iddle East War a Market Breaker? By David Gilmore Special to TheStreet.com Originally posted at 3:22 PM ET 10/11/00 on RealMoney.com

This is the first of a new series: The Guest Speaker, which we hope will provide compelling insights and debate of interest to our readers. The author of this piece is David Gilmore, analyst for Foreign Exchange Analytics, a currency markets advisory service for institutional investors. As always, we welcome your thoughts.

--------------------------------------------------------------------------------

Not since the Persian Gulf War has the Middle East been as tense as in the last two weeks. Oil prices are climbing, stock prices are plummeting, and bond yields are falling.

Yet, for the most part, the currency market is suffering from myopia, fixated instead on G7 intervention, the likely liquidation of Japanese insurer Chiyoda Mutual Life, and share prices that are down everywhere and offering little guidance.

But it's high time that the foreign exchange market paid more attention to the key driver behind portfolio shifts rather than to the shifts themselves.

War is a significant risk in the Middle East. And unlike the Persian Gulf War, the current situation risks the far more disruptive squaring off of an Arab-Israeli war.

Neither side is bending to international efforts to restart peace talks between Israeli Prime Minister Ehud Barak and Palestinian leader Yasser Arafat. In addition, Israel has instituted ultimatums, and the Palestinians are showing no sign of backing down from violent protests. The U.S. has asked Egypt to host a four-way summit, but the Egyptians have refused unless Israel drops its ultimatums, removes its military from the Palestinian autonomous regions, and agrees to an international investigation of the root cause of the violence.

Israel has said no so far, but ironically it is the minority government of Barak that has bent the most to flush out a peace deal. Meanwhile, the more radical elements on both sides have seen their positions enhanced as the result of increasing violence. Arafat is more at risk than ever before for cozying up to the Israelis. And Hezbollah guerillas are holding three Israeli soldiers in southern Lebanon, where Syria is calling the shots with a large military presence.

Could it be any hotter?

Hopefully war will be avoided, because there are no winners in this situation. But a broad regional conflict looks likely before concessions are made and the situation cools. And that means higher oil prices, which, in turn, could have a drastic effect on the economy.

Look at what has happened to the euro in the face of rising oil prices: It wasn't until Sept. 21, when the Clinton Administration announced that it would sell some of its strategic oil reserves, that the prices slid and the euro showed signs of life. So a conflict in the Middle East can't be good for the euro.

The yen has a different pathology. Japan is dependent on oil, yet inflation is still running in the negative there year over year. But, going against the tide, I expect a weaker yen forecast based on rising oil prices and a safe-haven dollar demand as the conflict in the Middle East worsens before it improves.

But the biggest risk of all is to global growth, because oil prices are surely headed to more than $50 a barrel if war breaks out. And the effects of that could be exacerbated by a cold winter in the U.S., like Europe had last year.

If that happens, disposable income will sink quickly and a hard-landing scenario will find wide support among investors. Budget surpluses in the U.S. and elsewhere among G7 countries (but not Japan) would disappear.

In that scenario, bonds would look good, stocks would look bad, emerging markets would be in trouble and the dollar would be higher, initially. But the dollar's upside might well be tempered in the long term as foreign savings were repatriated behind losses in the U.S. stock market.

Foreign investment is also at risk longer term. In a hard-landing scenario, the flood of capital from European corporations buying U.S. enterprises could be turned off, removing what has become a key prop for the dollar.

http://www.thestreet.com/comment/guestspeaker/1120442.html

-- Martin Thompson (mthom1927@aol.com), October 12, 2000

Answers

Good piece.

-- Wayward (wayward@webtv.net), October 13, 2000.