It is not yet clear what would be the impact of the current crisis on the region’s financial markets. It will all depend on the degree of the reprisal and the countries targeted. The normal reaction of markets to non-financial crises in the past has been a flight to safety away from the higher risk of equities toward government bonds, including US Treasuries and other sovereign European bonds. The Euro bond issues of the emerging countries would normally suffer and commodity markets will become more volatile.
In previous crises, the US dollar used to be the refuge currency, today a move out of the dollar into local currencies, as well as, the Swiss franc, the UK pound and the euro is likely to take place. It is expected that after the initial reprisal, calm will return to equity markets and prices may go back to pre-crisis levels. For those who have a stomach for risk, the current situation may provide a buying opportunity for medium to long-term investors.
For the global economy, the attacks last week on New York and Washington could not have come at a worse time. Both the US economy and the rest of the world (with the exception of pockets of growth in certain OPEC countries) were already very close to a recession. Over the coming few weeks, the expected drop in the value of shares that households around the world hold and with the rising fear of public places (e.g. shopping malls) consumer confidence could be undermined. The US consumer confidence for example, dropped from 101.7 in July 1990, just before Iraq invaded Kuwait to only 55.1 six months later (confidence now stands at 114.3). This was followed with a drop in consumer spending at an annual rate of 2.6 percent for six months.
No economic model could predict what the effects are likely to be. Experience from before suggests that a disaster like that of last week often has less impact than what was predicted at a time of the event. Between Aug. 1, 1990 when Iraq invaded Kuwait and Oct. 1, 1990, oil prices jumped from $20 to $40 a barrel. Over that 8-week period, S&P of the US stock market dropped by 11 percent, FTSE of the UK was down 13 percent, the French stock market lost 21 percent and the German 25 percent. All these markets surged to much higher levels in the following months after Iraq was forced to leave Kuwait. During the Gulf crisis, all Arab stock markets suffered and massive capital outflows from the region were recorded. However, those stock markets surged across the board in 1991, the first year after the crisis.
To dampen the initial effect of the crisis, central banks worldwide have been injecting liquidity in their respective financial markets. The Federal Reserve is widely expected to cut interest rates, with Fed Funds dropping to 3 percent from their current level of 3.5 percent. The European Central Bank is also expected to lower its repo rate by 50 b.p. to 3.75 percent. The trough of the current interest rate cycle is likely to be below these levels. Such as expansionary monetary policy coupled with higher public spending on construction and defense should support the US economy by next year. In the coming few weeks, as the first shock of the crisis starts to fade away, stock markets worldwide will stabilize and they may well assume an upward trend.
Oil prices that surged by four dollars a barrel following the attack on New York and Washington last Tuesday have now given back practically all of this gain. Major supply disruption could not be ruled out, especially if a large oil producer is among those targeted for retaliation. However, markets are now discounting the prospects of weaker demand associated with a much slower global economy. It is estimated that every 1 percent loss in expected global GDP growth reduces world oil demand by 400,000 bpd. Furthermore, oil demand will also be dampened by the drop in airline flights which make up 10 percent of America’s oil consumption. Oil prices are likely to trade to a slightly lower level in the fourth quarter, with an average for the year as a whole of $25 a barrel. The region’s capital markets will undoubtedly be impacted by developments in the US financial markets. Most Arab countries have their currencies pegged to the dollar, and a weaker dollar would help remove some of the pressure recently seen on the Egyptian pound and the Lebanese lira. Weaker exchange rates will also give a boost to exports and help support smaller external imbalances. Further decline in dollar interest rates would make it possible for the central banks and monetary authorities in the region to reduce domestic interest rates, thus putting in place a much needed expansionary monetary policy.
With threats of reprisal targeting certain Middle Eastern countries, a thicker cloud of uncertainty will hover on the region affecting aid, tourism, investment and capital flows to the area. The bond issued in the Eurodollar markets by governments of Egypt, Lebanon and Qatar, as well as, by Arab corporates are likely to suffer as international portfolios reduce their exposure to the region. Uncertainty will also reflect negatively on the local stock markets, as investors get out of the higher risk equities toward more safe and liquid instruments such as bank deposits. Again we consider the current situation as an opportunity to build long-term positions in equities in selective Arab markets based on positive mid year corporate results, especially in the Gulf and Jordan.
It is not clear whether some good will come out of all the recent developments or if the situation will deteriorate further.