Philip Coggan: Biggest surprises
Published: December 3 2004 19:01 | Last updated: December 3 2004 19:01
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How will you cope with a US attack on Iran?The biggest surprises for markets tend to come out of nowhere. Is it possible that the big issue to concern investors in 2005 will be a US attack on Iran?
Few people are discussing the issue. They seem to feel that the Bush administration has enough on its plate with Iraq and would not have the resources, or the will, to mount an invasion of another hostile Muslim country.
Probably not. But an attack does not mean an invasion. The US could mount air strikes to try to eliminate Iran's nuclear facilities or it could encourage Israel to do so. Twenty years ago, Israel attacked a nuclear power plant in Iraq.
Even those who have thought about the Iranian issue may still think an attack unlikely. After all, this week Iran reached an agreement with European nations that was endorsed by the International Atomic Energy Agency. Iran has suspended its nuclear enrichment programme.
But suspension does not equal cancellation, and previous agreements have foundered and the US has expressed its reservations about the Europe-Iran deal.
Why might the US attack next year? The rationale seems to have three elements. The first is that the US believes Iran is determined to acquire nuclear weapons and that the Europeans will be too ineffectual to stop them. In the aftermath of the September 11 2001 attacks, the US simply cannot tolerate the risk that a hostile power might either launch attacks against it, or (more likely) pass to terrorists weapons suitable for such attacks. Since Iran has been defined by the US as part of the "axis of evil", a group of nations willing to support terrorism, it is seen as vital that it does not develop nuclear capability. The US would have the right to make a pre-emptive attack on these grounds.
The second rationale is that Iran has been playing a part in destabilising Iraq by supporting the resistance there. Keep Iran in check and the task of tidying up Iraq will be made easier.
The third rationale is that the neo-conservatives at the heart of the Bush administration believe that the previous policy of laissez faire with regard to Middle East regimes has proved a failure. The US is perceived in the region as propping up corrupt governments. In the long run, the US should aim for democracy because that would be more stable (and a good thing). And the neocons may only have four more years to bring about Middle East reform.
It seems unlikely that an attack would happen early in the year. The agreement with Europe will need to break down and it will take time for the US administration to build up its case for acting. But, of course, markets normally anticipate events and investors will certainly adjust their behaviour if US sabre-rattling starts.
What would happen to financial markets in the face of an attack, or indeed speculation about an attack? The likely beneficiary would be government bonds, particularly Treasuries; one investment banker suggested to me that 10-year Treasury bond yields could drop to 3.5 per cent.
The fall in yields would not just be caused by the "safe haven" appeal of Treasuries. Conflict in Iran, a leading oil producer, would also lead to a spike in the price of crude. As we have seen this year, investors now regard oil price rises as a tax on global growth; good for bonds but bad for equities. Stock markets would undoubtedly wobble in the event of a conflict.
All this might seem like scaremongering. But it is a real possibility. I recall writing in March 2002 about the possibility of war with Iraq. In those innocent days, oil had edged up to $25 a barrel but equity markets seemed unconcerned; many investors dismissed the idea that war could happen. By the end of 2002, and the start of 2003, investors were thinking of little else.
What are the chances of an attack this time? Republican strategist Jim Pinkerton said a few weeks ago that he thought action against Iran was likely in 2005. And there are no signs as yet that President Bush's second term foreign policy would be any more emollient than his first. Perhaps the likelihood is less than 50-50 but it is certainly not negligible.
Iran may not be the only geopolitical risk facing investors. David Murrin, chief investment officer of the hedge fund group Emergent Asset Management, warns that the risks of a nuclear incident have been underestimated.
During the cold war, a delicate balance of power prevented any nation from using its weapons. After the fall of the Berlin Wall, the risk was assumed to have disappeared completely. But while the risk of a cataclysmic world war may have vanished, the dangers of small-scale conflict have increased.
More nations are acquiring nuclear weapons, with Pakistan and North Korea joining the club in recent years. As the example of Iran may show, other nations would like to. Indeed, they may see it as the best protection against a more aggressive US foreign policy. Note the more cautious approach of the US towards North Korea, another member of the "axis of evil". Because weaponry is more widespread, the balance is more fragile and the risk of conflict (or use by terrorists) has increased. A United Nations panel said this week there was the threat of a "cascade of proliferation" and urged the Security Council to pledge collective action against the trend.
Murrin admits that there is not much investors can do about this risk. It is one of those big events that has a very small chance of occurring at any particular time, but that has a big impact when it does. The underlying idea is that geopolitical risks have increased since the 1990s, something that has become clear since September 11. It is not just the threat of terrorism that is destabilising, but the reaction of the US (and others) towards it.
In the circumstances, investors should be chary of becoming over-exposed to risky assets and should retain a solid proportion of safe haven assets (government bonds, conventional and index-linked, even a bit of gold) in their portfolios.