Thursday, June 05, 2003
Gulf War II - an economic non-event?
Posted by David Smith at 09:19 PM
Category: David Smith' s magazine articles

The second Gulf War, or more accurately the campaign to depose Saddam Hussein, was over remarkably quickly, in little more than a month. Militarily it was a success, despite regrettable civilian casualties, but what about the economic impact?

Before the latest war with Iraq, the economic template was provided by the first Gulf war. Stock markets fell by around 20% following Iraq’s invasion of Kuwait in July 1990. They began recovering strongly with the onset of military action against Saddam’s forces in January 1991 and by the time of the ceasefire were around 10% above their initial level.

This time the pattern was slightly different. Markets embarked on a further downward leg in the autumn of last year, partly on war worries. These jitters turned into a fully-fledged sell-off in January and February, at the low point of which the London market was about a third down on its “pre-Iraq” level. The market recovery started earlier than in 1990-91, shares rising even before the bombs started dropping. Victory maintained the market recovery, although far less convincingly than in response to the previous Gulf conflict. At time of writing global markets were still between 10% and 15% below their autumn levels.

The oil market also responded differently. After Iraq’s invasion of Kuwait, crude oil prices rose to more than $40 a barrel, equivalent to $60 a barrel in today’s prices, before falling sharply in its aftermath, dropping to under $15 a barrel within a couple of years.

This time, oil’s response has been much more muted. Brent crude oil hit a peak of just over $35 a barrel and, like stock markets, began to move even before the fighting started, to about $25. But there was no immediate collapse in prices on victory. It may yet happen, and the betting remains on prices of under $20 a barrel by the end of the year. But those who expected a Gulf victory to bring the onset of a new era of very cheap oil have so far been disappointed.

Why, if the victory was quicker than many had feared, has the reaction – in markets and economies – been relatively muted? Mark Cliffe, chief economist at ING Financial Markets, put forward a “V for victory” view last autumn, in which equities and economic activity would weaken significantly ahead of the war but then recover sharply afterwards on reduced geopolitical uncertainty, lower oil prices and extra government spending.

The reason it has not happened that way, he argues, is because of the collateral damage incurred in the run-up to war. That includes the damage to relations between America and Europe, which could have knock-on effects for world trade. It also includes the relationship between the Arab world and America. What looked good to American viewers on CNN would have seemed like a humiliation of a fellow Arab country when viewed on Al-Jazeera or Abu Dhabi TV. This in turn raises the rise that one threat – from Iraq – has diminished, but at the expense of creating many more terrorist martyrs.

That does not tell the full story. The damage to US-European relations can be repaired, and in most respects the effect on Arab public opinion of the toppling of Saddam has been milder than many feared.

The real difficulty is that the war was not, nor ever could be, a panacea for problems that existed before the White House and the Pentagon embarked upon on it. Those problems are familiar, While many equity markets now look attractive in valuation terms, the market that everybody looks to for leadership – Wall Street – still looks dear to many investors. Only if they were convinced that US economic growth was about to rehearse the dynamism of the 1990s would there be a convincing case for driving the market sharply higher.

Instead, the prospect appears to be for what the Organisation for Economic Co-operation and Development, in a post-war assessment, describes as an “unspectacular” global recovery. That recovery may be somewhat stronger in North America and Britain than in euroland and Japan – where serious doubts remain - but it nevertheless looks to be some time before the world can begin to fire on all cylinders.

The best example of this is in business investment, which in Britain and elsewhere has been through a savage retrenchment, dropping 9% last year alone. The hope was that the removal of war uncertainty would release the logjam holding back corporate spending. Talk to any businessman, however, and they will give a long list of other reasons for maintaining a cautious approach, from lack of pricing power and the need to top up company pension schemes, to continuing economic uncertainties. It is a chicken and egg situation – businessmen won’t invest until they see stronger growth but stronger growth may not happen without that investment – and will not be resolved for a while.

We should not be too gloomy. Hindsight tells us that the first Gulf conflict, more than a decade ago, was followed by an instant return to growth and optimism. The reality was rather different. George Bush senior lost an election nearly two years after that war, partly because of continuing doubts about the economy. The build-up to recovery, and the roaring nineties for the stock market, took time.

History, in that respect, could yet repeat itself. Then, as now, though, we just need to be patient. After all, if wars solved all our economic problems, it would be a strange sort of world.

From Professional Investor, June 2003