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Mid-Week Analysis

US Trade Deficit
Turkish Stock Market

With Turkey now in full-fledged financial crisis, markets have turned quite unsettled globally. Here at home, stocks are coming under considerable selling pressure in both the key technology and financial sectors. So far this week, the Dow has declined 3% and the S&P500 has dropped 4%. The Transports are unchanged, the Morgan Stanley Consumer index has declined 1%, and the Morgan Stanley Cyclical index has dropped 2%. Utilities have added about 1%. The broader market is showing vulnerability as well, with the small cap Russell 2000 and the S&P400 Mid-Cap indices declining 3%. Technology stocks have come under heavy selling pressure, with the NASDAQ100 dropping 7%, the Morgan Stanley High Tech index 6%, and the Semiconductors 7%. The Street.com Internet and NASDAQ Telecommunications indices have declined 8%. The Biotechs have retreated 4%. In a development to follow closely, financial stocks are performing poorly, with the S&P Bank index dropping 5% and the AMEX Securities Broker/Dealer index sinking 8%. Gold stocks are unchanged.

Despite heightened global financial stress, there has been little safe-haven buying of U.S. credit market instruments. But, then again, just take a look at recent inflation data. So far this week, 2-year Treasury yields are unchanged, while rates have actually increased further out the yield curve. Yields on 5 to 30-year Treasuries have generally added 3 basis points. Mortgage-backs have underperformed, with benchmark Fannie Mae mortgage-back yields increasing 5 basis points. Agency yields have generally increased 3 basis points. Spreads are relatively quiet thus far, with the benchmark 10-year dollar swap spread about unchanged at 94. The dollar has rallied marginally.

An unfolding political crisis was more than Turkey’s acutely fragile financial system could take this week. With its central bank allowing short-term interest-rates to rise to as high as 6100% (compared to 40% last week) to stabilize the lira and stem flight out of Turkish assets, bonds and stocks have been crushed. Apparently, the Turkish central bank used $3 billion of its reserves to defend its currency today. There is now significant risk of financial collapse with implications for what should be considered a vulnerable global financial system.

The following came this afternoon from Fitch, the international rating agency: “the renewed upheaval in the Turkish financial markets was placing strain on the domestic banking sector, with severe liquidity pressures resulting in systemic default in the interbank market… The crisis was triggered by a spat between the country's two most senior politicians on Monday, which resulted in an increase in perceived currency devaluation risk in the market and led many banks to buy foreign exchange in order to close their positions. In order to avoid further selling pressure on the Turkish lira, the Central Bank yesterday withheld lira liquidity from the market, leaving banks in a position where selling foreign currency was the only option available to purchase Turkish lira from that source.”

A systemic liquidity crisis and panic has resulted in a 30% stock market collapse so far this week, with an 18% decline just today. The Turkish bond market has been hammered. The benchmark 10-year government bond has lost almost 15% of its value in the past three sessions, with the yield surging 300 basis points to 16.67%. Clearly, the Turkish financial system cannot survive long in the current rate environment, and there are already indications that the government may abandon its currency intervention and allow the lira to float. A floating lira, however, will usher in other problems such as inflation and capital flight.

Emerging markets both near and far from Turkey have suffered contagion effects. It is quite likely that there has been considerable speculation in the Turkish bond market, with enticing yields and the perception of a pegged currency certainly enticing the leveraged speculating community. When financial players are hit with losses in one market, they are often forced to reduce exposure to other markets, with liquidations first in the more risky asset classes. Today, Russian stocks were hit hard, with the Russian RTS index dropping 8%. Less dramatic losses were suffered in markets throughout Eastern Europe. Stocks in Greece were hit for 2%. Shockwaves were felt on the other side of the globe as well, with the Mexican Bolsa and the Argentina Merval indices hit for 4% today, and Brazil down 2%. The Brazilian real declined about 1.5% today to its lowest level in two years. Heavy trading in Argentine peso forward contracts saw prices reach 3-month lows as traders scramble to buy protection against a possible faltering in the peso’s peg to the U.S. dollar. Emerging market currencies were weak generally, and it certainly appears we are entering a period of significant general financial instability. The Asian markets are worth following closely tonight.

Here at home, an uncomfortable combination of ominous data and market action is behind a palpable deterioration in the general financial environment. Following last week’s dreadful report on producer prices, this morning’s inflation report saw consumer prices rising at the most rapid pace since last March. Today’s 0.6% gain was double the consensus estimate of 0.3%. Energy prices surged 3.9%, with natural gas prices jumping 17%. Year-over-year, energy prices increased almost 18%. Transportation cost rose 0.3% for the month, while tobacco prices increased 1.9%. This report provides confirmation of heightened cost pressures in the service sector. Medical costs increased 0.6% and prescription costs added 0.7%, the strongest price gains in this sector in about six years. Food prices rose 0.3%, with higher prices almost across the board. Physician and hospital services prices increased 1%, the sharpest increase since 1993. The key aspect to garner from this disappointing report was the broadness of categories experiencing rising prices.

This morning also provided another dreadful trade report. December’s wider than expected trade deficit of $33 billion was 29% larger than December of 1999. For the entire year, the trade gap came in at $370 billion, a 40% increase from 1999. Amazingly, the trade gap has surged 120% since 1998’s deficit of $167 billion. Our annual deficit with China jumped to almost $84 billion, surpassing Japan for the biggest trade gap. Imports from China surged 18% to $100 billion during 2000. For the year, the value of crude oil imports surged 76%, with a record 3.4 billion barrels imported. Year-over-year goods imports increased 11% and services imports jumped 15%. For December, merchandise imports dropped 0.8%, led by a 9% decline in autos, while exports declined 1.4%. Excluding automobiles, exports dropped nearly 2%. By region and/or country, year-over-year imports increased almost 12% from Canada, 7% from Mexico, 7% from Western Europe, 5% from the Pacific Rim, 14% from China, 10% from Latin America and 37% from OPEC.

And while imports slowed from the torrid pace earlier in the year, consumer demand remains exceptionally strong. Today the Bank of Tokyo-Mitsubishi weekly retail sales report had same store sales strengthening from the previous week and 4.1% above what were very strong sales from last year. There appears to be some cooling in the mortgage market, with the Mortgage Bankers Association reporting yesterday that its weekly applications index declined almost 8%. The index of mortgage purchases remains slightly ahead of levels from this time last year, while refinancing volume is running about double year ago levels.

Interestingly, the S&P Retail Stores Composite index declined 5% today. Considering our view that consumer demand will inevitably falter, we will be keeping a keen eye on the retail sector. The retailers have begun releasing fourth quarter financial results, all adopting a consensus view for the rest of the year. Not surprisingly, the retailers have joined the chorus singing of a Fed-induced second half recovery for the U.S. economy.

We will pick on Home Depot tonight, but several other retailers could fit the bill. Home Depot is planning on adopting a “conservative” approach for the year, reducing the number of new store openings to 200 from the previous expectation of 225. The majority of stores are schedules to open during the first half. This represents an increase of 18%, compared to last year’s 22% increase in new store openings. Instead of concentrating solely on adding additional stores, Home Depot has pledged to accelerate its plans for improving existing store revenues. Of course, Wall Street analysts love this idea. However, analysts appear less than fully confident, choosing to hedge their bets by resting their positive outlook on the assumption of a "V" recovery in consumer spending. Several admit that if the recovery lags at all, the second half could be quite disappointing.

An aside on Home Depot: Here in Dallas, Home Depot is test marketing it’s the Floor Store concept. This is a 12,000 square foot showroom combined with an 18,000 square foot warehouse that sells nothing but flooring. By the way, this store is within 10 miles of four Home Depots and 2 Expo Centers (If you haven't seen an Expo center, you're missing out on the lunacy of the high end housing market).

It strikes us that in the face of significant economic uncertainty the major retailers continue to aggressively add new stores. Home Depot alone will be adding 22.5 million square feet of retail space in 2001, according to Merrill Lynch estimates.

Between 1964 and 1997 (most recent available data from the US Census Bureau), the amount of total retail space per person in the U.S. has jumped almost 300% to 19 square feet per person. Now, several research firms put the number at over 20 square feet. By the way, Europe has about one and a half square feet per person. On regional level, here in Dallas market experts claim 34 square feet of retail space per person; Chicago has 25 square feet, up from 20 square feet in 1990. Southern New Hampshire has a whopping 48 square feet per person, more that Boston's 36 square feet.

While the media and Wall Street touted the rapidly slowing U.S. economy, the retailing stocks for the past four months have climbed the proverbial "Wall of Worry." However, consumer spending has bounced back strongly and it is becoming clearer that it was largely the manufacturing sector that has thus far slowed significantly. In fact, Home Depot increased total sales by 14% for the latest quarter ending in January, a particularly impressive accomplishment if we are actually in a recession. Ironically, now that everyone is getting geared up for a second half recovery, we see increasing risk to this sanguine view. We do see the economy slowing appreciably in the future, and nothing like the soft landing Wall Street is attempting to sell. With the unprecedented build up of retail space across the entire county, retailers have enormous capacity and overhead that will be quite burdensome come any meaningful recession. With the S&P Retail Index rising 30% from its lows last October to the high hit early this month, it seems there is a lot of good news being discounted.

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