-->PAUL B. FARRELL

'War' footing is slippery
Prepare now for shocking tax, interest rate increases
By Paul B. Farrell, CBS.MarketWatch.com
Last Update: 7:55 PM ET Feb. 16, 2004

LOS ANGELES (CBS.MW) -- President Bush told America during his"Meet The Press" interview:"I am a war president. I make decisions here in the Oval office in foreign policy matters with war on my mind."

War is never about foreign policy matters in isolation. War has profound implications on the domestic economy and markets, a lesson that every American investor as well as the current president is rapidly learning in an age of overwhelming domestic and trade deficits"as far as the eye can see," deficits guaranteed to have a profound impact on your future.

Don't get me wrong, nobody doubts that America is engaged in a war on terrorism.

And regardless of your feelings about the wisdom of a preemptive war on Iraq, the fact is we are at war in Iraq, a war that has become the opening gambit in what many quietly refer to as World War III -- a vast global cultural war that will last for decades, a war that seems destined to end with nuclear bombs as the weapons of choice rather than taxis loaded with C-4 explosives.

What are the implications of having a war president on your short-term and long-term investment strategies? In 2004? For the next five years until 2008? And what about the real long-term?

Deficits key

The single most significant consequence of having a war president is the constantly increasing federal debt as President Bush prepares us for the war that dominates his thinking.

Kevin Phillips warned us of this tendency. Phillips was a Republican strategist under President Nixon and a political historian who has authored 25 books, including"Wealth & Democracy." Phillips observes that"most great nations, at the peak of their economic power, become arrogant and wage great world wars at great cost, wasting vast resources, taking on huge debt, and ultimately burning themselves out."

Not everyone agrees, of course, certainly not in Bush's administration. In fact, the Reagan Presidency convinced them that"deficits don't matter." We will find out soon enough.

But no matter what, I am optimistic. In the past America has risen to the occasion and recovered from overwhelming deficits. So there is no reason to believe that we can't reverse gears and move back to the surplus we enjoyed when Bush took office.

But it will take more than doubletalk to change direction. For example, Pulitzer prize-winning columnist Thomas Friedman says the message coming from our war president contradicts reality. It may play well at the Daytona 500, but it will eventually hurt the S&P 500. The message Friedman hears is:

"You all go about your business of being Americans, pursuing happiness, spending your tax cuts... buying a new Hummer. No sacrifices are required, no new tax cuts to pay for this long-term endeavor, and no need to reduce gas consumption... No, we are so rich and so strong and so right, we can win this war without anyone other than the armed forces paying any price or accepting any burden."

When will it stop? Not before the November presidential elections. Fiscal restraint is unpopular in elections. As one anonymous government official said in Newsweek:"I've never seen an administration spend money like this... They give money away on phone calls. No documentation. No budget. It's the worst I've ever seen."

So in the short-term (eight months to the election), the consensus estimates of most economists and market gurus is probably accurate: 2004 will be a good year because pre-election years are filled with political giveaways. And although the real money in this bull market was probably made last year, you can still expect we'll match the historic average of 12 percent.

Preparing for the worst

But soon"pursuing happiness" will stop working and sacrifices will be required. Indeed, that shocker may not wait until the election. As Fed Chairman Alan Greenspan so diplomatically put it in his recent semi-annual testimony before Congress:"Should investors become significantly more doubtful that the Congress will take necessary fiscal measures, an appreciable backup in interest rates is possible."

BusinessWeek magazine warns that in spite of the president's claims, neither Congress nor the White House can stop the hemorrhaging deficits. In fact, the scenario is much worse than anyone will admit, because the 2005 budget has no costs for the Iraq and Afghanistan wars after September, no costs for the new Medicare program and it hides most of the lost revenues in assuming the tax cuts are made permanent. These and other costs will drive the federal deficit into the $6 trillion range by the time boomers start retiring.

Tax increases are inevitable says InvestmentNews. The Fed will be forced to increase rates within a year, if not sooner. Bond funds will drop as much as 10 percent. And the stock market will drop well below 10,000.

As a rational investor you have only one of two choices: You can restructure your portfolio along the lines of one of the lazy portfolios we discussed earlier.

Or, if you are super-cautious, you should prepare for the worse, assume the market is near the top anyway, sell everything, take your profits, go to cash and sit on it until somebody takes care of those killer deficits. But do nothing and you'll lose.

Bottom line, you have about eight months to get your house in order. Forget the happy-talk: Start preparing now for a series of economic shockers guaranteed to happen after November... if not triggered before November by another domestic terrorist attack, or a major international surprise, such as a terrorist takeover of nuclear-armed Pakistan.