U.S.: A Drawn-Out Conflict Will Pound the Economy, Prolong the Slump

Last week, as TV images depicted impressive explosions in Baghdad and American troops rolled easily northward, relieved investors drove U.S. stocks up by more than 8%, putting the major indexes into the black for the year and sparking hopes that the three-year bear market was over.

 

But then, after a weekend of discouraging images and reports of dead and captured American soldiers, the mood soured. When the markets opened Monday, stocks plummeted by more than 3.5% and the dollar had its biggest drop against the euro in eight months. U.S. Treasuries had their biggest gains in six months as investors sought safe havens.

 

Clearly, war was the biggest factor to affect investor sentiment in the first days of fighting. A March 3-10 survey of 223 economists by the National Association for Business Economics found that 40% cited war and domestic security as the main threats to the economy, up from 3% last August.

 

But will it continue to be the chief influence on the financial markets and economy? To what extent has the anticipation of war influenced the markets in recent months? How will the markets, and the underlying U.S. economy, react to different outcomes – a resolution in mere days, a battle that goes on for weeks, or a quagmire that drags on for many months?

 

“Two things have happened,” says Wharton finance professor Jeremy Siegel, speaking Sunday night, March 23, after the stock market rally but before the drop the next day. “First of all, markets always pattern themselves after the most recent event that looks the same, which would be the Gulf War 12 years ago, where there was a huge rally … The markets went into a repeat mode of that, propelled upward by early successes that exceeded expectations.”

 

Among the most favorable early signals were the small number of oil-well fires and the lack of a major terrorist strike against the U.S., he said. The easy going of the first days diminished the importance of what had earlier looked like a serious setback, Turkey’s refusal to allow coalition forces to use its bases. The market’s upward movement snowballed as short sellers bought frantically to cover their positions, he said. “I think the market went to a price that represented a very optimistic scenario. When we look at the whole world picture, I would say it’s been a good first week.”

 

After a weekend of less encouraging news, he predicted the market pullback that came the next morning, with many traders rushing to take profits. “I think the market is saying this should be wrapped up, or close to wrapped up, in three to four weeks. If it’s not, then you’ve got more downside.”

 

A resolution within that period could drive the markets up by 10%, he suggested, but much will depend on the number of casualties, the nature of the Iraqi surrender and the form of government installed.

 

“You should always get back to basic principles,” added Wharton finance professor Marshall Blume. “What drives the stock market is corporate earnings and uncertainty about those corporate earnings … If war creates a disruption to world trade, that will clearly impact corporate earnings in this country. If it does not lead to disruption of world trade, and things start to move along as they normally would, then it won’t have any impact.”

 

The war in Afghanistan, he noted, had virtually no effect on the U.S. financial markets and economy. “Why? They don’t trade with anybody. But now we’re dealing with big players, and if the world oil supply were disrupted, that could have a very deleterious effect on corporate earnings in this country.” While oil prices fell dramatically during the first days of fighting, it is too soon to be sure that oil supplies won’t be impacted, in Iraq or elsewhere, he said.

 

With a heightened prospect of rising fuel prices and falling trade, American companies have been tightening belts rather than spending on new equipment and employees. Indeed, oil prices soared in the months prior to the war, while unemployment continued to rise.

 

“I think most small and large companies alike have basically deferred all major capital spending,” noted Wharton management professor Raphael H. Amit, suggesting that this will not change until war worries are over. Consumers, too, are showing signs of anxiety, he added, pointing to shrinking auto sales and reports of lackluster retail spending. Many Americans are worried about gasoline prices, their lost investment value and the prospect of losing their jobs.

 

Confirming that, the Conference Board reported March 25 that consumer confidence sank in February to the lowest level since October 1993. “Lackluster job and financial markets, rising fuel costs, and the increasing threat of war and terrorism appear to have taken a toll on consumers,” said Lynn Franco, director of the Conference Board Research Center. “This month’s confidence readings paint a gloomy picture of current economic conditions, with no apparent rebound on the short-term horizon.”

 

As Amit put it, “There is an enormous amount of anxiety. When people are anxious, they will defer buying a new car.” The automobile industry is critical to the health of the U.S. economy. “People are also not making other consumer durable purchasing decisions and that has affected the availability of jobs.” Thus, worry about the war is likely to prolong the economic slump by undermining both business and consumer purchases. This year, he added, Wharton students are having a hard time finding jobs. “Many companies are just not coming to campus, let alone hiring.”

 

Amit, too, said the markets had priced in a quick victory, and that the markets and economy would suffer if the war drags on, casualties are high, Iraq uses weapons of mass destruction or there’s an adverse impact on oil prices. “That scenario can easily bring this economy – the U.S. economy and the economies of the West – into a recession that could last for a while.” He considers that outcome possible but, for the moment, not probable.

 

Franklin Allen, finance and economics professor at Wharton, warned that even if the war is over quickly, the economy and financial markets face grave underlying problems. “I think the basic problems are different from the war. The war is kind of a sideshow.” The very high level of debt carried by consumers and corporations, and the growing federal budget deficit, reduce the prospects for the spending increase that’s needed to spur an economic rebound.

 

According to Allen, many consumers and corporate executives have stepped up borrowing in the belief that the economic problems are temporary, and that incomes will rise to make debt payments more affordable. But there may be more fundamental, long-term shifts in economic conditions from factors such as greater competition from low-cost countries like China.

 

The U.S. economy could slip into a period of deflation, he cautioned. As that drives down wages and corporate earnings, it would become harder and harder for individuals and companies to pay their debts. The war makes the economic situation more precarious, he added, noting that even if the war were not a factor, he expects the U.S. economy to further deteriorate  by the end of the year.

 

The Federal Reserve, having cut short-term interest rates to 1.25%, is running out of room to use rate reductions to stimulate the economy. Still, said Amit, the government can use fiscal stimuli such as increasing government spending and reducing taxes, to give consumers more spending money. “There are a lot of levers the government has other than monetary measures,” he added. “They will reduce, but not eliminate, the impact of a prolonged war with many casualties.” Among the key industries hit hardest by war concerns are all those that are dependent on oil, including automobiles, chemicals and airlines, he said. The airlines already have been deeply undermined by high fuel costs and a decline in both business and personal travel.

 

Even if the war ends well and soon, that’s no guarantee of a rebound in the financial markets and economy, Amit predicted, noting that technology industries, among others, are still suffering the aftermath of the bubble.

 

“Tech spending and all of those other problems are still there,” Siegel added. Even without the war, American companies are worried about competition from China and other low-cost countries. And as energy and other factors drive up manufacturing costs, companies have not been able to raise prices, he said. Industrial production has declined for 18 straight months.

 

In the first days of the war, oil prices dropped from the high $30s to the low $20s. “Oil prices were definitely a problem,” Siegel said. “Now, if it gets down to $24, gasoline prices will slowly come back. That’s a very favorable factor going forward.”

 

He expects first-quarter figures will show the economy growing at an annualized rate of 1.5 to 2%. Without war worry and winter storms, which pushed up energy prices and kept consumers away from stores, growth might have hit 3 to 4%. Hence, he believes the economy could return to a respectable 4 to 5% growth rate in the fourth quarter.

 

A survey of 67 economists by Bloomberg News found that most expected growth to slow down in the first half of the year because of the war. They said it would pick up in the second half. The median prediction called for a sluggish 2.5% growth rate for the year and an employment rate hovering around the recent levels just under 6%.

 

“The earnings bounce-back from the recession had been lousy,” Siegel said. “It hasn’t been the spurt that we have all been waiting for. The market is getting a little nervous and a little tired.”

 

There are, however, some hopeful signs, he added. “A successful prosecution of this war will do wonders for consumer sentiment, I think, increasing spending. But, of course, it’s a high-risk situation.”

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