

If the conventional wisdom holds true, war is good for stocks and the economy. Historically, stocks tend to fall in the run-up to war as investors reduce their holdings and allocate funds to "safer" or less-risky investments, such as Treasury bonds or gold. When the bombs start to fall, the saying goes, stocks rally. The adage is: "Buy on the sound of gunfire."

While many people believe this scenario will play out if the second Bush/Saddam showdown takes place, sceptics caution that Iraq is not the only reason behind the recent market malaise and once the war factor is out of the way, investors will once again have to confront the bleak underlying US and global economy.

In the three days following Iraq's invasion of Kuwait the Dow Jones Industrial Average dropped 6.31 per cent.

As the US began gearing up for Operation Desert Storm, stocks started climbing. Within four weeks of the campaign, the Dow gained 17 per cent.

"Once the war starts, it is not unreasonable to expect that investors could start betting on a favourable outcome. After all, the US is hardly the underdog. A quick decisive victory would create at least a temporary big rally," says Alexander Paris, chief economist at Barrington Research Associates, a brokerage and research firm.

But there are caveats: the success of the initial operations, the length of the war and whether the US is in Iraq as part of broad-based coalition that has the support of the international community or not.

"It is clearly different this time around," says Joseph Keating, chief investment officer of AmSouth Funds, referring to the Gulf war, which started in January 1991. "The last time, the US was pushing Iraqi forces out of Kuwait whereas now the effort is to bring about a regime change - this is a different ball game."

Providing there is a quick, successful turn of events, there should be a broad rally in the equity markets. "There is a lot of money sitting on the sidelines. There is a buyer strike out there right now," says Mr Keating. "Investors are waiting to get in."

Phil Dow, market strategist at RBC Dain Rauscher, cautions that investors should not expect "bluebirds and rainbows" once the war fears are taken out of the market. There is still North Korea, he says.

While stocks have been hammered, the debt market has remained strong. Frazzled investors have poured money into bond funds, which have had record inflows. But there is concern now that the bond market may fall apart because bond prices have gone up sharply, and their yields are falling.

US Treasuries, a traditional haven, would likely face a sell-off after the start of the war.

Gold funds have also seen strong inflows as the metal is often viewed as a hedge against war and other potential crises. But once the war is under way, the gold price is expected to fall.

The price of gold soared amid the panic buying just after the start of the Gulf war but fell when it was clear the war was going in the US's favour.

As for the oil price, that, too, should drop. In the last Iraq conflict, oil soared after Iraq's invasion of Kuwait but fell sharply once the war began.

In today's prices, the cost of a barrel of oil jumped from $23 in July 1990 to an average of $47 in October 1990. By February 1991, with the war under way, it was down to $25.

Mr Paris believes that if the war is concluded successfully - and Venezuela's production is back on track - the price of oil could be around $20 by the end of the year. "There is a war premium in oil prices," he says. "Take out the war and you take out the premium."

If Saddam Hussein uses a "scorched earth policy" and sets fire to the oil fields, the price of crude would soar. Some analysts are discounting a worse scenario: that the Iraqi leader could use dirty bombs to destroy the oil fields.

And what if the US goes into Iraq with only Britain and Spain on its side? Or Mr Hussein uses weapons of mass destruction? Or the conflict drags on?

"If the war goes badly, the West fractures and the Middle East explodes, obviously it will create more uncertainty and further disrupt economic activity and world trade," says Barton Biggs, global strategist at Morgan Stanley, in a research note.

"The price of oil will soar, delivering a lethal blow to the world economy. The result will be a worldwide recession and new lows in the stock markets. Cash, government bonds and gold will be the safe havens in a dark and dangerous world."