War in Iraq, no help for US equities

American and British military and political strategists were of the opinion that the local population would rise against Saddam Hussein's unpopular and despotic regime and that, therefore, the invading allied forces would be greeted with as much relieve and joy as the French population welcomed American troupes during the Second World War when they liberated France from the German occupation.

However, as one might expect, lacking any knowledge of history, these American strategists overlooked that, no matter how vicious a leader is, the invasion of a sovereign territory by a foreign force will always rally people around their leader and stiffen the resistance.

In fact, since the protagonists for the war against Saddam Hussein have repeatedly compared his viciousness to Stalin, they should have known how badly Hitler miscalculated when he attacked Russia in the belief that the Russian population would receive his troupes with open arms and support his 'liberation' of Russia from the yoke of Stalin - one of history's most ruthless leaders.

But, to the contrary, Hitler's attack led to one of the fiercest resistances in military history and the defeat of the invading German Wehrmacht, which really turned around the Second World War in favor of the allied forces. To be sure, I did not expect a repetition of the German defeat at Stalingrad in 1943 to occur in Baghdad, since the coalition forces had such an overwhelming military superiority.

However, as we now know from the looting and chaos, which followed the capture of Baghdad and other Iraqi cities, the problem may have been less the removal of Saddam Hussein than the maintenance of peace and order in future since for all practical purposes Iraq is now without any governmental authority at all.

Having spent some time in the Middle East, I am convinced that the Arabs will never tolerate an occupation by any foreign power for long and, therefore, I believe that the victory of the coalition forces in Iraq will be followed by a nasty, messy and factional guerilla war, which will drag on for a very long time and in the course mortally bleed the coalition and peacekeeping forces.

I remember well how I met a French member of the Foreign Legion in the 1960s on the Island of Corsica. He had fought in 1954 at Dien Bien Phu in Vietnam, and served during the Algerian uprising prior to Algeria gaining independence in 1962. According to him, his regiment was relieved when they left Vietnam and every legionnaire was looking forward to be stationed in Algeria, which they thought would be like a paradise when compared to the tough campaign and eventual hellish defeat they had experienced in Vietnam. But, this proofed to be an illusion.

He said the Algerian war turned out to be far worse than Vietnam, because the French troupes in Algeria never knew who was friend or enemy and, therefore, incurred tremendous casualties in continuously recurring ambushes, acts of sabotage, and raids on their camps.

In Iraq, there will be another complication since the country is composed of so many different ethnic groups who will all wish to gain some immediate economic and political advantages from Saddam Hussein's demise.

Moreover, it is likely that the Syrians, the Turks and the Iranians will in time also meddle in the affairs of their Iraqi neighbor, which is likely to bring turmoil to the region for a long time to come.

In short, while the coalition forces are sure to eventually win the battle for Iraq and to get rid of Saddam Hussein and his clan who may still put up some resistance at Tikrit, such a victory may not bring the expected stability and peace to Iraq and the Middle East, but lead to a series of unintended consequences, such as the possibility of an independent Kurdistan in the north of the country and guerilla warfare against the occupation forces of the coalition.

In fact, I should like to remind our readers that a number of economists and historians have observed the existence of 'War Cycles' in history.

The historian, Arnold Toynbee believed in a war-and-peace cycle as a consequence of a 'Generation Cycle in the transmission of a social heritage'.

He noted that, 'The survivors of a generation that has been of military age during a bout of war will be shy, for the rest of their lives, of bringing a repetition of this tragic experience either upon themselves or upon their children, and… therefore the psychological resistance of any move towards the breaking of a peace ….is likely to be prohibitively strong until a new generation…. has had the time to grow up and to come into power. On the same showing, a bout of war, once precipitated, is likely to persist until the peace-bred generation that has been lightheartedly run into war has been replaced, in its turn, by a war-worn generation'

Some other observers of cycles maintain that wartimes tend to occur when a certain 'climate' or belligerent mood among people exists. The famous economist Kondratieff established empirically that the periods of the rising wave (which are characterized by a rise in commodity prices and interest rates) 'are considerably richer in social upheavals and radical changes in the life of society (revolutions, wars) than are periods of downward waves'.

According to him, 'the upward movement in business conditions, and the growth of productive forces, cause a sharpening of the struggle for new markets - in particular, raw materials markets. On the one hand this makes for an expansion of the orbit of the world market and the involvement of new countries and regions in the trade network. On the other hand, it makes for an aggravation of international political relations, an increase in the occasions for military conflicts, and military conflicts themselves.

At the same time, the rapid growth of new productive forces, intensifying the activity of the classes and groups within, that have an interest in that growth, creates the prerequisite for sharpening the struggle against socioeconomic relations that are obsolescent and hinder development. It creates the prerequisite for big internal upheavals'.

I may point out that major conflicts such as the Napoleonic Wars, the Crimean War (1853-1856), the American Civil War, the Franco Prussian War (1870-71), the Sino-Japanese War (1895), the Spanish American War, the Russo-Japanese War (1905), the First World War, the February Revolution in Russia (1917), the Second World War and the Vietnam War all occurred in periods of the rising Kondratieff wave. And although the Kondratieff cycle is now only bottoming out, the increase in commodity prices we have seen over the last 18 months does suggest that the long wave has probably already started to turn up - at least as far as commodity prices are concerned.

So, if I combine the Toynbee's peace-bred generation - in our case the American in warfare inexperienced baby boomers - which are more likely to run 'lightheartedly' into war than their parents, since most of them hardly remember the Vietnam war, not to mention the horrors of the Second World War, and the rising wave of the Kondratieff cycle, we should be prepared for a more hostile and bellicose world in the years to come -regardless of how quickly the present military conflict in Iraq will be settled.

Moreover, while a rising Kondratieff wave has in the past led to a more belligerent mood, wars in turn also had the effect to create 'upside distortions' in commodity and wholesale prices, because wars tend to temporary push up demand for raw materials.

In sum, I think that investors should be aware that the late 1980s and 1990s were extremely unusual from a historical point of view since, aside from some minor conflicts, there were no major wars or revolutions. 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.