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Mid-Week Analysis

Emerging Market Bonds
Argentine 5-Year Government Bond Yield
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Storm clouds grow darker by the day. With Nortel shocking technology bulls, it was another tumultuous day throughout the technology sector. So far this week, however, many indices have held up relatively well. The Dow and the Morgan Stanley Cyclical indices have gained 1%, while the Morgan Stanley Consumer index has added 2%. The Utilities have come under selling pressure, dropping 3% so far this week. The small cap Russell 2000 has declined 3%, and the S&P400 Mid-Cap index has dropped 4%. The tech sector has been a rout, with the NASDAQ100 dropping 10%, the Morgan Stanley High Tech index 9%, and the Semiconductors 12%. The Street.com Internet index has declined 7% and the NASDAQ Telecommunications index 10%. The Biotechs have bucked the trend, gaining 1%. Financial stocks have also performed well, with the S&P Bank index adding 2% and the Bloomberg Wall Street index increasing 1% so far this week. Gold stocks have dropped 2% so far this week.

There is considerable debate as to whether the market overreacted to Nortel's earnings. To help clarify this issue, we turned to Tim Heitman, ace telecommunications analyst at David Tice and Associates who wrote: "For whom the Nortel tolls. There is no joy in Mudville today because the mighty Casey has struck out. Nortel Networks, the one stock in the optical equipment sector that investors thought was a sure winner, swung mightily and missed today. Without going into a long play-by-play, here is what all of the fuss is about. Nortel's revenues were light to the tune of about $300 million. The company beat First Call earnings estimates due to a larger than expected increase in "other income." Even though revenues were down $500 million sequentially, receivables rose $400 million sequentially. It appears as though optical revenues declined sequentially, which is not supposed to happen if the market is as strong as the company says it is. While management blamed the revenue shortfall on a bottleneck in the installation process, the real problem seems to be the same thing that has happened to the chip manufacturers, the double ordering of product by customers. Management stated that customers were depleting their backlog, rather than increasing orders. Companies ordered more than they needed earlier in the year when supply was tight. Now demand seems to have slowed, while supply is increasing. This means next year's estimated revenue growth rate of 20%+ could be too high. One analyst pointed out that Mr. Roth, the CEO stated in September that he thought the company would do $12 billion in optical revenues. It now looks like $10 billion is going to be the real number. In the final analysis, investors choose to be enamored with Nortel's technology and ignored the signs (slumping share prices of CLECs and other telcos, increasing yields on junk debt, tightening lending standards, severe product shortages earlier in the year) of a potential slowdown in Nortel's business."

We certainly believe today's announcement from Nortel is one more key piece of data supporting our view of a major unfolding industry shakeout/debacle. There will certainly be great losses and many "casualties." At the same time, this afternoon many pundits are stating that today's tech rout was "just the capitulation the marketplace needed" to set the stage for a significant rebound. Well, we have no idea what stock prices will do tomorrow, but we certainly see things in a much different light. That disappointing news comes in the optical area is certainly a key development fundamentally. It was also a big event in respect to market "dynamics," as this sector had become an important "last bastion of refuge" for the technology "momentum" players. For these aggressive speculators, today was quite a "body blow." And the fact they were hit so hard definitely increases the possibility that the "mo players" and aggressive growth investors could panic and all move toward the exit at the same time.

Yet, today's "action" was certainly not limited to technology stocks. The treasury market reversed from strong gains in the morning, possibly related to a stronger than expected report on existing home sales. The market was also uncomfortable with comments from Atlanta Fed President Jack Guynn questioning the sustainability of productivity growth. It appears that there is also increasing worries that inflationary pressures are building, and investors/speculators can not be blamed for booking profits. After all, Treasuries have recently been trading in a "meltup" market dislocation as other fixed- income securities are dumped in favor of the safe haven of U.S. government debt. Today, however, there was no place to hide. Two-year Treasuries were hit the hardest, with yields rising 9 basis points. Five-year yields jumped 6 basis points, 10-year 7 basis points, and the long-bond saw yields add 4 basis points. Mortgage yields increased 6 basis points and agency yields generally added 4 basis points. The benchmark 10-year dollar swap spread was largely unchanged.

Again this week, tumult is paralyzing the junk bond market. Today, Levi's joined the list of companies shelving issuance plans as it dropped its $350 million junk deal. Levi's had hoped to pay down bank debt with proceeds from the offering. That a company like Levi's would cancel its deal was seen as one more blow to an already faltering sector. Even with the index of junk bond yields approaching 14%, the highest since 1991, there are few buyers to be found within the marketplace.

While the media's focus is on today's technology drubbing, little attention is paid to a most critical development: an unfolding global financial crisis that seemingly gathers momentum by the day. Importantly, it appears that the rapidly growing financial cancer that has ravaged the U.S. junk bond market has now spread to the acutely vulnerable emerging markets. In particular, the situation appears to have taken a dramatic turn for the worst in Argentina, with fears of a developing liquidity crisis leading to a virtual panic in the bond market. Argentine yields surged a shocking 120 basis points today, with yields jumping to 14-month highs. Argentine bond spreads have widened 350 basis points since earlier this month. With liquidity from international investors/speculators having evaporated, the Argentine government was today forced to borrow $1.2 billion from local banks to complete its financing needs for the remainder of the year.

Bloomberg quoted Mohamed El-Erian from Pacific Investment Management: "The market's focus is now shifting to various credit lines that Argentina could access to navigate the more difficult market conditions." Quoting Bloomberg, "Argentina bonds have been battered amid broader emerging market declines as investors bet that Latin America's biggest borrower may have trouble tapping capital markets for the more than $20 billion it needs to finance its debt and budget deficit in the next 15 months." Argentina has $123 billion of public debt. Rumors of debt downgrades, and political coups added to the tumult. The Argentina Merval index sank 4% today, and has now dropped 28% year-to-date.

There was another ominous paragraph in the Bloomberg article. "…some bankers said they have begun to receive phone calls from big U.S. and European hedge funds interested in betting against the peso in the futures market. As those orders mount, the peso's decline in the futures market could turn into a tumble because the hedge funds, which normally concentrate on trading developed market fixed-income securities, have enough money to place hefty bets, analysts say."

In neighboring Brazil, bond yields generally rose 10 basis points today, with spreads having widened 100 basis points in two weeks. Overnight borrowing rates jumped 35 basis points today. The Brazilian real dropped 1%, and has now declined seven straight sessions. The real now stands at the lowest level in almost one year. The Mexican Bolsa dropped 1% today, increasing year-to-date declines to 16%. The Mexican peso has declined four consecutive days and has dropped 2% this month. The Chilean peso and Venezuelan Bolivar also sank to a record lows today. Bloomberg quoted an economist from Fleet Global Markets, "Risk assets are being punished. What is going on is that people are worried about emerging markets in general. People are worried about the region and selling everything." Most unfortunately, it sure looks to us like many countries within the region are heading right into what will be a very difficult period both politically and economically.

In Asia, as political, financial and economic instability worsens by the week, the Philippine peso suffered its largest drop in 10 sessions. The peso has declined 7% so far this month, and has lost 24% of its value so far this year. The Bank of Thailand has moved to support the baht that now trades near 31-month lows, this after having declined 14% year-to-date. The Indonesia rupia has declined 21% this year. Today, the Indian rupee closed at a record low. The Australian dollar trades near a record low, with year-to-date losses of 21%. The New Zealand dollar trades near a record low, having declined nearly 24% this year. Year-to-date, the Nikkei has dropped 22%, the major Taiwanese index 29%, South Korea 47%, Singapore 22%, Thailand 44%, Indonesia 38%, India 25%, and the Philippines 40%. For U.S. investors/speculators in particular, losses have been devastating.

The euro was also hit hard today, falling to an all-time low. It is now about 18% below where it began the year. The British pound suffered its largest drop in weeks today, increasing its year-2000 decline to 11%. The Swiss franc lost more than 1% of its value today, increasing its year-to-date decline versus the dollar to 13%. Eastern European currencies are under even heavier selling pressure. The South African rand sank to a record low today, dropping more than 1%. Dow Jones quoted an international banker, "the dollar's strength is getting to be beyond what you possibly imagined. My guess is that the U.S. is getting closer to rethinking its strong dollar policy but we're not there yet."

We cannot stress enough how ominous the backdrop has become both domestically and internationally. Presently, global currency, equity and fixed income markets are trading in an increasingly turbulent and dislocated fashion. The leveraged speculating community has likely been hammered, and one must assume that there will be a move to reduce risk. Such an environment can be particularly parlous for derivative players. And like 1998, liquidity can evaporate abruptly and simultaneously in a myriad of markets. We certainly see such a circumstance in process.

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