What Iraq means for investors

After booming on hopes of a quick Iraq war, the stock markets have now slumped in the expectation of a long and messy war. The US wants to send and deploy an additional 100,000 soldiers in Iraq, and the logistics of that alone could take five to seven weeks. Even after that, some hard fighting is to be expected.

US air-power is unstoppable, but Saddam’s forces now know the best defence is to have troops mingling with civilians and fighting a guerrilla urban war, instead of getting annihilated in open conflict. In theory, the US could wipe out all sniper fire through carpet bombing.

But since the US wants to win the succeeding peace, and is doing all it can to win hearts and minds, it has to try and minimise civilian casualties. Thus political compulsion will tend to make the war drag on further.

Now, wars are quirky things, and events can change with lightning speed. Saddam may yet be overthrown quickly by an internal coup. However, the likelihood is that the Iraq war will drag on for at least three months. That greatly increases the chances of global economic stagnation or outright recession.

Many anxious investors ask me what they should do in the light of war uncertainties and a global recession. I would advise long-term investors to simply hold tight and wait for an eventual recovery, even if that takes a year or more.

Plunging into and out of the stock market is a very dangerous game, and amateurs are especially likely to get their timing wrong. But for those who want to take risks, here is some tentative advice.

First, give priority to sectors that are most insulated from the global economy and yet have decent long-term prospects. Second, avoid sectors that are most exposed to global markets.

Third, remember that in many sectors the positive impact of a good monsoon may outweigh the negative impact of a recession.

Consider these elements one by one. Not all non-tradable sectors are immune from global developments: hotels and tourism will be badly hit. But non-tradable sectors least affected by war or recession include housing, banks, and road transport.

Housing finance companies should continue to fare well. So should construction-related manufacturing such as cement, sanitary-ware, paints and construction material. Cement should have a good domestic market, though profits are depressed by the constant creation of massive new capacities.

Relatively little cement is traded internationally because of high transport costs, yet Iraq will probably require a lot of cement for reconstruction after the war, and Afghan demand is picking up. India is geographically well located as a supplier.

Banks, especially public sector banks, have been reporting bumper profits in the last few quarters, based mainly on trading profits from rising gilt prices.

The huge inflow of dollars into our forex reserves has simultaneously made the financial sector awash with liquidity. However, interest rates seem to have bottomed out. Forex reserves have fallen a bit, and the earlier flood of dollars may soon be reversed.

High oil import bills and uncertainties affecting remittances could, in a long war, erode forex reserves by up to $10 billion. That will not threaten international confidence in India, but will certainly reduce domestic liquidity and send interest rates up.

However, the recent uptrend in interest rates also owes much to rising non-food credit. Lending to the private sector will be profitable for banks provided bad loans do not proliferate in this upsurge.

Indian companies are finally beginning to look internationally competitive, so project lending today should not be the disaster it was in the mid-1990s. In sum, the banking sector is recession-protected, if not quite recession-proof.

Auto sector demand has been hit by the sharp rise in fuel prices. A global recession will also hit auto and auto component exports, which have been rising fast.

Yet the bulk of auto demand is domestic, and the rise in oil price should be reversed after some months. So there remains much promise in commercial vehicles, two-wheelers, four-wheelers, auto ancillaries and tyres.

Which are the sectors to avoid? A global recession will hurt information technology, which is highly dependent on US markets. Outsourcing by global companies to India could increase as a cost-cutting measure in a recession.

But they will demand a sharp pruning of margins. The upshot may be a rise in the top line but no corresponding rise in the bottom line of IT companies. IT is beginning to look a commodity industry, for all but a few specialist companies.

Export-oriented industries like gems and jewellery, textiles and leather will suffer. A recession will also pull down prices of a wide range of importable commodities and manufactures.

Examples are non-ferrous metals, fibres, chemicals and plastics, agricultural raw materials (rubber, cotton), and a vast range of consumer goods. Many Indian companies will face a profit squeeze, as they did during the Asian financial crisis.

The prospects for steel are more mixed. Indian steel capacity is significantly export-dependent, especially for flat products. Flat steel products have risen fastest in price in recent months, thanks mainly to Chinese demand, and should retreat fastest.

Construction bars have risen less and should fall less. Indian producers can hope to get export orders for reconstruction in Afghanistan and Iraq.

Finally, remember that a good monsoon will impact most Indians more than a global recession. Two of the last three years have been drought years, and a good monsoon is overdue.

A recession will depress global commodity prices, affecting growers of cotton, sugar, rubber and plantation crops. But, overall, a good monsoon will boost consumer demand. Tractors have been in the doldrums for three years, and could revive.

So could fast moving consumer goods. Poor rains and decelerating agricultural prices in recent years have depressed demand for the FMCG sector. A bountiful monsoon could reverse this.

In sum, a global recession, with its many tribulations, will not be bad news for all sectors. Investors, please note.

What do you think?