Why Iraq is bad news for financial markets

A word of caution: The September to November period is seasonally a weak period. Expectations in the US are now an extreme and reflect a very optimistic sentiment about an economic recovery and higher stock prices directly ahead.

Any disappointment could lead to a sharp sell-off or even a crash, which would temporary strengthen the bond market. A new high in the bond market appears, however, to be most unlikely.

I have recently taken a negative view about bonds... despite the almost universal consensus that bond markets around the world had reached a bubble peak and would from now on decline. The so-called 'reflation trade', which most strategists are advocating, implies that the selling of
bonds and the purchase of equities is the way to play of the day.

Recently, however, I received a study by Ray Dalio and Jason Rotenberg of Bridgewater Associates, an institutional economic service I highly recommend, which pointed out that whereas the twin deficits - the budget deficit and the current account deficit - exploded in the period from 1983 to 1987, and in the process weakened the US dollar, bonds continued to rally from their secondary lows in 1984 (the major low was reached in September 1981) until 1987.

Bridgewater doesn't buy the argument that the present bulging twin deficits, each of which will soon reach around 5% of GDP (a record, I might add), is necessarily be bearish for bonds. The Fed has the means to create sufficient liquidity to support bond prices and simply let the dollar slide in order to make the necessary adjustments.

Since I religiously read the research papers published by Bridgewater Associates, I did some thinking about whether bonds could resume their 22-year bull market and confound the consensus, while the dollar weakened much further. In the process, I discovered some important fundamental differences between the present situation and the economic conditions that prevailed in the 1984-1987 period, which permitted the bond market to rally while the dollar was tumbling.

First, when bonds began to rally in the fall of 1981, they had completed an almost 40-year bear market. In addition, the 1983-1984 renewed weakness in bond prices saw the yield on government bonds spike up once again to over 14%, whereas inflation had by then already declined to less than 4%. Thus, in 1984, bonds had an unusually high real yield, as the investment community still believed that inflation would reaccelerate at any time.

In other words, in those days, inflationary expectations were extremely high, because investors were conditioned by the highly inflationary 1970s during which it appeared that there was no end in sight to rising commodity prices and inflation rates.

However, when commodity prices continued to decline between 1984 and the summer of 1986 and the CPI declined to around 2.5%, while at the same time the Producer Price Index was briefly deflating, bonds staged a huge rally, bringing yields down from above 14% to less than 7.5%. Now, however, it seems to me that the very high inflationary expectations of the early 1980s, which led to record-high real interest rates on long-term bonds, have been replaced by widespread complacency about future inflation rates and, in fact, fear about outright deflation.

Another point that should be mentioned is that, whereas until 1987 the US had a positive net investment balance (it owned more assets abroad than foreigners owned assets in the US), this has today been replaced by a negative investment balance, which amounts now to around 25% of GDP and is currently growing by around 5% of GDP.

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!