ECONOMIC IMPACT OF THE WAR WITH IRAQ

September 24, 2002

1. Economic Outlook Depends On Oil.

2. Will The Saudis Be With Us Or Against Us?

3. Bush's New Policy On The Middle East.

4. British Provide More Evidence On Iraq.

5. Stratfor On Economic Impact Of Oil Spike.

6. Investment Implications & Recommendations.

With each passing day it looks as though war with Iraq is just a matter of when, not if. As the political dissention fades, new concerns are emerging with regard to the possible economic impact of a protracted Iraqi conflict. As I will discuss below, any economic chaos we may experience from renewed Middle Eastern military action will not center on Iraq but rather Saudi Arabia.

It is a common misconception that war is good for the economy. It is more accurate to say that some wars are good for some economies. As it stands now a war in the Middle East could further damage the global economy. The resulting increase in oil prices could be disastrous, IF they remain high. That's the key. There are two models: the Gulf War Model and the Militant Saudi Model.

The Gulf War Model

The Gulf War Model is a known quantity. We have the benefit of history to know the effects and outcomes. I can remember feeling the same way then as I do now. There was a great deal of uncertainty regarding the impact of the war since the US economy was already in a mild recession. Talking heads and politicos everywhere were certain that oil prices were going through the roof.

Oil prices rose dramatically in anticipation of the war and equity prices fell off sharply. However, Saudi Arabia stepped up exports to offset any oil production lost as a result of the action against Iraq.

Once the war began and it became obvious that there would not be a significant interruption in the flow of oil to the West and Japan, nor a protracted conflict that could devolve into a Vietnam-like quagmire, oil prices fell to near pre-war levels and the equity markets came roaring back.

It is easy to make an argument that the same series of events is unfolding now. We are already seeing oil prices spike up in anticipation of an Iraqi conflict, and the stock market is in the doldrums. However, this time around there are some very important differences that are worth noting.

What's Different?

A lot, really. The good news is the U.S. economy is not technically in a recession as we enter into a potential conflict. It continues to grow at a subdued but nonetheless positive rate and inflation is nowhere to be seen. However, the weak level of growth could turn negative with little provocation, so the strength of the economy is not a large advantage this time around.

The bad news is we are in a turbulent post-bubble equity environment where Treasuries are now peaking. Capital and corporate expenditures are weak with corporate profits falling. Investor confidence has been shattered and a near total disconnect has emerged between the economy and the markets. The dollar is weakening; a housing bubble may be forming; and an activist FED is moving to head-off deflation.

Taking these factors into consideration and applying the effects of the Gulf War Model (short-term spike in oil prices), the outcome is not good. In this event, the economy may continue in its current malaise but without further significant deterioration. However, the economic effects of a spike in oil prices could also be the catalyst to send the economy into another recession.

Another difference is in the nature of the military operation. In Desert Storm, the objective was to drive Iraq out of Kuwait. Taking out Saddam Hussein was never the goal, even though many suggested doing so.

Any action against Iraq today will target taking out Hussein and his henchmen, which will mean taking the war all the way to Baghdad. The pursuit of Osama bin Laden has shown us how difficult it is to capture one man, and Hussein is likely to be just as slippery as bin Laden. In addition, military experts predict the fighting in Baghdad to be slow and costly in terms of US casualties.

From a military standpoint, this means more loss of life, more costly operations, and fewer pictures of Iraqi soldiers surrendering en-mass on CNN. There is little doubt that these pictures had a lot to do with re-establishing investor confidence during Desert Storm.

From an economic standpoint, it means that any spike in the price of oil could be more protracted than in Desert Storm, since it is less likely that a sense of total victory will be achieved as quickly.

Therefore, even with Saudi Arabia's support as in the Gulf War Model, the economic effects of a war with Iraq could be more protracted and severe than what we witnessed in 1990.

The Militant Saudi Model

The Militant Saudi Model is an unknown quantity. In many respects, it is the inverse of the Gulf War Model. Under the Militant Saudi Model oil prices will rise in anticipation of war with Iraq and equity prices will fall, as in the Gulf War Model. However, in this Model, Saudi Arabia will NOT guarantee oil production to the US and its allies, and may even convince other oil-producing Arab countries to join in their embargo.

In such a case, the spike in oil prices could be much more severe than in Desert Storm, even if it becomes obvious that the US will have no trouble toppling Hussein and replacing his absolutist regime with a democratic one. If Saudi Arabia reduces oil exports, this would plunge the global economy into recession, and be especially damaging to Europe and probably the death-blow to the beleaguered Japanese. If this happens, oil prices would remain high and could even trend higher, while equity prices could suffer further erosion.

When you factor in the state of our economy to this equation the result is negative to say the least. Sustained high oil prices could herald a return to the economies of 1972-74 and 1978-79. In a word, "stagflation."

As a practical matter, however, the ability of any OPEC nation to cut production too long is limited. These countries primarily have economies built on one thing -- oil. Reducing oil production would have almost as drastic an economic effect on these countries as it would to those countries which import their oil.

But The Saudis Are Our Allies, Right?

The Saudis were our allies during Desert Storm, but only out of necessity. Remember that they feared Hussein was coming after them after Kuwait, so self-preservation played a big role in their actions during Desert Storm. No such threat is evident this time around. (I could really go off on a rant here about Saudi Arabia harboring terrorists and supporting terrorism, but I won't.)

Over the past few months, you have probably noticed the on-again, off-again nature of Saudi support for action in Iraq. Ultimately, they will support such action, if only by not directly opposing it. In truth, the Saudi's couldn't care less what happens to Saddam. The war doesn't bother them. Its what comes AFTER the war that they are truly afraid of. That is, the establishment of a viable democratic government in Iraq.

A post-war democratic Iraq with UN sanctions lifted and renewed aide from the US could flourish and shift the balance of power in the Middle East away from the Saudis, thus giving the US a very strong hand in dealing with OPEC and the region in the future. This is to say nothing of the effect a free and prosperous Iraq would have on an oppressed Saudi populace, most of which still live in the 12th century by modern standards.

Couple this with the potential of increased oil production from non-OPEC countries such as Norway and Russia, and you get the kind of thing that keeps the Saud family awake at night worrying about.

Bush Administration Policy Toward The Middle East

The policy aim of the Bush administration, as outlined by National Security Advisor Condi Rice over the weekend, is a staggering departure from our current stance as this quote from the Financial Times illustrates:

"Reinforcing the Bush administration's message that the values of freedom, democracy and free enterprise do not 'stop at the edge of Islam,' Ms. Rice underlined US interest in the 'democratisation or the march of freedom in the Muslim world.' This could signal that the Bush administration is willing to impose a "Pax Americana" on the Middle East if necessary."

The Bush administration knows full-well the economic impact of the Militant Saudi Model. They know that the Saudis can't be relied on this time around. Which is why they won't allow it to happen. IF the Saudis take such drastic action, they will add themselves to the Axis of Evil. Have no doubt that the US will ensure the flow of oil to the West and Japan, by military means if necessary.

I think the Bush administration is taking the long view of the Middle East with this recent shift toward regional democratization. The pursuit of this policy could in and of itself bring about the Militant Saudi Model. Of course, it cannot be discounted that this is what the administration is seeking as a means to an end for establishing a new Middle East under a Pax Americana.

The Significance Of The Blair Dossier

As you may already know, the government of the United Kingdom has compiled an extensive dossier on Iraq and Saddam Hussein. The contents of the dossier center around the Iraqi quest for fissile material (nukes), current Iraqi weapons of mass destruction (WMDs) capabilities, and Iraq's aggressive program to conceal these capabilities.

The significance of this document is not in its minutia of detail. While both fascinating and alarming, the real significance of this dossier is simply in its ORIGIN. Had this dossier been prepared and released by a US intelligence agency, it could have been easily ignored by the international community, and the EU specifically.

The fact that the source of this damning evidence is a respected world leader other than President Bush is very powerful. That it comes from the Labour (left wing) government of Tony Blair is nothing short of astounding. Tony Blair is not viewed as a "cowboy" by the international community or the EU as is President Bush. Tony Blair is a liberal who has taken this position at tremendous political cost. With that in mind the following pronouncement from Tony Blair carries considerable weight:

"In recent months, I have been alarmed by the evidence from inside Iraq that despite sanctions, despite the damage done to his capability in the past, despite the UN Security Council Resolutions expressly outlawing it, and despite his denials, Saddam Hussein is continuing to develop WMD, and with the ability to inflict real damage upon the region, and the stability of the world."

This dossier diffuses the arguments that the US is merely settling old scores, cleaning up unfinished business, or pursuing a politically motivated witch-hunt. It serves to confirm US allegations and lends a valuable multi-lateral aspect to the case against Iraq and Saddam. With the case now being made on both sides of the Atlantic, military action against Iraq now looks virtually certain.

Conclusions

With the Brits now solidly onboard, the next step will be up to the Saudis. Clearly the Gulf War Model, with steady oil supplies to the West and use of their military bases, is preferable. Certainly the US will do everything in its power to make that scenario happen. However, the Saudi Royals may be so fearful of a democratic and prosperous Iraq that they choose the Militant Saudi Model. My military and geopolitical sources caution against assuming it will be the first scenario and not the second.

I think the Bush administration is taking the long view of the Middle East with this recent shift toward regional democratization. The pursuit of this policy could, in and of itself, bring about the Militant Saudi Model. The Saudis may have decided that it is only a matter of time before they, too, are in the crosshairs of the War On Terror. So it remains to be seen what the Saudis may decide.

Whatever the future may bring, it is relatively certain that the United States will suffer the least from the effects of the spike in oil prices. So says the widely respected Stratfor.com, one of my very best sources for global intelligence:

"Those who suffer the most [from higher oil prices] will be states that depend on heavy industry and those whose consumers have low levels of disposable income. Heavy industry is very energy-intensive, and consumer and industrial energy demands tend to be inelastic. Therefore, any increase in energy prices translates into a direct hit on the pocketbooks of industrialists and consumers. The knock-on effect from consumers is particularly sharp, since it reduces the amount of money consumers spend in all areas. The end result is that the non-energy sector is starved of sales and, therefore, funds. In short, high energy prices slam purchasing power across the board, lowering both standards of living and national output.

That means that developing states stand to be hurt the most by a war with Iraq. Almost all of the world's poorer states are deeply dependent upon heavy industry or have little to no disposable income -- or, in many cases, both.

Within the developed world, the United States will suffer least. It enjoys the highest level of disposable income of all the major developed states, and its dependence on heavy industry withered years before the dot-com boom materialized.

The United States also has four other critical buffers. First, it is the fastest-growing of the major economies, having racked up relatively steady -- if modest -- growth since the fourth quarter of 2001. During that time, Europe and Japan have remained in recession.

Second, as a proportion of national output, the United States spends less on energy consumption than do other industrialized states. Net imports account for about 1 percent of U.S. GDP, versus 1.5 percent for the European Union and 1.4 percent for Japan. The Organization for Economic Cooperation and Development estimates that the recessionary effect of high oil prices hits the EU approximately one-third harder than the United States.

Third, the United States is a major energy producer as well as importer. It produces 41 percent of its own oil; Japan, by comparison, produces 2 percent of its domestic demand.

Finally, and perhaps most important, U.S. dollars dominate the oil market. Since the dollar tends to do well in times of international crisis, other countries will suffer disproportionately. For example, while oil prices tripled in dollar terms from the beginning of 1999 to the end of 2000, they quadrupled in euro terms."

Investment Implications

The price of oil has already spiked to some extent in anticipation of war with Iraq. Crude oil prices soared above $30 on Monday, a 19-month high, and up from $20 per barrel earlier this year. I look for the price to spike even higher when the war comes about, and possibly spike higher than in Desert Storm depending on what Saudi Arabia does.

I also look for gold to continue to appreciate in value driven by the overabundance of global uncertainty. Bonds, too, will likely stay high during this time. Even long-term Treasuries may have further upside potential. However, long-term Treasuries are also likely to FALL HARD, as will gold, when it appears that we have won the war. That's the problem with this type of investment, they do well in times of global uncertainty, but tend to "fall off a cliff" when that uncertainty abates.

There is an alternative to buying and holding bonds. You can read my latest SPECIAL REPORT, "How To Own Bonds Today" by going to my website at www.profutures.com where you will see the Report featured on the home page. You will learn how one successful bond manager protects his clients by moving to cash if risks in the bond markets get too high.

Finally, equities are likely to stay low and trend even lower as the global effects of a spike in oil prices becomes more of a reality. As this E-Letter is written, it appears that both the Dow and the S&P 500 will close below their July 23 major lows. This is not good.

For most investors, this means exiting any index funds and concentrating on equity portfolios that can capitalize on good stocks or mutual funds whose prices have been driven down by the lower-trending markets. That means sticking to proven "value" managers and/or professional managers that use "market-timing" systems. You can learn more about professionals that use "market-timing" strategies on my website.

That's all for this week.

Wishing you a pleasant fall season,

Gary D. Halbert

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