Suddenly, Iraq Is an Issue for the Market

Updated from April 9

The war in Iraq has been going on for a year, but it wasn't until this past week that the stock market registered any serious concern.

Sure, stocks sold off mightily last March on the eve of war, but that was just a momentary blip in what turned out to be a sustained upward march. In the main, Wall Street -- at least as measured by prices -- has held up well, as long it looked like the invasion would do no harm to the economic recovery and President Bush's re-election chances.

That composure changed with the shocking images of Iraqis dragging the mutilated bodies of four dead U.S. civilians through the streets of Fallujah, the news of Shiite uprisings in several cities, a surge in U.S. military casualties and a general sense that things in Iraq are spinning out of control.

By week's end, some of Bush's political enemies were comparing Iraq to Vietnam. A poll taken by the nonpartisan Pew Research Center finds U.S. support for keeping troops in Iraq slipping and President Bush's approval rating falling to 43% -- its lowest level yet. Even some of the president's supporters were beginning to whisper that the administration's Iraq strategy was veering off course.

Wall Street saw its own slippage in the wake of the events in Iraq. After rallying 5% in the prior two weeks, the Dow Jones Industrial Average fell 1.2% in an abbreviated trading week because of the Good Friday holiday. The Dow fell despite a strong start to the first quarter earnings season with good numbers posted by General Electric ( GE), SunTrust ( STI) and Yahoo! ( YHOO). The Nasdaq Composite ended the week down about 1%.

Concern grew over the weekend following reports that Bush was briefed in August 2001 about investigations into possible terrorism threats in the U.S. Various media outlets were reporting Saturday that in August 2001, U.S. intelligence officials also received two uncorroborated reports suggesting that terrorists might use airplanes as terror weapons.

To be sure, some of the selling is due to the profit-taking that often follows a run-up into the beginning of earnings season and the big bounce stocks got from a strong March jobs report. But market watchers see something more ominous in the past week's events, and it stems from investor concern that Iraq could imperil Bush's re-election chances, no matter how well the economy performs.

"If we stay in this morass, it's real fodder for the Democrats," says Timothy Ghriskey, president of Solaris Asset Management, a Connecticut hedge fund. "It could have a huge impact on the election and the market."

As we reported during the market's surge in advance of the March employment report, Wall Street is betting big on a Bush re-election. At last count, Wall Street firms have contributed $5.5 million to Bush's re-election campaign, compared with $1.2 million to John Kerry, according to the Center for Responsive Politics, a nonpartisan organization. In fact, a recent analysis by the center found that many of Kerry's biggest donors on Wall Street actually have given far more generously to Bush's re-election effort.

Wall Street's love affair with the Bush administration is born mostly of fear about what Kerry, the presumptive Democratic nominee, would do to corporate profits. The Massachusetts senator is suspected by many traders of planning to undo the tax cuts for the wealthy that the Bush administration pushed through Congress.

In that vein, Ghriskey says bad news from Iraq is increasingly bad for the markets, as investors fret over "tax rollbacks with Kerry."

Another thing that has the potential to unsettle Wall Street if the violence in Iraq morphs into terrorism at home.

Last year the market seemed to price out the threat posed by another major terrorist attack. But the March 11 train bombings in Spain rekindled some of those old fears. Many economists say the only thing that could put a halt to the economic recovery is another major terrorist attack. Some say the growing violence in Iraq might give renewed inspiration to al Qaeda and the terrorist group's sympathizers to carry out a major strike somewhere in the U.S.

John Lonski, an economist with Moody's Investor Services, says one of the x-factors facing the economy and the stock market the next few months is whether the "Iraqi conflict finds it way to the United States in some ... new large scale terror attack.''

Iraq might start looking and feeling like Vietnam, but the threat of global terrorism is a big difference between that war and the situation now. While the battlefields of Southeast Asia were far more deadly to U.S. soldiers than those in Iraq so far, there was little chance of Vietnam surfacing at home. That's not the case this time around.

Of course, the irony is that war is often good for an economy and stock markets -- at least early on.

From 1962 through 1972 -- the height of the Vietnam War -- the Dow Jones Industrial Average rose 30% before fears about inflation, the Watergate scandal and a bad recession began to whack away at those gains in the early 1970s. Consumer confidence remained high through much of the Vietnam War because jobs were plentiful and the big surge in defense spending fueled economic growth.

To some degree, the war in Iraq is having a similar economic impact. Lonski says the past two years have been the strongest for defense spending since the mid-1980s. In 2003, defense-related capital spending rose 32% compared to the prior year. He says that trend is likely to continue this year and serve as an additional fiscal stimulus.

"If you go to back Vietnam, the economy flourished,'' says Lonski. "Consumer confidence was very high.''

If it must live with violence, the Bush administration no doubt hopes the economy reacts with similar resiliency this time.

Another thing that could work in the president's favor, even if soldiers keep dying in Iraq, is the absence of a draft -- something that led to protests in the streets and was ultimately President Johnson's undoing.

But for the vast majority of Americans, the Iraq war remains a distant affair because there's little chance they, or someone they know, will be ordered to serve there. Iraq, for the most part, remains a war fought by strangers.

Indeed, it's the very remoteness of the Iraq war that allowed Americans to become inured to the relentless, but steady drumbeat of the daily death of another U.S. soldier. In time, Americans could become just as easily numb to the death of several soldiers a day, as long as the violence in Iraq doesn't escalate further.

While numbness to death is nothing for a society to be proud of, it could be the Bush administration's best hope come November if the situation in Iraq isn't resolved.

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