t’s almost painfully clichéd to attribute every wiggle of stock market decline to “war jitters.” Whenever the market goes down, the media say “It’s the threat of war!” And whenever the market goes up, the media say “War concerns have eased!” If only it were that simple.
The conventional wisdom is correct that the market cares deeply about war prospects — but it may well be correct for the wrong reasons. For one thing, the market may be worried about the risk of not going to war with Iraq. War is a terrible thing, but it has upsides as well as downsides. And making matters more complicated, war has profound political implications — both good and bad — that may be more meaningful than the war itself.
This means that “war jitters” are pure uncertainty. They’re comprised of outcomes both bullish and bearish. This is borne out by the continuing resiliency of the riskiest sectors of the capital markets during the broad market’s decline this year. Stocks overall have delivered negative returns year-to-date, but high-yield bonds have moved higher. And within the equity market, the information technology sector and the Nasdaq have been astonishingly resilient — strongly outperforming the broad market year-to-date. If war risk were all downside, the riskiest market sectors would have taken it on the chin.
But the conventional wisdom treats the possibility of war as a deadweight cost. The risk of war is thought to include strictly negative concerns about direct economic consequences — the cost of the war itself, of possible disruption of oil supplies, of post-war reconstruction, and so on. Yes, such costs would be negative on face value — a tax on the global economy, as it were. But if we assume the likely scenario that a war would be brief and successful, then these costs are both forecastable and small in the grand scheme of things. The real downside risk is that the war will become a Vietnam-like quagmire.
But there is an upside, too. While I dismiss “broken windows” stimulus arguments about war spending, it may well be that bearing the costs of war will raise the net present value of the world economy considerably. A world without Saddam Hussein and his weapons of mass destruction would be a better place in which to do business for years to come, with the risk of terrorism reduced and oil supplies vastly more secure. While “doing nothing” always seems intuitively to be the less risky course, the market in its wisdom may in fact be worried about precisely that possibility.
A special case of the concern over costs has to do with the possibility of terrorist retaliations on U.S. soil. It’s easy to let one’s imagination run wild on this front. Dismal scenarios now range from suicide bombers in malls to nuclear bombs in major cities. The felt intensity of these imaginings may be out of all proportion to their small likelihood. But each does have some likelihood, and they must be downside risks that are already impounded in market prices. But it’s not at all obvious that staying out of war would decrease these risks. In fact, the putative purpose of going to war is precisely to decrease them.
The most important risk of war with Iraq is political. The prestige and influence of President Bush is intimately connected to the war on terrorism in all its aspects. As the war has evolved from the crisis atmosphere following the terrorist attacks of 9/11 to today’s seemingly endless, Hamlet-like decision process on Iraq, Bush’s once-enormous approval ratings have steadily declined. Before his State of the Union address two weeks ago they had fallen back to within 10% of their pre-9/11 levels. With the increasing sense of resolve following the SOTU and Colin Powell’s United Nations address, Bush’s poll numbers ticked up visibly. Now, as global anti-war protests threaten to erode that resolve and delay decision further, Bush’s approval ratings have ticked back down.
The president’s opponents understand very clearly that the best way to undermine him is to draw out today’s state of anxious waiting. The last thing they want is a war-time president — and probably a victorious president — pushing for the growth initiatives that could strongly turn the U.S. economy around by the elections in 2004. As long as the Iraq decision remains unmade, it can be used to crowd out all other initiatives while Bush’s popularity deteriorates. Once it is made, Bush will be — for at least a time and perhaps for a long time — politically invincible. With the kind of pro-growth initiatives that are on the table today, such an outcome would be extremely bullish.
So the domestic political risk entails a very wide spread of highly divergent outcomes. The downside is two more years of a muddle-through economy with the Democrats blocking Bush’s economic initiatives, and then another hanging-chad election with Bush running as a beaten man. The upside is a popular war-time president who can end the double-taxation of corporate income, slash top personal income-tax rates, and reform Social Security.
The market has declined in order to embed a risk discount appropriate to these uncertainties. But these uncertainties will resolve, and soon. Remember, President Bush is, to a large extent, in control of the timing decisions — and it’s not in his interest to wait much longer. The deep risk discount in markets, then, may be one that investors will be able to capture fairly quickly. And beyond that, we could see a political environment that will be extraordinarily favorable in terms of robust economic growth.