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Mid-Week Analysis

DLJ Junk Bond Spreads
Emerging Market Debt Spreads

Amazingly, already wild conditions have become only more chaotic in global equity, currency, and credit markets. Here at home, the NASDAQ100 today traded in an intra-day 9% range, with the third-greatest volume (2.5 billion shares) on record. It was more than just tech stocks in retreat, with the Dow recovering from an earlier 435-point decline to end the session down 115. So far this week, the Dow and the S&P500 have dropped 2%, while the Transports have declined 1%. Defensive stocks continue to outperform, with the Morgan Stanley Consumer index actually gaining 1%. The Morgan Stanley Cyclical index has declined 1%, while the Utilities are unchanged. The small cap Russell 2000 has declined 3%, and the S&P400 Mid-cap index has dropped 2%. The NASDAQ100 and Morgan Stanley High Tech indices have declined 4%, while the Semiconductors have added 1%. The Street.com Internet index and the NASDAQ Telecommunications indices have sunk 8%. Apparently, the Biotechs have become the "safe haven," gaining 7% so far this week. The financial stocks have been under pressure, with the S&P Bank index dropping 4% and the Bloomberg Wall Street index declining 2%. Gold shares have dropped 4% this week.

This morning also saw virtual panic buying of Treasury securities. At one point, the long-bond had gained almost one full point, before recovering stock prices caused a sharp reversal. So far this week, 2-year Treasury yields have declined 3 basis points to 5.82%, while 5 and 10-year T-note yields have dropped 5 basis points to about 5.67%. Ten-year yields have declined 20 basis points during just the past 10 sessions. Mortgage yields continue to decline, with the benchmark Fannie Mae security seeing its yield drop 3 basis points to 7.5%. With the corporate debt market in tatters, Agency securities are apparently the vehicle of choice with yields sinking 6 basis points this week. Narrowing agency spreads, however, are not impacting the key 10-year dollar swap spread. This spread has widened 2 basis points to 121 so far this week. Things are going from bad to worse in junk bonds, with no end yet in sight for this problematic market collapse. Yesterday, the S&P US industrial speculative grade index widened almost 21 basis points. Money is fleeing high-yield debt funds, as the prices for closed-end funds sink on a daily basis.

Globally, currency markets are extremely tumultuous, with the euro sinking to record lows against the dollar. Today, the euro dropped almost 2% to close at a new low against both the dollar and yen. Gold has yet to benefit from the unfolding global financial quagmire, dropping more than $2 so far this week. Energy prices remain quite resilient as data from the American Petroleum Institute again indicate inadequate inventories. Inventories of crude remain near 24-year lows, with distillate inventories down 22% percent from a year ago and heating oil supplies 37% below last year. Bloomberg quoted an energy trader: "The question is: Where are all these phantom OPEC barrels? Supplies are significantly less than what you would expect."

While the focus on CNBC seems to be on trying to pick the bottom for Intel and semiconductor stocks, a truly ugly financial collapse gathers steam in Asia. So far this week, the Japanese Nikkei has declined 3% to trade below 15,000, increasing its year to date loss to 21%. The Nikkei is today 62% below its record high established at the latter end of the bubble in 1989. Elsewhere in Asia, Taiwan has suffered a 36% year 2000 decline, 15% in Hong Kong, 26% in Singapore, 44% in Thailand, and 38% in Indonesia. The South Korean Composite Index has dropped 50%, while their KOSDAQ Venture Index has collapse 73%. With political, financial and economic disarray in the Philippines, the country's stock market has lost 40% of its value, while its currency and bonds have been hammered. Bank lending rates in the Philippines have surged as much as 400 basis points over the last two weeks, in an unfolding vicious credit crunch. In South Korea, the Korean won traded at the lowest levels since May as the government entered to aggressively support the stock market. The government in Taiwan has also been forced to support a collapsing stock market and currency suffering from aggressive capital flight. Problematic currency weakness is also hitting the Thai baht, Australian dollar, and Singapore dollar, to mention just a few. Make no mistake; the Asian crisis is back.

Increasingly, Latin American currencies are coming under pressure as well, with trading becoming turbulent in emerging bond and currency markets generally. The JPMorgan Emerging Markets Bond Index has seen spreads jump 75 basis points in six sessions. Today the Mexican Bolsa opened 5% lower, although a 6% rally provided a close 1% higher. In Brazil, the Bovespa dropped 3%. Year to date, the Bolsa has declined 19% and the Bovespa 15%, while the Argentine Merval has sank 25%. Beyond weakness in global financial markets, both Mexico and Brazil are facing overheating economies.

Ominously, overseas markets are in virtual freefall despite continued surging imports to the U.S. Quoting MarketNews International, "U.S. imports continued to avalanche in August, breaking fresh records and widening the trade gap, as the holiday import season got underway…" The Port of Los Angeles reported a record 221,000 import containers during September, 22% above year ago levels. Bloomberg quoted a port spokesman: ``We are right in the middle of the holiday shipping season, which is prime time for us in terms of cargo volume, particularly on the inbound side. U.S. retail sales remain strong despite the shakiness and volatility of the stock market." Outbound containers increased 19 percent, to 79,000 containers. Quoting Bloomberg, "The imbalance between imports and exports has forced shipping lines to send many cargo boats back to Asia piled high with empties. The number of empty containers shipped back to Asia and other destinations through Los Angeles rose 37 percent in September, to 123,000 containers."

With mortgage lenders remaining exceedingly aggressive, it should be no surprise that our nation's housing market remains resilient. During September, housing starts were at the strongest pace since June. Building permits registered their first increase since June. This morning, the Mortgage Bankers Association reported their increase in their weekly application indices for both refinancings and purchases. The purchase index remains 12% above year ago levels. Yesterday, the National Association of Home Builders reported their housing index added two points to 63, the highest level since March.

This morning, the Labor Department reported that consumer prices rose by .5% (6% annualized) during the month of September. The core rate excluding food and energy increased .3%, the strongest gain since March. Energy prices rose at the strongest rate since June, although it certainly is not only energy prices that are on the move. Clothing prices had their largest jump in 10 years, with strong gains also for medical costs and insurance, housing, tobacco and transportation. It certainly looks like heightened general inflationary pressures to us. Also today, the government announced that next year Social Security recipients would receive a 3.5% cost of living adjustment, the largest adjustment since the 3.7% increase in 1991. Bloomberg quoted economist Joel Naroff, "inflation is broadening and pressures are beginning to build."

Pimco's Bill Gross has been creating news headlines with his talk of "hard landings" and continued troubles in the corporate debt market. We have included excerpts from comments he made Monday evening. Apologies, the transcription is a bit "rough."

Question from audience: "I'm wondering the recent downturn in the stock market, whether you think that makes the Fed more likely to move to a neutral stance?"

Bill Gross responding: "The neutral stance yes. I think Greenspan would not precipitate another run simply by going to neutral. I do think and as you all know Greenspan has sort of downplayed his exuberance comments of several years past. But, to me at least he has never forgotten them. The fact that he doesn't mention them, the fact that he has moved on to the productivity miracle and other topics that the press and investors talk about immediately after his speeches, to me doesn't mean that he never gave up on the exuberance. And I think Greenspan is well pleased, and this is just spec how would I know, but I think he is well pleased with the cooling off, if you want to describe it that way, of the markets, especially the NASDAQ and the potential for the markets to potentially slow the economy down. Whether or not he ultimately lowers rates, I think he hesitates. And this is delicate fabric (for a) central bank in a new age economy; it is no easy task.

It is one thing on the upside to be talking about productivity miracles and to trying to guess whether or not the appropriate speed of the economy is 4, 5, or 6 percent. Those are all fun things to talk about, but the critical question becomes on the downside, like you suggest, when does a Fed chairman step in and provide liquidity to a new age economy. Now we know they did that in concert with other central banks back in 1998, and it was successful 75 basis points worth (??). But, we also know what that did; it basically restarted the exuberance and produced in retrospect looks like exceedingly lofty levels for markets. Not just stock markets but perhaps other risk/speculative markets as well. I think Greenspan wants to do that again, but that is his dilemma. His dilemma is when to step in. Because he has stepped in before. He saved the world along with Rubin and Summers and a few others I suppose. And did a great job, but he also kicked the cycle off again. I think he hesitates longer than he would have previously, and there in lies the real dilemma for a Feb chairman in a new age economy is that will the hesitation be too long. Because there are legitimate questions that no one brings up because of the exuberance. But Japan made that mistake. Japan has a lot of other things wrong with it that the United States doesn't, but they raised rates in the late 80s and failed to bring them down quick enough and Greenspan knows that. It is just a delicate situation; it is not an easy game from this point forward. IT has been for the last year and a half it been very much fun and games and very easy, but from this point forward it is going to be a heavy, heavy burden on Greenspan and company.

Well, you know Greg I am a bond guy so I come before you with a natural dose of pessimism, which hasn't always been borne out in terms of reality. That's the bond person/stock person... Bond people see glass that are half empty, and stock people three quarters to completely full. And it might be true too. If you went back and looked at some of my outlooks. Sort of like Barton Biggs, I've been forecasting the next 5 out of the last 1 or 2 slowdowns. So, I don't know. it's difficult because it involves, to some extent, a correlation between the equity market and the bond market through the wealth effect, not entirely. It's really hard to know. Having said that, I never try and straddle the fence unless that's the place to be I guess. But I do lean more towards the hard than the soft landing. And that's because of a number of things. One: interest rates have risen substantially, not just in the United States but elsewhere. I'm talking about the Fed as well as corporate yields, and high junk bond yields as well. Yea, so that's one potential for a hard landing. Oil is another and we all know about that. And the bubble in the markets having been popped or certainly deflated. it brings forth the question. And again, another unique occurrence in a new age economy. How do these things play out? Nobody knows. How do corporations respond in the form of future investment and plant and equipment and technology if the technology sector itself and the exuberance in technology has been somewhat flattened and deflated.

So, typically in the past, if you look at correlations, corporations in the past increase their investment as the markets themselves move up. I'm not sure which leads which but they seem together. And because NASDAQ and tech stocks have come down so dramatically I wonder whether the 5% of GDP which tech investment now represents if that might not only level off but might move back down to 4 or 3% and therefore take 1% bite out of GDP growth that we might not have expected. The consumer. We all know the potential that is there. The savings rate is negative. They're in debt. the consumer, himself or herself could start a savings party anytime anywhere, but they haven't. And that's been one of the bond failings, having viewed the savings rate over years and years and years and suggested that at some point in time American consumers have to start saving. they haven't. Supposedly it could go on forever as long stocks keep going up. But yea, I think the hard landing primarily because investment tech spending going forward is a potential - and a hard landing doesn't necessarily mean recession. A hard landing in the New Age economy may mean zero to one to two. But I think that's where were headed. For bond people that's good. Right. As long as you hold the right bonds. Not spread product.

The message tonight is to avoid spread product - except for mortgages - at almost any cost because spread product is vulnerable - not just in a cyclical slowdown. And here's the case: it's rare when you have a slam-dunk. And I use the word hesitantly, because you never have a slam-dunk. But this is as close to a slam-dunk as you can get because spread product doesn't do well in a cyclical slowdown, and spread product doesn't do well in a continuation of a New Age economic revival. And the reasons for that probably encompass 5, 10, 15 minutes and a lot of it is subjective as opposed to objective and you could certainly disagree. Spread product is in for some grim reapings here in the next few months and quarters, I think.

The Fed is obviously concerned about oil prices and their effect on the economy. I don't think the Fed would explicitly act to counter oil's effect on the economy unless it was obvious that we were going to be at these levels or higher for a long time. The problem with the Fed is that once they start moving in a certain direction they initiate a certain momentum with investors be it up or down. Were as oil is subject to more cyclical and short-term and more political - or anything else you want to name - in terms of factors that drive its movement. It's more variable and volatile and less predictable. I think. So I don't think the Fed moves to counteract oil's influence unless it's obvious we are going to be here for a long time. And then, that begs the question as to which way they move. Because if oils going to be at $35 and therefore core inflation starts to build on the effect of that oil, perhaps it prevents them from easing into an economic slowdown. So it's another one of those tricky dilemmas, I guess, the Fed has before them as to judge oil and even after they judge it what do they do about it. Do they ease interest rates in order to revive the New Age economy or do they keep interest rates high in order to prevent accelerating inflation. My guess is the latter. But we'll just have to find out how hard the hard landing is, if we are going to have one."

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