War in Iraq, no help for US equities (page 3 of 3)

Moreover, the peace dividend following the end of the cold war was certainly a contributing factor to higher stock valuations around the world (declining interest rates and rising profits aside). If the world is now moving into an era of increased geopolitical tensions thanks to the belligerent, hawkish and arrogant Rumsfeld/Bush team, then this will be an additional negative factor for equity valuations.

Furthermore, it is very doubtful that the US has the financial means to pursue imperialistic policies around the world. The US increasingly depends on foreign capital flows to finance its excessive consumption and has, also, by now a negative net investment position. Until 1987, US investments in foreign countries exceeded foreign holdings in the USA.

However, over the last 15 years or so, the US net asset balance has deteriorated very badly with the result that foreigners now hold more than $7.3 trillion of US assets compared to US holding of foreign assets of around $5.3 trillion - which means a current negative net balance of more than $2 trillion, or 20% of GDP.

Now let us assume that the current account deficit does no longer grow but stabilizes at an annual rate of around $500 billion (the US current account deficit rose in the fourth quarter of 2002, 44% y-o-y to $136.9 billion or annualized $547 billion). In this case the US net asset balance will continue to deteriorate and reach around 50% of GDP in about 5 to 6 years time and 100% of GDP in approximately ten years time!

Now, I am not suggesting that it would be impossible for foreigners to boost their net assets in the US to 100% of GDP, but obviously the larger the percentage of US assets, which are held by foreigners, the more the US becomes vulnerable to the whims of foreign investors, and this not just in terms of the value of the dollar but also in terms of all asset markets, since foreigners hold approximately 30% of US treasuries, 13% of US equities and 23% of corporate bonds.

I must say that I admire the US government's ambition to be or to become an empire with such a poor net investment position to start with! If the historian Barbara Tuchman was alive she might include such imperial and military ambitions, at a time of the already existing huge US external imbalances, in her collection of 'follies of history'.

Given above thoughts, I doubt that the completion of the Iraqi invasion and the removal of Saddam Hussein's ruling party will lead to a sustainable equity bull market in the USA. More likely, the aftermath of the war will be painful and full of tensions in and outside of Iraq. This will, in my opinion, continue to weight on US equity and bond prices, and the dollar in the long term.

Still, the stock market rally, which began in mid March, may have some more life in the next few days, as April tends to be a seasonally strong month for equities. But after that investors will focus again more on poor economic fundamentals, high valuations, and increasingly on the threat of infectious diseases, such as SARS, which recently broke out in Hong Kong, brought the city almost to a standstill, and thereafter rapidly spread around the world.