Investment Insights: The ongoing conflict in Iraq - implications for investors

Friday 4th February 2005

For investors, the importance of the ongoing conflict in Iraq has waxed and waned since major combat operations, i.e. the conventional military war, ended in April 2003. Around April last year, as the conflict in Iraq appeared to be escalating in the face of insurgent attacks, it helped fuel investor concerns about rising oil prices and broader geopolitical conflict.

Concerns that Iraq was becoming a "quagmire" lead to obvious comparisons to the Vietnam war of the 1960s and early 1970s. But, since the handover of political authority to the Iraqi interim government last June and as other factors appeared to be more important in driving oil prices, developments in Iraq have faded to background noise for most investors.

While this is not to take sides in the political debate over the Iraq War, and we don't profess to be experts on Iraq, the situation there appears to remain highly difficult and poses ongoing risks for investors. With the 30 January Iraqi elections looming it is appropriate to review what the situation in Iraq might mean for investors.

Signs of escalation

Over the past year, the Iraqi insurgency has steadily grown. The US has now lost 1,360 military personnel in Iraq with most of these occurring in the post-conventional war period. Attacks on Coalition forces and on Iraqi oil and gas facilities have increased significantly as have attacks on the Iraqi Security Forces and Shia muslim leaders.

In the face of the rising insurgency threat, the number of troops deployed in Iraq by the US and its Coalition partners (which includes the UK, South Korea, Italy, Poland and Australia) is now back to the levels of May 2003.

While it is tempting to conclude that the escalation in violence in recent months just represents an attempt to destabilise or stop the upcoming election, the same was said in relation to the increase in violence prior to the political handover last year. The post-election period may come with its own set of issues - particularly with indications that Sunni participation in the election is likely to be low. This may lead to questions about the new post-election government's legitimacy.

There are several parallels between the situation in Iraq today and the Vietnam War, including:

An aggressive US policy commitment - to hold back communism in relation to Vietnam and to hold back terrorism in relation to Iraq;

Limited global support for US policy;

In both conflicts the "enemy" is coming in the form of insurgents and terrorists as opposed to a conventional standing army;

Both South Vietnam and Iraq today suffer from poor local leadership; and

There was no clear exit strategy in either conflict.

However, there are some differences as well. For example, in Iraq the borders are relatively contained and North Vietnam also had a conventional army, which the Coalition does not face in Iraq.

Why the Vietnam comparison is a concern

The relevance of the comparison for investors is that just as the war in Vietnam was ultimately bad for investors, so too could be extended conflict in Iraq. The steady escalation of the Vietnam War through the 1960s contributed to a steady rise in US inflation (as easy money was used to finance the war via a US budget deficit blow out), a decline in respect for government and authority and increasing divisions in US / western society. Ultimately, this was associated with a surge in wage demands and a slump in profits. The outcome was that the Vietnam War was a major contributor to a secular bear market in shares from the late 1960s until 1982 (particularly if allowance is made for the high inflation of the 1970s).

If the conflict in Iraq continues to drag on it is quite conceivable that, like the Vietnam War a generation ago, there will be adverse economic effects, which will have negative implications for share markets. The US budget deficit is already a concern and just as in the late 1960s, shares are trading on relatively high price earnings multiples. These depend on inflation remaining low to be justified and profit margins are already relatively high and hence vulnerable. In addition, some would argue that an extended conflict in Iraq risks an intensification of the terrorist threat, greater instability in the Middle East and hence upwards pressure on oil prices.

The more sanguine scenario

Of course there remains other scenarios in terms of how Iraq turns out.

Firstly, while it is hard to be optimistic after the experience of the last year or so, it is possible to envisage a positive outcome in Iraq. Staging democratic elections in Iraq is a great achievement in itself and with a significant proportion of the population supporting them, it is possible that a strong government will be established, enabling Iraq to move forward and eventually allowing US and Coalition troops to leave. This is a relatively benign scenario for investors and would see Iraq fade further as an issue for investors.

Alternatively, the US could simply decide to cut its losses and leave Iraq in the face of a spiralling security situation or approaching civil war. Given the risks for stability in the Middle East and the oil price, it is hard to see the US simply quitting Iraq.

Conclusion

The cut and run scenario is not really an option and it is too early to conclude that Iraq is the new Vietnam. As such, our base case assumption is that Iraq will eventually be stabilised and that the US-led military commitment will gradually wind down over the next few years. But, given that the risks of an adverse scenario appear to be rising and the potential negative impacts this could have on financial markets, it is necessary to keep a close watch on the situation. At the very least, the ongoing situation in Iraq is likely to remain a risk factor for share markets over the next year. Key signposts to watch in this regard are the following:

A continuing high level of insurgent attacks;

Repeated failure of the Iraqi Security Forces to control the situation; and

The failure of a strong and legitimate government to emerge after the election.

While none of this is to enter sides in the political debate over the Iraq War, the reality is that the ongoing conflict in Iraq is posing risks for investors that will intensify if the conflict becomes protracted. So, the experience for investors associated with previous extended conflicts like that in Vietnam is worth keeping in mind.

Investment Insights is provided by AMP Capital Investors (New Zealand) Limited

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