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Mid-Week Analysis

Crude Oil
U.S. Imports

We are in the midst of another tumultuous week for global markets, with surging energy prices, sinking currencies and equities, and vulnerable credit markets. The past two sessions, however, have witnessed a strong rally in NASDAQ and technology stocks in particular. From Monday's intraday trading lows, the Semiconductors jumped 9%, and have posted a 6% gain so far this week. The NASDAQ100 has added 3% and the Morgan Stanley High Tech index 2%, increasing year-to-date gains to 2% and 12%. Elsewhere, selling has intensified. So far this week, the Dow has declined 2% and the S&P500 1%. The Transports have dropped 3%, while the Morgan Stanley Cyclical index has sank 4%. The previously high-flying Utilities have dropped 7% this week, while the Morgan Stanley Consumer index has declined 2%. The small cap Russell 2000 and the S&P400 Mid-cap indices have declined 2%. The Street.com Internet index and the NASDAQ Telecommunications index have also declined 2%. The telecommunications sector is coming under significant selling pressure as expectations for future earnings and cash flow diminish. The financial stocks have not been immune to selling either, with the S&P Bank and AMEX Security Broker/Dealer indices dropping 3%. The gold stock index continues to sink, dropping 6% so far this week.

The U.S. credit market continues to look quite vulnerable. Treasury yields are on the rise, with 2 to 5-year yields rising 3 basis points. Longer maturities are under pressure, with 10 to 30-year Treasury debt yields rising 6 basis points. Agency yields have generally increased 6 basis points as well, while mortgage-backs continue to outperform as yield increased 4 basis points. The benchmark 10-year dollar swap spread has narrowed 1 basis point to 117. With enormous corporate supply coming to market over the coming weeks, we expect the credit market to remain unsettled.

The headlines will point out that the euro sank to a new record low today, but there is much more to the continuing global currency tumult. Today, the euro joined the Australian dollar, the New Zealand dollar, the South African rand, Philippine peso and Chilean peso to trade at new lows against the dollar. Recent currency weakness has also hit the Mexican peso, Brazilian real, Thai baht, Singapore dollar, Indian rupee, Korean won and emerging currencies worldwide. Quarter-to-date, the following currencies have declined at least 10% against the dollar: the Romanian leu, Iceland krona, Swedish krona, Czech koruna, euro, Danish krone, Greek drachma, Hungarian forint, New Zealand dollar and the Zimbabwe dollar. Asian currencies have been particularly weak, as have their equity markets. Year-to-date, the Japanese Nikkei has dropped 13% and Japanese JASDAQ 21%. Major indices in Hong Kong have declined 8%, Taiwan 19%, South Korea 41%, Singapore 19%, Thailand 41%, Indonesia 38% and Philippines 33%.

Crude oil price rose to 10-year highs this week and other energy prices to record highs on continued extraordinarily tight supplies. Yesterday it was reported that U.S. inventories of distillate fuels (including heating oil and diesel) remain about 20% below year ago levels. Heating oil inventories are 35% below where they were this time last year. Alarmingly, inventories are not building despite refineries running at near maximum capacity. From Bloomberg, industry consultant Daniel Yergin today warned of "a natural-gas price ‘shock'" with consumers faced with winter heating costs 20% to 40% above last year.

Another month another record trade deficit as July saw the shortfall in good and services jump to $31.9 billion. This is a 33% increase over last July's $24 billion deficit and almost 120% above 1998's $15.5 billion. Year-to-date, imports have increased 19%. During the first seven months of the year, the U.S. has posted a trade gap of $206.3 billion, a 47% increase versus 1999. The goods deficit increased $1.8 billion from June to $38.7 billion. Exports of goods actually decreased $1.5 billion to $65 billion, while imports increased $700 million to $120.8 billion. From the government release: "The June to July change in imports of goods reflected increases in industrial supplies and materials of $0.4 billion (primarily crude oil and natural gas); automotive vehicles, parts, and engines ($0.3 billion); foods, feeds, and beverages ($0.1 billion)."

For July, the U.S. posted record deficits with Canada, Western Europe, Japan and China. Certainly exacerbated by the surging dollar, the deficit with Western Europe reached $7.2 billion during July, this compared to $4.33 billion during June. The deficit with Japan jumped almost 20% during the month as imports increased 8% and exports dropped 13%. The trade deficit with Canada jumped 16% to a record $4.1 billion. The largest deficit, however, is the $7.6 billion shortfall with China - a pretty hefty shortfall considering total imports from China were $9.3 billion. Year over year, imports from China have surged 22% to $57.7 billion, while exports have increased 20% to $8.9 billion. The U.S. deficit to the Pacific Rim jumped 12% to $19.4 billion. It continues to be simply amazing to view the year-over-year increases in U.S. imports by country - Belgium 12%, Italy 10%, Spain 20%, UK 5%, France 7%, Norway 62%, Hungary 24%, Poland 23%, Russia 53%, Australia 30%, China 25%, Japan 13%, Hong Kong 7%, Korea 32%, Taiwan 19%, Argentina 8%, Brazil 29%, Saudi Arabia 61%, Venezuela 48%, and Indonesia 9%. Imports from OPEC have surged 59%.

And while there is a perception that we export high technology products and import toys and personal electronics, this is certainly not the case. For July, imports of capital goods totaled $29.5 billion, industrial supplies $25.8 billion, automotive $17 billion, consumer goods $23 billion, and food and beverage $4 billion. As to exports, consumer goods totaled $7.5 billion, capital goods $30.7 billion, industrial supplies $14 billion, and automotive $6.5 billion.

There is little evidence that our disastrous trade position will improve anytime soon. Certainly, we will be paying more for energy in the months to come. Also, yesterday the Port of Long Beach reported that imports during August surged again to a new record. For the month, 237,000 20-foot containers arrived compared to 215,000 during August 1999, a month that marked a major acceleration of inbound shipments. Full outbound containers increased to 86,000 during August from last year's 81,000. During August a record 112,000 containers left the port empty.

Today the Mortgage Bankers Association reported a slight decline in its weekly application index. However, the mortgage application volume is running 18% ahead of last year, with the index of purchase applications 20% above a year ago. Yesterday, the Commerce Department reported an increase in August housing starts after four months of declines. Interestingly, the key single-family starts component jumped almost 5% to the strongest pace in four months. This is consistent with reports from the National Association of Homebuilders. Their monthly survey of expectations for single-family home sales during the next six months reported a 4-point increase to the highest level since February, the third straight month of increase. Recent data is also consistent with the 35% gain in the S&P Homebuilding index since the end of July. Clearly, the has been an up tick in housing activity, but we had to chuckle at a quote Bloomberg pulled from an economist: "'It looks as if the worst is behind us' for the housing industry." Residential construction is on track for 1.6 million units, a very strong year.

Yesterday, Market News International's (MNI) Reality Check column was titled, "US Homebuilders Report August Surge in Orders." MNI quoted a spokeswoman from Centex Corp. stating, "From the month of August we're up 25% and have added an additional 1,000 units to what we originally thought we would have this year…typically August is not that strong of a month, but we had a really strong month. We don't see a slowdown right now." August orders were up 5% at Pulte and 12% at Kaufman and Broad. A Minnesota homebuilder estimated that prices had increased in the 12% range in Minneapolis. "We haven't seen home prices climbing at 1% a month compounded since the inflationary late ‘80s."

This afternoon the Federal Reserve released its monthly "beige book" of economic conditions throughout its twelve districts. Some of the headlines certainly providing an interesting contrast to previous reports. "Labor Markets Remained Tight In Most Areas;" "Fed Says Increase in Material Costs More Widespread;" Several Districts Say Sales Strengthened in Early September;" "Lending Activity Remains Strong in Most Districts."

The credit market, not surprisingly, was not comfortable with the tone of this report. From the report: "Labor markets remained tight in most Districts, although signs of some easing were reported by Boston and Kansas City. Reports of wage increases were widespread and some firms indicated that higher labor costs were an increasing problem… New York cited a severe shortage of computer "techies" as well as unmet demand for office workers…Chicago noted that competition for qualified workers remained intense in most areas… In Atlanta, skilled labor such as nurses and IT professionals were said to be in short supply."

"Most Districts characterized economic conditions as strong and several said that economic growth continued to be solid.'' ``Reports of wage increases were widespread and some firms indicated that higher labor costs were an increasing problem…''

Most districts reported that manufacturing activity remained ``generally strong'' and more than half of the districts reported manufacturing activity ``increased moderately to strongly.'' There were also reports from several districts that the consumer had increased spending in early September - "Strong back-to-school sales in the New York, Richmond, Chicago, and Kansas City districts…" "Reports indicated that business activity in services industries generally increased."

Putting it all together, for now we see continued global economic strength, great global demand for energy products, extreme demand for borrowings, and additional manifestations of extreme economic and financial imbalances. Such an environment is certainly not conducive to stable financial markets. We definitely expect extraordinary turbulence for key financial markets both here and abroad to continue.

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