Plenty of ups and downs ahead as war worries grow

There has been a theory around financial markets for the past few weeks that a quick and successful US-led military strike on Iraq would clear the way for a global economic recovery - fuelled in part by falling oil prices - and for a revival in financial markets. The sharp fall in equity markets recently has, however, demonstrated increasing uncertainty and nervousness about this scenario.

The questions being asked by investors reflect the wider political dilemmas: is war now inevitable? When might an attack come? Would it be quick and decisive? Could it trigger wider instability, or fresh terrorist attacks? What will it mean for oil prices?

All these questions have major implications for the economic outlook - and significant funds are not likely to go back into equity markets until the answers are at least halfway clear. In the meantime, investors will either sit on the sidelines or sell shares and buy "safer" investments such as gold and government bonds.

For the markets, this political uncertainty adds a most unwelcome twist to existing economic weakness. The international economy remains stuck in first gear. There had been hopes that renewed buoyancy in the US would lead the way to recovery. Now, however, it is difficult to see companies making plans for new spending until the political outlook is clear - and such corporate investment is required to spark an upturn. In turn, corporate caution threatens to knock-on to consumer confidence - partly through rising unemployment - and lower spending in the shops would further damage the economic outlook.

Investors are now nervous that this downward cycle of corporate cutbacks and consumer nervousness will take hold.

This is despite some evidence of recovering earnings in US companies and the fact that share prices, having fallen for three years, are now not unreasonably valued compared to expected profits. To add to this, niggling concerns about whether profit forecasts can be believed are still in the back of investors minds after the string of Enron-type scandals over the past year.

What can be expected over the coming weeks? It is very difficult to see any sustained recovery until the political situation becomes clearer. In the meantime, volatility will be the order of the day, as the mixture of political and economic uncertainty lead to jumpy markets, prone to significant swings. This was demonstrated yesterday, when gossip about possible central bank intervention to support the US dollar sent the currency up for a period, after sharp falls earlier in the day. Expect more swings in the dollar and in equity markets in the days ahead.