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Mid-Week Analysis

Consumer Confidence Index

One could say that a two-tiered stock market has developed this week. While the technology rout continues in full force, the Dow and many blue-chip stocks perform well. So far this week, the Dow has increased 2%, while the S&P500 is largely unchanged. The Morgan Stanley Cyclical index and the Utilities have gained 2%. The defensive issues continue to shine, with the Morgan Stanley Consumer index gaining 2%, increasing its year-to-date gain to 9%. The financial stocks have generally performed strongly, with the S&P Bank index surging 6% and the Bloomberg Wall Street index 3%. The Transports have been under pressure, dropping 2% so far this week. The small cap Russell 2000 has declined 4% and the S&P400 Mid-cap index has dropped 2%. The Biotech stocks have declined about 2%. Throughout the technology sector, it has been unrelenting selling. For the week, the NASDAQ100 and Morgan Stanley High Tech index have declined 8%, with the Semiconductors dropping 15% and The Street.com Internet index 10%. The NASDAQ Telecommunications index has declined 9%.

The faltering NASDAQ and the perception of a slowing economy has fostered sinking credit market yields. The 2-year Treasury has seen its yield drop 13 basis points (to 5.73%) in just three sessions. Five-year yields have declined 12 basis points to 5.50%. Ten-year yields have declined 7 basis points to 5.55%, and the long-bond 1 basis point to 5.65%. Mortgage and agency securities continue to perform well, with yields generally declining 8 basis points so far this week. The 10-year dollar swap spread has narrowed 1 basis point to 116. The junk bond market continues to falter, with spreads to Treasuries at record highs. The dollar has come under selling pressure this week, dropping about 2% against the euro and Swiss franc.

Interestingly, the financial stocks continue to ignore the unfolding collapse throughout the Internet/telecommunications/technology sector. So far this week, the New York Stock Exchange Financial Index has jumped almost 4%. Year-to-date, this index has gained 15%. Elsewhere, the AMEX Securities Broker/Dealer index sports a year 2000 gain of 14%. Yet, despite the market's current perceptions, we don't think one can overstate the negative ramifications for the entire financial sector from the developing collapse of the great technology bubble.

With technology stocks in a freefall worldwide, we seemingly come closer to global financial crisis by the week. It is certainly no surprise that Asian stock markets and currencies generally perform poorly. A technology collapse is the last thing these already impaired financial systems need. It also appears that faltering technology demand is now impacting economies, with news from the Bank of Korea of slowing domestic growth and mounting inventories. The Korean won has been the worst performing currency in the world this month, dropping more than 1% today and 5% for the month. And after getting through the 1997 crisis relatively unscathed, the Taiwan dollar traded today at a 19-month low. Taiwan's economy is heavily dependent on technology exports, with one-half of all notebook computers manufactured on the island. Looking at markets throughout the region, Japan's Nikkei has a year-to-date decline of 23% and the JASDAQ 39%. Equities have dropped 16% in Hong Kong, 37% in Taiwan, 50% in South Korea, 21% in Singapore, 41% in Thailand, 37% in Indonesia, and 34% in the Philippines. It's not pretty, but it can only get much worse.

Bloomberg captured market sentiment with a quote from a senior portfolio manager: "It's not just the (Korean) won. People are withdrawing funds from emerging markets."

In Turkey, there is currently an episode reminiscent of the 1997/98 global crises, with destabilizing capital flight out of the country. We want to highlight the financial dilemma currently facing Turkey, as it is an illustration of the multifaceted aspect of the rapidly deteriorating global financial environment. It is also an example of how quickly crisis can develop within a financial system; it's all about liquidity, and liquidity can be very fleeting.

Virtually overnight, a dramatic break in confidence and a full-fledged liquidity crisis has erupted in Turkey. Yesterday, the Turkish stock market declined 9%, its worst decline in 15 months. Over just the past 13 sessions, the market has declined almost 30%. Last month, the government took control of 10 problem banks, and quickly concern has grown over the soundness of the entire banking system. And then this week rumors of bank illiquidity sent foreign investors rushing to the exit. The talk is that foreign banks are pulling credit lines and reducing exposure. As was the case in 1997/98, when the banks and speculators move to reduce exposure, there is no one to take the other side of the trade - no liquidity. Yesterday, interest rates spiked, with overnight rates surging to 180% from the previous day's 80%. Just last week, overnight rates were 30% to 40%. Bond yields jumped 1000 basis points (10 percentage points) to over 60%. Even foreign currency denominated bonds have declined 10 straight sessions to yield 14.45%. These high rates place only more pressure on an already impaired banking sector.

The Turkish central bank is aggressively purchasing the lira, spending almost $5 billion the past week. Outflows are estimated at $500 to $600 million daily. Central bank reserves are now likely below $13 billion. Heavily dependent on imported oil, surging crude prices have caused higher than expected inflation and mounting trade deficits. And with its rapidly deteriorating capital account, the government is under intense pressure to go forward with its privatization of Turk Telecom. Unfortunately, it is a particularly poor environment to monetize such an asset. In a sign of increasing animosity, a government official today blamed foreign speculators for the financial crisis. At the same time, the IMF stated it would speed up a disbursement and the World Bank will apparently provide the country $1 billion million of emergency credit. On the news of emergency credit, there was some relief in the Turkish credit market today with overnight rates dropping to 165%. Here also, it's not a pretty picture.

Elsewhere, the unfolding financial turbulence in Argentina has seemingly settled down for now. Apparently, the country will tap its IMF credit line for $2 billion to get through December. The entire region, and emerging markets in general, is quite vulnerable to what appears an increasing global flight away from risky assets.

With last week's Mid-Week Analysis raising a few questions, we will expound a bit on the subjects of inflation and the trade deficits - a brief "tutorial."

It is important to appreciate that inflation is not simply higher goods prices. Webster's defines inflation as "an increase in the volume of money and credit relative to available goods and services resulting in a continuing rise in the general price level." Notice, rising prices are a manifestation of inflationary forces, not inflation itself. The concept of inflation is simple given the assumption of a closed economy. Given the dynamics and complexity of the U.S. economy, and the different mechanisms available for people to spend, inflation is anything but "simple." Importantly, inflation can manifest itself in two other important and destructive ways - through trade deficits and asset inflation.

A simple example will help visualize how inflation can result in higher trade deficits and asset inflation. First, we will start with a closed economy without any investment opportunities. All money must be spent or saved. If there is an increase in the amount of money, people will obviously have more money to spend. Using Econ 101 terms, this influx of money shifts out the demand curve. The amount of goods stays constant so the supply curve does not move. Since there is more money (demand) relative to the quantity of goods (supply), prices increase. Now, let's open the economy up to investment alternatives. Here, the same people can either choose to purchase more goods or make additional investments with the extra money. One of our principle contentions is that the increase in money and credit has led to the increase in financial asset and real estate prices.

Finally, by adding foreign trade to the equation the results are even more ambiguous. By importing goods, supply increases and shifts out the supply curve. Now, both the supply and the demand curves shift out. Depending on which curve shifts out more, prices can either increase (demand curve shift out more) or decrease (supply curve shifts out more). So a massive increase in demand does necessarily lead to an increase in prices. This is precisely what has occurred in the U.S. economy. However, instead of causing the concern it would have traditionally, it instead has been heralded as an advantage of the "New Economy."

The Asian financial crisis dramatically benefited the proponents of the "New Economy." When the Asian economies collapsed, it reduced worldwide demand for goods. However, it did not reduce the supply of goods. In fact, it might have actually increased the supply of goods. Since Asian companies are predominantly financed with debt, many companies (economies) increased production in order to generate the cash flow to service their obligations. Continuing with the steel industry example from last week, the U.S. imported 30% more steel from Asia in 1998 than 1997. This pushed the market share of imported steel to almost 35% at its peak, well above the normal levels of 20% before the crisis. Even with the economy humming along at 5%, the increase in imported steel caused a 20% price decline. This obviously put a damper on inflation as steel is used extensively throughout manufacturing, which benefited the U.S. consumer through lower prices for finished goods.

The strong dollar has also played a significant role in the growing trade deficit. As the dollar strengthens, imported goods become cheaper than those produced domestically. This makes domestic companies less competitive relative to the foreign companies exporting goods to the U.S. If this persist for long periods of time (a protracted boom) and a significant amount of goods in a particular industry are imported, domestic manufactures/producers are crowed out of the market place. As was mentioned last week, there have been seven bankruptcies in the steel industry this year. Importantly, over time bubble economies create severe structural economic distortions.

The recent price increase in oil has refreshed everyone's mind as to the consequences of dependency on foreign sources for goods and resources. As more industries are driven out of business, the U.S. economy will be held hostage to the capital markets more than ever. This is not detrimental when foreign investors are enamored with your capital markets, working to keep your currency strong. However, if the day ever comes when King Dollar slips in stature and becomes the court jester, we are likely to experience a period of increasing prices for goods. This could occur in a slowing economy or even during a recession. Clearly, the current technology collapse greatly increases the likelihood that perceptions will turn against the soundness of the so-called New U.S. economy, with profound ramifications for the dollar. If the marketplace turns on the dollar, there may be much more serious discussion about inflation and trade deficits.

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