Economic conditions should improve not only immediately following the outbreak of a war with Iraq, but also in the longer-term thanks to a more supportive policy environment and better business fundamentals, the economics department of RBC Financial says in a new report.

The analysis, by John Anania, assistant chief economist, and Carl Gomez, economist, looks at the 1991 Persian Gulf war in an effort to understand the market’s current situation.

“Geopolitical uncertainty and, specifically, the threat of war with Iraq have weighed heavily on the world economy in recent months,” the report says. “In such an environment, economic developments and decision-making have increasingly been pushed aside as consumers, businesses and investors focus intently on the developing geopolitical situation in a search for answers. This type of temporary economic paralysis is not without precedent.”

RBC says that economic activity improved dramatically immediately following the 1991 conflict only to deteriorate again because of the unsupportive economic climate in that period.

RBC recalls that investors bid down share prices relative to bonds shortly after Iraq invaded Kuwait, while corporate credit spreads jumped by more than 30 basis points. “Once uncertainty about the outcome of war began to recede, bond and stock markets immediately unwound risk premiums. During the month of the outbreak of war, the Dow Jones industrial average rose 10.6% from the month before, while the risk premium embedded in corporate credit spreads began to diminish.”

It has a more optimistic view this time around. RBC says both consumer and business sentiment indicators are now sliding in much the same way they did in 1990-91, while oil, equity and bond markets have again built in war premiums. However, retail sales and production indicators have held up better this time.

“Economic indicators and confidence levels are likely to remain soft or become weaker in the near-term. Yet unlike the 1991 war, the initial acceleration of economic activity following the outbreak of war is expected to be sustained because of a more supportive policy environment and better business fundamentals this time around.”

There are, however, some unique risks today that may have a negative impact that were not present at the time of the previous Gulf War, the authors say. “First, should a war take place, the United States may lead a smaller coalition without a United Nations mandate. This could complicate the war on terror especially in light of the broader war on terror since Sept. 11, 2001. Should the war be immediately followed by a renewed sense of uncertainty associated with additional terror attacks or a prolonged occupation of Iraq, our outlook of a sustained recovery following the post-war bounce in economic activity could be jeopardized.”