QUARTERLY LETTER
Special Edition

Iraqnaphobia

We've received a number of questions on the effects of the Iraqi invasion of Kuwait on the U.S. economy, on market values and prices. Our reading of the current situation is as follows:

The effects are both economic and psychological. Economically, four to five million barrels of oil per day were removed from the marketplace. This has driven the price of crude from $18-20/bbl to $28-30/bbl, an increase of over 50 percent! (At the retail level, gasoline has increased 20%.) This energy cost increase will prolong the current GNP slowdown by 6 to 9 months and deepen it into a probable recession. It will also result in higher reported inflation for the next 6 to 12 months as the higher energy costs work their way through the various price indices. In turn, these higher inflation numbers will make it difficult for the Federal Reserve to ease the money supply as soon as it would like. The net result of this delayed turn in U.S. GNP growth is to lower economic values by 5 to 10%.

Overlaid on the economic effects are the psychological aspects of the crisis. These take two forms. First, fear and uncertainty about the eventual outcome have taken an additional 5 to 10% out of stock and bond prices. Second, our perception is that a continuing public focus on the Mid-East and its uncertainties may make people more cautious with their pocketbooks. Unlike 1987, when the American public largely ignored the stock market break, this time the trigger (a fear of war) is more immediate and thus more likely to have real and lingering effects.

We believe it is important to put all this in context:

First, the Mid-East conflict does not threaten U.S. survival or (even) prosperity. A similar situation five years ago would have raised the specter of superpower confrontation. Such an outcome is not likely today.

Second, the degree to which George Bush has solicited and received international cooperation will discourage future incursions by the Saddam Husseins of the world. It's clear that Hussein perceived the rules of the international game to be quite different from the rules that President Bush has now made explicit.

Third, international focus remains on disinflation. Recent actions by the U.S., Germany, Japan and numerous other countries have verified their willingness to risk recession to avoid the high inflation levels of the 1970s.

Fourth, we believe that if recession comes it will be self correcting. The public response to recession is to work harder and spend less. These actions result in improved family finances, subdued inflation and lower interest rates as time goes on. Unless government does something foolish, like discouraging international trade or raising taxes too much, we will work our way out of the current slowdown/ recession. Both of these topics are currently on the table in the form of the Textile Trade Act of 1990 and the ongoing budget negotiations, so holler at your Congressman.

The bottom line is that the stock and bond price declines relative to the Mid-East problems seem a bit overdone. We expect current prices to linger, along with the threat of hostilities. We don't know how the conflict will be resolved, but we suspect that Saddam Hussein's hold on his country can withstand world opinion and the embargo longer than the experts think. For this reason, we don't yet have a handle on the timing, but we're seeing prices and psychological fears that usually characterize a good long-term buying opportunity.

Read our quarterly newsletter, Muhlenkamp Memorandum, for more by Ron Muhlenkamp.