Markets dive after Allied setbacks in Iraq war

Shares reverse their gains and oil prices rise after coalition advance on Baghdad runs into trouble

The financial markets snapped out of their week-long war-driven euphoria yesterday as a series of military setbacks in Iraq triggered a slump in share prices.

As the reality of war in Iraq hit home, investors rushed to buy back the oil, gold and investments they had frantically dumped last week.

James Luke, portfolio manager for BB&T Asset Management in the US, said: "It's coming to the realisation that we are going to have a difficult and costly conflict."

The tumble brought an end to the so-called "war rally" that saw the FTSE 100 rise 600 points, or 17 per cent, in seven sessions on the back of hopes of a short war.

Yesterday the UK blue-chip index closed down 118 points, or 3 per cent, at 3,743. The market close came too early to absorb an upbeat assessment of the UK economy by Sir Edward George, the Governor of the Bank of England.

On Wall Street the Dow Jones Industrial Average fell 307 points, or 3.6 per cent, to 8,215, wiping out the 235-point surge on Friday that capped off the index's 13 per cent rise.

Just as traders last week cited television images of advancing soldiers and missile attacks on Baghdad as reasons to buy shares, yesterday the mood was quelled by the mounting casualty toll over the weekend.

At least 30 British and American soldiers have been killed, and 14 are captured or missing, while four aircraft have so far been destroyed by "friendly fire" alone.

Ciaran Barr, the chief UK economist at Deutsche Bank, said: "The news from Iraq over the weekend raises the risk that the war is not as short as had initially been priced in."

A protracted conflict that could cause prolonged disruption to the oil supply and the price of crude rose sharply yesterday.

In London Brent jumped $1.75 to $26.10 a barrel, partly recouping a slump that saw prices collapse $10, or 28 per cent, in just two weeks.

This in turn led to a sell-off in airline shares as analysts fretted about the rising cost of oil and likely impact on demand for airplane tickets if the Iraqi war drags on.

British Airways, Lufthansa and Finnair were all down 4 per cent while in the US, Continental Airlines and American Airlines' parent, AMR Corp, both dropped 14 per cent.

Meanwhile, gold ­ traditionally a safe haven investment in times of uncertainty ­ rose $3.80, or 1.2 per cent, to $329.90 an ounce.

Some analysts pointed out that the adverse turn of events for the coalition forces in the Middle East had allowed investors to focus on the underlying concern over the global economy.

This week sees confidence figures for the US today, Germany tomorrow and the UK the following day ­ all of which are expected to show households remain depressed.

But in his speech last night, Sir Edward told a business audience the most likely outcome was for a "gradual pick up" in the pace of the global recovery over the next two years.

The Governor acknowledged that uncertainty over Iraq has hit both business and consumer sentiment and the financial markets.

But Sir Edward predicted a slow recovery in business investment and hailed as "positively welcome" the massive increase in government spending outlined by the Chancellor, Gordon Brown.

"Taken together, these developments should accommodate the moderation in the rate of growth of consumer spending, which we anticipate and may now be beginning to see," Sir Edward told the Finance and Leasing Association.