HCMI Client Letter - February 4th, 2003
Limbo.
That's where we are
until the situation in the Middle East is resolved. In our January letter,
we commented that hostilities could break out on February 1st, the date of the
new moon. Some last minute political maneuvering and the need to position
additional troops and materiel has postponed the final assault to March
1st. It doesn't seem possible for any further postponements because that
would take ground fighting into the hot season. However, Special Forces
troops are already on the ground in Northern Iraq (the Kurdish zone) preparing
and extending runways, additional Special Forces are in the Western desert
region looking for Scuds, and US and Allied aircraft have been systematically
degrading Iraqi air defenses in the no-fly zones. Whether the US gets a UN
resolution authorizing force remains to be seen (France, which stands to lose
substantial oil contracts with Iraq in the event of "regime change", has
threatened to veto this resolution.) However, the US, in conjunction with
about 16 other European, Middle and Far East countries, appears prepared to move
forward with or without such a resolution.
What could go
wrong?
The consensus is
that the Iraqi armed forces will cave in weeks if not days. Iraqi forces
are at half their strength prior to the first Gulf War, yet the US military is
assembling an attack force almost as large as for the first Gulf War. This
attack force is substantially enhanced by the adoption of "smart bombs" in the
air force, and by considerable improvements in "command and control" technology,
which allows military planners to react to threats within minutes, not
hours. However, unlike during the first Gulf War, when Iraqi forces fled
from Kuwait after 100 hours of battle, these forces will be fighting on their
home territory. Hussein appears to be preparing a last stand in and around
Baghdad, which would work to the disadvantage of attacking troops.
Not only would these troops have to be careful about avoiding civilian
casualties, but fighting in urban environments tends to negate the US
technological advantage.
In the first Gulf
War, Hussein held back from using chemical and biological weapons after being
explicitly warned that such use would cause allied forces to continue with the
attack until Hussein was forced from power. This time around, Hussein has
nothing to lose, so we may well see a final spasm of these weapons flung against
troops, Kuwait, Saudi Arabia, Jordan and Israel. Hussein's government
recently issued chemical protection suits to members of the Iraqi
elite - this action doesn't bode well for most Iraqi
civilians.
The invasion may
well trigger al-Qaeda terrorist attacks (we've already seen hit and run
incidents against US troops assembling in Kuwait.) Indeed, if Bin Laden
wants to maintain credibility, al-Qaeda has to do something. However,
increased activity in terrorist networks increases the probability of
identification and disruption of these networks. Several dozen terrorists
were arrested recently in France, Germany, Britain, Italy and Spain who were
apparently preparing chemical attacks or assassinations.
Assuming that the
optimistic scenarios play out and Hussein is deposed, US and Allied troops may
well occupy Iraq for quite some time (US troops are still in Korea, 50
years after the end of the Korean conflict.) There is, at this point
in time, even less of a natural government in Iraq than in Afghanistan.
The presence of these troops and the imposition of a secular government in
Iraq may cause the destabilization of the governments of Iran
and Saudi Arabia as the theocrats of those nations lose power and
influence.
The price of a
barrel of oil could surge as high as $60/barrel on the outbreak of
hostilities. There's evidence that Iraq is wiring explosives to oil
wellheads and will set them on fire as in Kuwait at the end of the first Gulf
War.
What could go
right?
Many have criticized
the US for preparing to attack Iraq, while deferring the situation in North
Korea to diplomacy. The bottom line is that Hussein can be defanged now
while in a weakened state, and Iraq is relatively isolated from its
neighbors. Iraq has already transferred weapons and know-how to Libya and
Syria, and it's just a matter of time before these weapons are transferred to
terrorist networks. North Korea, by comparison, is readily able to hit
China and Japan with missiles (including some with, perhaps, nuclear warheads)
and is able to hit Seoul, the capital of South Korea, home to a million
civilians, with artillery. In the event of an attack against North
Korean nuclear facilities, plutonium dust would be sprayed across the region,
which would be a public health catastrophe. However, seeing the example
made of Iraq might make the North Koreans more sincere about their treaty
obligations.
Iraq, the second
largest reserve of oil after Saudi Arabia, currently produces only a third of
its potential output. Reconstruction of Iraqi oil facilities after the war
could stabilize the price of oil at $20/barrel or less. Although it's
popularly believed that this conflict is merely about oil, in fact, the US could
have had full access to this oil years ago simply by lifting the UN sanctions as
was urged by France, Germany and Russia. Lifting these sanctions, however,
would have allowed Iraq to complete the construction of nuclear
weapons.
Impact on US
stocks
After experiencing a
mild recession in 2001, the US economy grew 2.4% in 2002 (vs. 0.3% in 2001 and
3.8% in 2000) and is forecast to grow 2.5% in 2003. Inflation remains
tame, unemployment is higher than desired at 6.0%. Consumer spending grew
at a low rate for the quarter (reflecting dismal holiday sales and the effect of
the October dock workers strike.) Consumer confidence is at a 9 year low,
reflecting fears about the war with Iraq, an uncertain job market, expiration of
jobless benefits for many and an end to the refinancing boom. However,
business spending increased for the first time since the Q4 2000. We've
discussed in previous reports that investments in hardware and technology made
in the late 1990's to deal with Y2K and the Internet boom would have to be
replaced after three years on average - here's the first evidence that
businesses are making these new investments. Add in rock bottom interest
rates, and we'd expect GDP growth for 2003 more in the 3.5% range.
However, CEO's and CFO's are simply sitting on their hands and postponing
building new factories, rolling out new marketing strategies and hiring new
staff, probably until at least the second quarter, until we know where we stand
with Iraq. Investors, likewise are sitting on their wallets.
Normally cash flows into US equity funds during January as people invest bonuses
and fund retirement programs. This year, preliminary numbers indicate that
investors withdrew a small amount of cash from equity funds, while money market
accounts remain near record levels.
About 2/3's of
S&P 500 companies have reported earnings so far, with gains averaging 8.8% -
not bad, but disappointing compared to the 11.7% estimated a month ago.
Earnings for Q1 2003 are estimated at 8.3%, down from 10.9% on January
1st. Many companies have reported results substantially above estimates,
but have given no or bearish guidance for future quarters. At this point,
company managements want to aggressively low-ball expectations - the penalties
for missing estimates even by a penny are devastating to a stock price.
Even, with lowered expectations for earnings in 2003, the S&P 500 remains at
least 30% undervalued.
Impact on
European and Asian stocks
Investors are
selling dollars, buying Euros and Yen, which makes exports to the US more
expensive, and reduces demand for those exports. As a result, the France
is expected to grow 1.6% in 2003, Germany 0.8% and Japan 0.4%. US stocks
(S&P 500) remain 43.4% off the all-time high, but in Europe, stocks remain
off 57.4% and in Japan, off 78.6%.
Other
Issues
We'll explore this
in more detail in future reports, but the new budget proposal, with a sharp
increase in spending combined with an acceleration in tax-cuts, bodes ill for
future budget deficits.
Strategy
Stocks had a solid
rally in the first three weeks of January, which quickly dissipated as Iraq's
failure to cooperate with UN inspectors sharply increased the risk of war.
The major US averages fell 3.5% for the Dow, 2.7% for the S&P 500 and 1.1%
for the NASDAQ. Stocks are too cheap to sell at current valuations, but no
one wants to buy in advance of the war. If Iraq falls quickly, as we saw
in the first Gulf War and in the war in Afghanistan last year, stock could rally
15-20% pretty quickly. So we will sit on our current investments and stay
ready to invest new cash quickly.
Yours sincerely,
David Edwards, President
Heron Capital Management, Inc.
(800) 99-HERON
http://www.HeronCapital.com