The Inflation Cycle of 2002 to 2015 - Uhlmann Price Securities

Industrial Portfolio Strategy
The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -65- Legg Mason Wood Walker, Inc.
Our approach is to watch actions rather than statements, and we believe the Bush Administration
has adopted a far more pervasive wartime footing than is currently recognized by the markets. The
distinct shift in budget priorities and deficit spending tolerance, as well as the risk to energy commodity
trade, have significant implications for investors. For example, the movement of the U.S. to a “shadow government”
is an unusual step. The shadow government concept originated in the Cold War, and requires a
group of senior federal government officials to rotate in a secure, off-site location to ensure government,
and particularly executive branch, continuity in case of an attack on Washington, D.C. In addition, on December
13, 2001, the U.S. pulled out of the Anti-Ballistic Missile treaty, and on January 8, 2002, the U.S.
modified its nuclear strategy, called the Single Integrated Operational Plan (SIOP), by lowering the bar for
first-use of nuclear weapons and shifting the focus from Cold War thinking to an increased awareness of
China, Iran, Iraq, Libya, North Korea, Syria and Russia. The revised plan appears to loosen the traditional
restraints the U.S. had in place with regard to its use of nuclear arms. We believe that this was not a budget
ploy, or a belated update of outdated Cold War strategy, but rather a deliberate decision by the Administration
that the 1970 Nuclear Nonproliferation Treaty (NNPT) has failed. We believe that the Bush Administration
weighed the risk of existing and emerging nuclear threats (including the proliferation risk presented
by Iraq, a NNPT signatory) against the risk of sending a signal to non-nuclear countries (in contravention to
the NNPT implicit guarantee) that simply because they are non-nuclear they are no longer protected from a
nuclear response to their hostile actions. After considering all of the ramifications, we believe the Administration
decided that the increased wartime footing of the U.S. justified the shift, and we interpret the shift
as added risk that is underappreciated by investors for the potential impact it may have.
Nuclear weapons are a complex subject, but they present a risk with potential repercussions for investors
that must be analyzed. In the box on page 66 we provide a primer on nuclear weapons, with an
emphasis on the sort that we believe the Bush Administration fears may be now or in the near future in
Iraq’s possession. We believe investors often receive incorrect information regarding the highly complex
world nuclear threat, and since misinformation is the enemy of markets, we believe that it obscures the appropriate
equity risk premium as well as commodity price reactions. For example, media reports have occasionally
failed to differentiate between weapons-grade highly enriched uranium-235 (HEU, having >80%
U-235 content) and ordinary low-enriched uranium (LEU, having 3% to 5% U-235 content) nuclear reactor
fuel. Later in this report we express our doubts about the widely reported “suitcase nuke” threat, for example,
in terms of the devices’ reputed destructive capabilities, and the likelihood that terror groups could obtain
or use them even if they ever existed in the Former Soviet Union or were ever misplaced.
The Risk of U.S. Military Action to Change the Iraqi Regime Which May Lead
to a Destabilized Region
An emerging war scenario that we believe is underestimated by investors involves U.S.-led efforts to
oust Saddam Hussein of Iraq, possibly with conventional military force. Since the expulsion of United
Nations (UNSCOM) weapons inspectors in late 1998, the only checks on Iraq’s WMD nuclear program
have come from International Atomic Energy Administration (IAEA) visits to Iraq, but we feel those inspections
are too limited to be of value, and note that other countries have developed nuclear weapons despite
being subject to IAEA inspections. Former Iraqi nuclear scientists and UNSCOM inspectors have provided
statements and evidence of a long-standing WMD nuclear program, possibly one that was revitalized
after the expulsion of the inspection regimen. In addition, former UNSCOM inspectors have uncovered evidence
that Iraq employed an elaborate scheme for hiding its WMD programs from inspectors. Although we