Why Iraq is bad news for financial markets (page 2 of 2)

Thus, today, the ownership by foreigners of US Treasuries, corporate bonds, and equities is more than twice as large as a percentage of GDP as it was in 1984 - not an insignificant point when appraising the future of bond prices amidst a US dollar bear market, as Bridgewater seems to forecast. It is, to my mind, doubtful that foreigners will continue to increase their already very significant exposure to US bonds, which are now offering very low yields, if the dollar is going to weaken much further.

Another point I believe to be relevant when comparing the 1984-1987 bond bull market and the present situation is that, at the time, Paul Volcker was Fed chairman. By contrast, we now have monetary policy makers such as Alan Greenspan and Mr. Bernanke at the helm, who are much more likely to tolerate higher inflation rates than Paul Volcker would ever have done.

Lastly, it should not be forgotten that crude oil prices tumbled between 1985 and 1986 from more than US$30 to less than US$12.

Now, I am not suggesting that oil prices couldn't decline once again, but a decline of this magnitude seems highly unlikely given both the rising oil demand we have in Asia and how badly the occupation by the coalition forces is going in Iraq, which will be unlikely to lead to significant oil exports from Iraq. At the same time, the cost of the occupation is almost certain to increase the US fiscal deficits for some time to come.

I have been highly skeptical about the invasion of Iraq. I have subsequently received several hate emails for having the audacity to question the war, so I have decided to refrain from making any additional comments. Now, if the US is indeed engaged in a guerrilla war in Iraq (and by all accounts, it certainly looks that way), victory won't be easy.

The problem with guerrilla wars is that the enemy isn't visible, and so, unless the local population almost unconditionally supports the occupying forces, guerrillas can easily hide among and seek support from the local
population. Claus von Clausewitz describes in his classic work 'On War' (first published in 1832) that any 'attack which does not lead to peace must necessarily end up as a defense. It is thus the defense itself that weakens the attack. Far from this being idle sophistry, we consider it to be the greatest disadvantage of the attack that one is eventually left in a most awkward defensive position.'

This is exactly where the coalition forces find themselves now - in a very awkward position. Not only do the minority Sunnis oppose the occupation, since in a reconstituted Iraqi government they would be outnumbered by the Shiites, but it is likely that some more radical elements of the Shiites with the support of Iran will fight the occupation, which, according to some well-placed sources, will lead to an American attack on Iran sometime early next year. In any event, it is doubtful that the occupation will be over soon.

The situation into which the coalition forces have boxed themselves in Iraq is potentially far more serious than the financial markets are giving it credit for. It could, if it deteriorates, not only have implications for the budget deficit and President Bush's chances of being re-elected, but also for geopolitics, since one can safely assume that both the Russians and the Chinese (who are becoming increasingly dependent on Middle Eastern oil) have little interest in seeing the Americans succeed in their endeavor.

As a result, I believe that the risks in US financial assets remain high and that the US dollar, US bonds, and US equities are vulnerable to a large number of potential negative factors, which could disappoint investors, if not in the second half of this year, then in 2004.

So where should investors get their chips into play? I continue to believe that commodities including gold, silver as well as industrial commodities are the place to be. I would, therefore, buy mining companies (Newmont Mining, Placer Dome, Inco, etc), oil and oil servicing stocks (Exxon, Royal Dutch, Diamond Offshore), and even some basic stocks (International Paper, Dow Chemical).

Rising commodity prices will also be favorable for countries like Indonesia, Malaysia, Thailand, Russia, Brazil and Argentina. All these purchases could be hedged to some extend by shorting the sectors, which will suffer from rising interest rates and commodity prices. These sectors include the interest rate sensitive financial sectors (banks, sub-prime lenders, consumer finance companies) and US homebuilding stocks, which are up fivefold since 2000!