The War Recovery Real or Illusory?

Now we have the sobering news that retail sales have dropped for the first time in years. Some of the problem is the reporting period, with the Easter holiday later this year, and the late winter storms in the Northeast and Midwest. Still, it suggests the consumer’s ability to sustain a recovery may be limited.

The Institute for Supply Management has reported a large drop in the service sector and that its index of manufacturing dropped to well below 50. A number below 50 indicated contraction in the sector. Auto sales are down significantly and the health scare from SARS (severe acute respiratory syndrome) and the war have impacted the airlines and the travel industry.

Although the economy remains under pressure, the hope is that a recovery will occur after the war with Iraq is successfully completed. The argument is that with the war over, oil prices will plummet and jumpstart the economy similar to what happened after the Gulf War. After the Gulf War the price of oil declined to below $20 a barrel and remained in the low $20 range for most of the 1990s. Lower oil prices had the effect of putting more income in the consumer’s pocket and strengthen profits for all industries except the oil and gas sector.

This time the price of oil is unlikely to drop to these levels. It is more likely to remain in the mid $20 to $30 range after the current conflict because of fundamental reasons. The current apparent over overproduction of oil (supply of oil greater than demand) is largely the result of a weak world economy. Contrary to the situation after the Gulf War, this time there is not the excess capacity or the ability to increase production, which is necessary to cause oil prices to drop significantly once the economy begins to rebound. It will not be until Iraqi oil production is back to normal, at the earliest late this year, that the price of oil will stabilize around the mid-$20 a barrel range and not until next year that Iraq production will be sufficient to drive prices to the low-$20 a barrel.

The outcome of the war is not in doubt and assuming the war requires only weeks before the Saddam regime is completely toppled; we can expect to see an increase in US investment and consumer spending. This will most likely be a short-lived situation. The successful conclusion of the war will not solve the underlying problems of the economy even with lower oil prices. Only time will gradually eliminate the excess capacity built up in the 1990s.

While the war will appear to have been easy, the peace will be more difficult and costly than suggested. Not everyone will support the US to run the country. Political and trade relations are strained with many countries around the world. We can expect attacks on US military and on oil facilities from Iraqi’s that are opposed to the US.

The assumption is that Iraqi oil will be used to pay for rebuilding Iraq. This will eventually be true but US aid will be necessary for several years before production is adequate to fully fund the recovery. The damage to the oil fields from the fires is unclear. What we are most likely seeing is gas burning, which reduces the pressure on the wells to pump oil. (See the simplified picture below.)

When oil is produced it includes some gas. This gas is separated from the oil. This gas has many uses but some is pumped into the structure from above to help in production. Water is also injected from below to push oil upwards into the producing zone. If the wells set afire are burning gas cap gas it could impact all the oil producing wells in the field, reducing oil production for some time. Other damage to wells and pipelines can also reduce production for months.

What is missing for a sustained recovery is an economic package of tax relief and government spending that would spur economic activity. What has been proposed so far will have little short-term impact and could create greater problems later. The central element of the economic stimulus plan seems to be to eliminate the tax on dividends. If provided as a tax deduction to the corporation as a cost of capital and treated as interest on loans it could have a significant impact on corporate investment. An alternative proposal floated, that the tax on dividends be capped at 18% would have no impact. To benefit a persons income would have to be well above $60,000. Those that would be likely to spend an additional after tax income would be excluded from a benefit. It would be better to allow a few thousand dollars of dividends to be deducted from taxable income.

There does not appear to be the relief for state governments that is needed to balance their budgets. This will be a continued drag on a recovery. The airline aid package will only provide temporary relief to the airlines. It would be better in the long run if one of the major airlines were permitted to fail. What would be left would be a healthier industry.

For all the reasons identified above, the recovery will be slow. Job creation will be insufficient to reduce unemployment significantly. Corporate profits will increase albeit slowly. The recovery will wait to see the results of the war in Iraq and if everything goes well a recovery could occur by early next year.

The Stock Market

The stock market defies reason. Investors seem to be ignoring the realities of the country's economic problems. Instead of worrying about a loss of their investments they seem worried about missing a war inspired rebound. Not a healthy situation.

While such an increase is possible, the staying power of such a move in the market seems doubtful. The price-earnings ratio for the stocks in the S&P is well over 20 and for the tech sector it is over 50 while the markets dividend yield is less than two percent. Companies like Siena Corp. and Corning Inc. as well as others are up in price while still expecting continued losses. With oil prices in the high $20 a barrel the consumers ability to spend and corporate profits will be eroded.

The outlook for the overall market is for continued decline in value. At the same time some stocks offer opportunities for investors. Oil stocks appear attractive, in some cases offering good dividends while awaiting an economic and stock market recovery. There are other solid companies with competitive dividend (over 4%) that should hold their value and return a reasonable return while awaiting a market recovery.

However, invest carefully and hold plenty of cash. Better opportunities await those who are patient.