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Blame it on Iraq ... or not

The looming prospect of war in Iraq is beginning to catch a little too much blame for U.S. economic and financial market ills, some analysts believe.  By Martin Wolk
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Sure, the prospect of war in Iraq is depressing investor confidence and business sentiment. But some economists and analysts think Iraq is starting to get a bit too much of the blame for economic and market problems that will not instantly abate when the bombs start flying.

There is broad consensus that uncertainty over a possible war has sent investor sentiment plummeting and made businesses more cautious in their investment and hiring plans. After a two-day meeting of policy-makers this week, the Federal Reserve confirmed that “geopolitical risks” appear to be restraining business spending and hiring.

But not everyone is buying the argument that a quick and clean resolution to the Iraq crisis will pave the way for rapid economic liftoff and a new bull market.

“In general to me it seems that the war is an overplayed card,” said David Rosenberg, chief North American economist at Merrill Lynch. “Is it a source of uncertainty? Yes. But it’s not like the economy or stock market was a runaway train even before the war talk began last fall.”

Concern about the impact of war uncertainty has been rising especially since a stock market rally in the first few trading days of the year gave way to another dispiriting slide. The market rallied Friday to push the Dow Jones industrial average back above the 8,000 level. But the blue-chip benchmark still lost more than 3 percent for the month — a bad omen for those who believe January’s trend determines the market’s outcome for the year.

The Wall Street Journal this week cited estimates that higher oil prices and lower business investment are cutting U.S. output by about $75 billion on an annualized run rate, or three-quarters of a percentage point out of a gross domestic product that is expected to grow by only about 3 percent this year.

Jan Hatzius, senior economist at Goldman Sachs, said such an estimate is “much too high.”

“Our own view is that war fears are not a major reason for why the economy is soft,” he said in a report. “Instead, we think the ongoing balance sheet adjustments among households, corporations, and state and local governments following the equity bubble’s demise are much more important.”

Hatzius acknowledges that a war, which appears increasingly likely, could have a significant economic impact, especially if the outcome were not favorable for the United States or oil prices were to rise further. And he said war fears indeed have depressed stock prices and sent investors for safer havens including Treasury securities.

But he said geopolitical uncertainty probably is having only a small effect on business investment, chiefly on businesses with major operations in the Middle East, like oil firms. And he said the idea that consumer spending is being dampened by war fears is “far-fetched,” considering that even a direct attack on the United States in 2001 had only a limited impact on consumer spending.

Consumer confidence may be at a nine-year low, based on one survey, but consumer spending has hardly been stopped in its tracks.

Hatzius complained that some forecasters are using war fears as a “catch-all explanation for unexpected economic weakness.”

Certainly Iraq has been a convenient hook to hang the blame for an economy that ended the year with an unexpected relapse as GDP growth slowed to 0.7 percent in the fourth quarter, its poorest performance in more than a year.

The bullish case, if you can call it that, is that the looming Iraq conflict is dragging down the economy in three ways: by raising the price of oil, by depressing stock prices and through the uncertainty factor itself, which encourages businesses to postpone major investment decisions.

Lynn Reaser, chief economist for Banc America Capital Management, noted that even when the shooting starts uncertainty will linger until the war’s outcome is beyond doubt. Once the situation is resolved, stocks will rally and confidence will rise, she predicted. But the $10 trillion U.S. economy does not move quite so quickly.

“Is the Iraq situation a major impediment to business investment and hiring, or is it primarily an excuse?” she said. “If the Iraqi situation were solved, would the economy get back on track? That is the $64,000 question.”

Jeffrey Saut, the bearish (he calls himself “boarish”) chief market strategist for Raymond James, said the latest forecasts remind him of the weeks after Sept. 11, 2001, when many analysts who failed to predict the recession were quick to blame their mistake on the terrorist attacks. In fact the recession had begun six months earlier, and most economists now agree that the attacks had a relatively minor economic impact.

“The winds of war have been with us for six months,” Saut said. “Clearly it does have some impact, but I think the impact of the war is de minimus. I think the real problem here is the profits depression we have, the fact that our manufacturing base is being devastated — those kinds of issues.”

Corporate earnings actually appear to be staging a modest comeback, with the just-ended fourth quarter likely to be the strongest in more than two years, according to First Call. Based on the initial two-thirds of big companies that have reported, adjusted earnings are likely to be up about 12.1 percent over year-earlier levels.

But valuations continue to decline from the inflated levels of the bubble years, and executives generally have been gloomy about growth prospects for the year ahead.

Rosenberg said war could indeed be a “cathartic experience” that will provide a boost to consumer confidence and the stock market, but he said it will not keep the economy from its the destiny of a long, slow recovery, similar to the early 1990s, which featured its own Iraq war.

“When long booms are followed by mild recessions what typically happens is the recovery is mild as well,” he said. “It comes down to time and patience. … There are still some problems to be worked through. It’s a judgment call as to how far we are through this process.”

In the early 1990s, he cautioned, there was no real self-sustaining economic recovery until more than two years after the end of the recession.