By Norman F. Klopp, Jr., CFA, Partner

In late 2002, the stock market appeared to be building a base after the historic three-year-long bear market. Retail spending continued to drive the U.S. economy. Automotive and housing markets extended their strength.

But as the “war on terror” escalated and Iraq failed to respond to diplomatic and implied military pressure, questions about the timing, length, outcome and cost of the war changed consumer sentiment significantly.

The Conference Board’s measure of consumer sentiment that had hovered around 110 from February through May of 2002 plummeted to 62.5 by March of 2003. It was apparent consumers had choked, and corporate managements retracted.

Necessary assumptions

The prospect of war had, in our opinion, caused the economy to stall. In fact, the Federal Reserve Board plans to withhold economic predictions until the war in Iraq is over.

I am an investment analyst, not a geo-political analyst. But at our investment management firm, we must include geo-political assumptions as we manage client portfolios. As the early stages of the war unfolded, we believed that:

• The war would be short – weeks not months.
• Chemical weapons might be used, but their impact would be limited.
• The U.S. would be accepted as liberators by the Iraqi people.
• Damage to Iraqi oil fields would be limited.
• Human costs on our side would not be catastrophic.
• Related terrorist activity in the U.S. would not be extensive.
• Tangible evidence of chemical and biological weapons would be found in Iraq.
  

If these factors become reality, U.S. involvement in Iraq could be viewed as positive and there will be, we believe, a rapid and significant psychological shift in the U.S., resulting in the end of the economic “war stall.” The stage would be set for renewed economic expansion by the fourth quarter of 2003.

Double-dip recession?

If the war outcomes are predominantly negative, the stall could lead to the much discussed double-dip recession in the second half of this year, although we don’t expect that to happen.

But, we also cannot ignore the longer-term impact the war could have on our economy. For example:

• The post-war costs of stabilizing and rebuilding Iraq will increase our deficit. As an offset, if Iraq can increase oil production quickly, it will provide significant self-help in rebuilding.
• This war could begin a period of massive geo-political change in the region that would be very positive long-term, but require our stabilizing presence for a number of years.
• Those costs could jeopardize the size of the Bush administration’s pro-growth tax cuts and reduce that potential economic stimulus.
• The magnitude of this war defines a new parameter in the “war on terror” and might create a long-term conservative consumer attitude that could dampen economic growth. On the positive side, that could result in a long-term pay down of consumer debt, which is not necessarily bad.

Looking beyond

If the war goes as is generally expected, sustained economic expansion should resume late this year. Over the ensuing three to five years of this expansion, the growth rate of the economy could be more muted than if the war had not occurred.

We are often asked “what price will we pay for the war on terror?”’ Somewhat slower economic growth over the forseeable future might be the “price we pay.”

If you have questions or comments about this story, you may contact Norm Klopp at (216) 830-1135 or e-mail: nfk@mimllc.com