How will financial markets react to war?

In general terms, some argue the mere threat of war, and a subsequent outbreak of war, represent good times to buy shares because once the fighting is over, share prices are higher than before there was any thought of war.

However, such comments were made before the Vietnam War, which is the first war the US ever lost. War with Iraq, with or without United Nations approval, is getting closer.

This raises the question of what impact this war would have on financial markets.

In the Gulf War of 1990-91, sharemarkets took off when US-led forces attacked Iraq.

However, the situation is different this time. A war with Iraq now can be expected to have a greater and longer lasting impact on financial markets than the Gulf War.

In 1990 there was a marked, but only brief, increase in oil prices. Since the US was not seen as the aggressor, Arab states did not restrict production as they may well do if the US attacks Iraq now.

Secondly, a war now would be much longer than the Gulf War because the objective of regime change is much more difficult to achieve.

Thirdly, the risk of increased terrorism is high and long lasting.

According to Tom Cottam, head of research atvan Eyk Research, the likely impact on financial markets of war with Iraq will vary depending upon the probable outcome.

He says van Eyk has identified four possible scenarios:

1. Iraq dismantles any weapons facilities and war does not occur. This would lead to lower oil prices and would be positive for financial markets.

2. The US moves swiftly to successfully remove Saddam Hussein. In the short-term, gold and oil prices would rise, but they would later fall. This would also be positive for financial markets.

3. The war becomes protracted, but eventually the US wins. Gold and oil prices would rise. Bond and equity markets would suffer. Ultimately, the outcome would be positive.

4. The US loses the war, because, for example, China or Russia defend Iraq. This would be negative for financial markets.

Cottam says van Eyk considers outcomes one and two the most likely.

As recent events indicate that the US may be preparing to attack Iraq regardless of whether UN inspectors find weapons facilities or not, it would suggest that outcome two might be the most probable.

Dominic McCormick, investment consultant and chief investment officer of Select Asset Management, says a war with Iraq is a “near certainty”.

However, he says that because it is a factor that has been weighing on financial markets for some time, it has already been priced in to some extent.

McCormick also says that a war with Iraq is only one element of the overall problem of terrorism and that other fundamentals are also driving financial markets.

“Enormous damage has been done in some financial markets, but valuations are not yet at a bear market bottom because investors, particularly in the US, have not backed out in wholesale fashion.

“In the US, the sharemarket will not reach its bottom until investor sentiment bottoms and that has not happened yet,” he says.

Gold and oil prices

Fear of war generally leads to strong gold prices, and a possible war with Iraq is no exception.

Indeed Cottam says that should China or Russia defend Iraq in a conflict and it therefore promises to be a long-term war, van Eyk’s advice is to buy gold and go on holidays.

McCormick’s view is that you should look at the broader perspective rather than just the threat of war.

“Gold looks good because of global political instability as well. In a bear market, gold stocks tend to be negatively correlated with the sharemarket,” he says.

In order to take advantage of rising gold prices, there may be justification for buying the shares of gold producers rather than gold itself. Cottam says that the prices of selected gold shares could be expected to rise faster than the price of gold because of leverage. He adds that you should focus on gold producing companies that had not hedged gold prices and gives Lihir Gold as an example.

On the other hand, Cottam advises staying away from such gold producers as Sons of Gwalia because they hedge. McCormick also favours buying the shares of gold producers rather than gold itself, but did not wish to name particular companies.

The main reason oil prices are high and likely to increase further is that if there is a war with Iraq, there is a possibility that Arab countries will band together and restrict production.

Hence the more likely it is that there will be a war, the more prudent it is to invest in oil and other energy producers such as BHP, Woodside, Santos and Origin Energy.

On the other hand, oil price increases would negatively impact on companies in the transportation sector such as Qantas, Toll Holdings, Patrick Corp and Brambles.

Cottam’s view is that any restrictions imposed by Arab countries are likely to end when hostilities do because they need the revenue from oil, especially Saudi Arabia, which is the largest Middle Eastern producer. Saudi Arabia has had a budget deficit for a number of years and selling oil would be seen as preferable to the alternative of massive tax increases.

In addition, Iraq, which accounts for around five per cent of world production, would likely increase production after a conflict is over in order to finance its reconstruction.

Therefore, if a war is short, which van Eyk considers likely, oil prices would not remain high for very long.

Other effects of a war

A war would disrupt trade flows and tourism, which would have adverse consequences for such companies as Qantas and Flight Centre, and to some extent some exporters such as wine producers.

There would be concerns about global growth rates, which would lead to falling metal prices affecting such companies as Rio Tinto, MIM and WMC.

A war would bring an increased risk of terrorist activity. This would have a negative impact on the insurance sector, which may also suffer from lower investment returns.

It is also expected that there would be a decline in business confidence, which would affect investment plans and advertising budgets, which would impact on such companies as News Corp, Publishing and Broadcasting, Seven Network and Ten Holdings.

On the other hand, lower interest rates could be expected as central banks would not raise rates during a war and may ease them.

However, interest rates in the US are already at a 41-year low and there is not much scope for reducing them further. This is in contrast to the Gulf War when interest rates in the US were eight per cent when Iraq invaded Kuwait. The US Federal Reserve subsequently cut rates eight times to six per cent by the time fighting finished in March 1991.

In the event of war, bond yields would fall because of a flight to quality investments, meaning banks, property trusts and other interest rate sensitive sectors, such as infrastructure, would outperform the market.

Although there are some effects that may be able to be predicted with confidence, McCormick warns that war would have a complicated outcome, and that investors shouldn’t lose sight of fundamentals.

“You have to look at the broad context of bull and bear markets,” he says.