War, inflation and investment strategy for 2003

In these troubled times for investors around the globe it is hard to find a theme on which to hang a theory about the future.

But step forward war and inflation. An expensive invasion of Iraq by a US led coalition looks more and more likely. Estimated cost? $100 million say Washington insiders.

Wars and inflation go hand in hand. War drives up demand while producing nothing. The Vietnam War sent prices spiraling in the 1960s and the accompaniment was a weak US dollar. In the absence of wealthy friends in the Middle East to pay for a war in Iraq then the USA will have to print money to pay for it.

Inflation will be the inevitable result. Now how should investors respond? Sticking money in the bank is suddenly dangerous, because money is losing its value due to inflation of the cost of goods and services.

Gold is surely attractive or gold mining shares. Indeed, gold spiked to a five-and-a-half year high this week. For investors are in a real dilemma as cash, bonds and equities all look equally unsafe. Even gold in euro rather than dollar terms is barely holding its own.

Real estate is one alternative asset class, although in most developed markets property prices are already sky-high and vulnerable to the high interest rates that will sooner or later become necessary to combat inflation and defend the value of money.

What is the rational investor to do? Switch cash holdings to a strong currency, the pound sterling or euro? It is not an easy call, and that threatens a further bout of instability in global financial markets in 2003. Rising inflation has always been the investor's worst nightmare, though some people do win.

Only those individuals with high levels of fixed debt and the means to service it will come out on top. For inflation erodes the value of capital debts as well as capital assets. So if you could buy a big house cheaply with a lot of debt that would make sense if you could handle the likely upswing in mortgage payments.

For 2003 investors face another year of severe problems and Merrill Lynch's house view that this will be a fourth year of decline for US equities looks realistic rather than pessimistic. Hopefully 2004 will be a year of recovery.