The financial markets will re-price substantially within a month based on the progress of Iraq’s disarmament. The re-pricing could start even sooner if the U.S. releases the Strategic Petroleum Reserve (SPRO) before the Iraq war. After that, investors can expect a constructive reflation process in the second quarter, adding to economic growth and corporate earnings. I say adding to because the economic picture has been getting much brighter of late.
The U.S. economic data for January was strong. It included: a 3.1% increase in durable goods orders, a 0.7% increase in industrial production, a 5.7% unemployment rate, a record 6.1 million home resales, a 1.3% increase in non-auto retail sales, and a 0.9% increase in core producer prices. This comes on top of 2.8% growth in 2002 and very low interest rates and inventories.
The U.S. tax-cutting process now underway is critical to current and future U.S. growth. The value of the tax cut is even bigger than its direct growth-impact in that passage would increase the chances for future growth-oriented changes in the U.S. tax code. Yet the tax cut is uncertain. Under present conditions, President Bush may not be popular enough, or have enough time, to push a pro-growth tax-cut through Congress. But Iraq is a key variable. Solving Iraq soon will allow the tax cut to become the next battlefront. Solving Iraq will also remove uncertainty in the stock market.
It is increasingly likely that a U.S.-led “coalition of the willing” will enter Iraq in March. This would reduce uncertainty substantially, causing a re-pricing in financial markets. At that point, equities and the dollar will strengthen, oil prices will fall, and interest rates will rise across the maturity spectrum (including bond yields, short-term interest rates, and interest-rate futures), with only the current federal funds rate lagging. In addition, the consensus of economic forecasts for U.S. and global GDP will rise toward this optimistic outlook.
The Bush administration could help things along, too. In 1991, the U.S. waited to release the Strategic Petroleum Reserve until Operation Desert Storm actually started. This meant that it was selling oil into a declining oil price. If Bush releases SPRO in the next few days, however, it would trigger most of the favorable re-pricing at that time because it would reduce some of the uncertainty in the outlook.
War-related market re-pricing is often substantial. On November 7, 2001 (the day before Kabul fell), the 10-year Treasury yield fell to 4.2% on the view that the Afghanistan war would be difficult. Within two weeks, the 10-year yield was at 5%. Two-year Treasury yields rose just as much, from 2.3% on November 7, 2001, to 3.1% on November 21.
Similarly, equity markets can re-price substantially based on new, positive information. The S&P 500 equity index rose 18% from January 15 to February 11, 1991, during the Gulf War. The U.S. recession ended that March.
Investors should also take into account that the market has already priced-in significant Iraq-related uncertainties that will decline when Iraqi disarmament begins. Extra Iraq-related terrorism risks (anthrax, dirty radiation bomb, nerve gas, attack on Israel) will peak when the war starts.
These clear Iraq-related uncertainties are enough to explain financial-market weakness today, and their removal will spell financial-market strength. The view that the weakness indicates an economic slowdown or equity overvaluation is a bearish view that’s way off the mark. Bush has said “weeks, not months,” and is showing no signs of wobbling. Investors should heed these words and stop wobbling themselves.
— Mr. Malpass is the Chief Global Economist for Bear Stearns.