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Economy slows to beat of war drums

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Treasury Secretary Paul O’Neill unquestionably was correct this week when he said the debate over going to war in Iraq is not an economic question. Who can argue with his logic that freedom is priceless? But with war appearing increasingly likely, the economic consequences already are roiling financial markets and eating into growth projections for next year.

At least two major brokerages downgraded their expectations for U.S. growth and corporate earnings next year, and both cited a likely war in Iraq as one of the major factors. The direct cost to U.S. taxpayers, estimated at anywhere from $50 billion to $200 billion, is only a small part of the story. The real cost is being measured in the potential impact of higher oil prices, lower consumer spending, declining business confidence and a cloud of uncertainty hanging over the stock market.

“No one knows exactly how much of an impact it would have, but clearly it’s negative for economic growth,” said Sung Won Sohn, chief economist at Wells Fargo. “If we had a magic wand and could get Iraq off the worry list, we would see some strength in the stock market. Not only are we facing uncertainties, but if something goes awry it’s going to be a lot more costly.”

Bruce Steinberg, chief economist of Merrill Lynch, agreed. He lowered his GDP growth forecast for next year to 3.3 percent from a previous forecast of 3.8 percent, assuming a quick victory over Iraq early in the year that results in only a brief spike in oil prices.

“Clearly, events could proceed otherwise,” he said in a conference call with clients. “If Iraq managed to shut down even part of the flow of Saudi or Kuwaiti oil, prices would spike to as yet unseen heights and a double-dip recession would ensue.”

He stressed that Iraq probably will not be able to disrupt oil supplies and said “excessive pessimism is unwarranted.”

“There are no deep-seated flaws in the U.S. economy,” he said. “Interest rates are extremely low, inflation is non-existent, and productivity growth is stupendous. Strong U.S. growth will be the eventual result.”

But that eventuality is getting pushed further and further into the future.

Rough September for Stocks
On the stock market, September is living up to its wretched reputation, as the upcoming third-quarter earnings season shapes up into a huge disappointment. With just one trading day left, the Dow Jones industrial average is down more than 11 percent for the month, its worst performance since last September. Analysts now expect the nation’s biggest companies to show only a 7.3 percent increase in earnings this quarter, rather than the 16.6 percent projected three months ago, according to First Call.

Salomon Smith Barney cut its overall corporate earnings estimate for the second time in six weeks, reflecting projected GDP growth of 2.7 percent next year, rather than the 3.4 percent previously expected.

“Energy spikes or unexpected consequences from the Middle East conflict pose potential event risks that would likely lead to a worse outlook than our new baseline view,” economist Steven Wieting said.

To be fair, the Middle East conflict could be resolved more favorably as well, and an all-out war still could be avoided, said Tobias Lefkovich, chief institutional equity strategist for Salomon Smith Barney. He pointed out that oil prices plunged and stock markets soared when the first shots finally were fired in the 1991 Gulf War.

“It may not be as negative as most people assume,” he said. “We’re in the era of uncertainty, and that’s the struggle we’re going through.”

Some financial bright spots
Even in the midst of the economic gloom there are financial bright spots, led by the robust housing market, which shows no signs of losing momentum. As mortgage rates fell to their lowest levels in more than 30 years, the government reported that new-home sales surged to a record rate in August. Sales of existing homes dipped, signaling that the long real estate sales boom may be near its peak.

Consumer sentiment is still falling, but more slowly than many analysts expected, and orders for durable goods likewise fell less than expected in the latest month. But confidence could take a hit next week when the crucial September employment report is released. Many analysts expect the economy to show a decline in jobs for the first time in five months.

Time for a rate cut?
It all adds up to increasing pressure on the Federal Reserve to fire some of the few rounds left in its monetary bazooka, as two central bankers advocated this week in a rare dissent from the policy backed by Chairman Alan Greenspan.

Steinberg predicts Fed policy-makers will ease credit at each of their next two meetings, in November and December, bringing the benchmark federal funds rate down a half-point to 1.25 percent, a rate not seen since 1961.

Economist Ethan Harris of Lehman Bros. predicts the Fed will cut the rate to just 1 percent by the end of the first quarter, and he said the stock market will respond — eventually.

“I think the stock market is stuck in a depressed range here for a while,” he said. ” I don’t see any collapse or recovery.”

After the shocks of 9-11, the wave of corporate scandal and now a possible war in Iraq, investors need some reasons for optimism, and that will take time, Harris said.

“I think we’re still in healing process,” he said. “I don’t see any reason to be bullish right now.”