04/08/2004 Ideologues and Quagmires *

Stocks were fractionally lower this week.  The Dow declined 0.3% and the S&P500 dipped 0.2%.  The Transports and Utilities each declined better than 1%.  The Morgan Stanley Cyclical index lost 1%, while the Morgan Stanley Consumer index gained slightly.  The broader market gave back some of recent gains.  The small cap Russell 2000 declined almost 1%, while the S&P400 Mid-cap index was down marginally.  The NASDAQ100 dipped 0.3%, and the Morgan Stanley High Tech index declined 1%.  The Semiconductors were slightly negative and The Street.com Internet index slightly positive for the week.  The NASDAQ Telecommunications index was unchanged.  Biotechs dropped about 1%.  Financial stocks were on the defensive, with the Broker/Dealers dropping 1.6% and the Banks 0.2%.  And while Bullion dipped only 60 cents, the HUI Gold index sank 3.1%. The Treasury market stabilized after last week’s drubbing.  Two-year Treasury yields were unchanged at 1.85%.  Five-year yields rose 4 basis points to 3.18%, with two-week gains of 30 basis points.  Ten-year Treasury yields were up 4.5 basis points to 4.19%, while long-bond yields rose 4 basis points to 5.02%.  Benchmark Fannie Mae mortgage-backed yields were unchanged.  The spread on Fannie’s 4 3/8% 2013 note narrowed 1 to 28, and the spread on Freddie’s 4 ½ 2013 note narrowed 1 to 27.  The 10-year dollar swap spread narrowed 0.5 basis points to 41.25.  The implied yield on December 3-month Eurodollars dropped 6.5 basis points to 1.805%.  Corporate debt added to last week’s strong relative performance, with spreads having narrowed significantly in the junk sector over the past five sessions. Bloomberg tallied corporate issuance of $5.4 billion for this holiday-shortened week.  Investment grade issuers included Bunge $500 million, Pacific Life $500 million, Webster Bank $150 million, and FBL Financial $75 million. Junk issuers included Allied Waste $675 million, International Steel $600 million, Mueller Group $415 million, Williams Companies $400 million, Severstal $375 million, Sup Essx Com $257 million, VWR International $200 million, Delco Remy $275 million, Memberworks $150 million, and Vicorp Restaurant $125 million. Convert issuance included Allied Waste $200 million, Financial Federal $175 million, and Decode Genetics $125 million. Foreign dollar debt issuers included the European Investment Bank ($1 billion). ABS issuance amounted to $3.8 billion (from JPMorgan), with y-t-d sales of $146 billion running up 24% from comparable 2003.  Year-to-date Home Equity ABS issuance of almost $84 billion is running 65% above comparable 2003. Freddie Mac posted 30-year fixed mortgage rates jumped 27 basis points to 5.79%, the highest rates since early January.  Long-term fixed rates were up 39 basis points over two weeks. For the week, 15-year fixed-rate mortgages were up 28 basis points to 5.12%.  One-year adjustable-rate mortgages could be had at 3.65%, up 19 basis points for the week (up 29 basis points in two weeks).  The Mortgage Bankers Association Purchase application index jumped almost 8% this week to the second-highest ever.  Purchase applications were up 19% from one year ago, with dollar volume up almost 39%.  Refi applications dropped 15%.  The average Purchase mortgage was for $220,400, and the average ARM was for $307,800.    Broad money supply (M3) surged $42.1 billion for the week of March 29, with 3-week gains of $91.3 billion.  For the first 13 weeks of 2004, M3 has expanded $221.6 billion, or 10.1% annualized.  For the week, Demand & Checkable Deposits increased $8.7 billion (up $48.0 billion over three weeks).  Savings Deposits added $3.9 billion and Small Denominated Deposits dipped $0.6 billion.  Retail Money Fund deposits declined $0.4 billion, while Institutional Money Fund deposits jumped $16.2 billion.  Large Denominated Deposits expanded $8.4 billion.  Repurchase Agreements rose $3.2 billion, while Eurodollar deposits added $2.4 billion.  It is also worth noting that Savings Deposits have expanded by $119.9 billion, or 15.2% annualized, during the first 13 weeks of 2004.  Over 52 weeks, Savings Deposits were up $413 billion, or 14.4%. Total Bank Credit jumped $9.1 billion to $6.53 Trillion (week of March 31).  Bank Credit is up $283.3 billion during the first 13 weeks of the year, or 18.1% annualized.  For the week, Securities holdings declined $7.4 billion.  Loans & Leases jumped $16.5 billion, with Real Estate loans up $15.8 billion.  Real Estate loans are up $92.2 billion y-t-d, or 16.6% annualized.  For the week, Commercial & Industrial loans declined $6.7 billion and Consumer loans dipped $0.2 billion.  Security loans surged $19.3 billion, while Other loans declined $11.6 billion.  Elsewhere, Total Commercial Paper increased $3.0 billion to $1.322 Trillion.  Financial CP declined $3.3 billion to $1.204 Trillion, while Non-financial CP increased $6.3 billion to $118.1 billion.  Year-to-date, Total CP is up $53.5 billion, or 15.7% annualized. Fed Foreign “Custody” Holdings of Treasury, Agency debt jumped $16.7 billion, reversing last week’s atypical decline.  Year-to-date, Custody Holdings are up $109.3 billion, or 38.1% annualized. Currency Watch: Currency markets settled down a bit this week.  The dollar index gained about 0.5%.  The Japanese yen, declining about 2%, gave back some of recent gains.  Commodities Watch: April 7 – Bloomberg (Koh Chin Ling):  “China Steel Corp., Taiwan’s largest steelmaker, said it will increase export prices by one-fifth on average in the three months ending July 31 because of higher raw material and transportation costs.  The state-controlled company plans to raise hot-rolled steel prices by $140 a ton to $500 for Southeast Asian customers, and by $135 for Chinese buyers…” April 6 – Bloomberg (Alex Lawler):  “The International Energy Agency, an adviser to 26 industrialized countries, raised its forecast for world oil consumption this year for the sixth straight month as the U.S. economy recovers and demand surges in China.  Global use of gasoline, diesel and other fuels will rise by 1.7 million barrels a day to almost 80.3 million barrels daily, the biggest gain since 1997. The increase is 60,000 barrels a day more than the IEA forecast last month. In the second quarter, demand will be 300,000 barrels a day higher than previously expected, the Paris-based agency said in a monthly report. ‘The driving force is the expanding economy,’ Klaus Rehaag, editor of the report, said by telephone from Paris. ‘We have a significant recovery from the recession that’s primarily driven by the U.S. At the same point in time, China and India are expanding extremely rapidly.’” Crude oil surged 8% this week, jumping back above $37 a barrel.  The Goldman Sachs Commodity Index (GSCI) jumped 4.4%, increasing y-t-d gains to almost 11%.  The GSCI rose yesterday to the highest level since November 1980.  The CRB index gained almost 1%. Asia Inflation Watch: April 9 – Bloomberg (Tian Ying and Samuel Shen):  “China’s industrial production growth accelerated to 19.4 percent in March, the fastest pace in more than a year, suggesting the government may need to raise interest rates or take other measures to cool Asia’s second-largest economy… Investment expansion was the main driver of production growth in the first quarter, the statistics bureau said. Steel production rose 29.5 percent in the first three months from a year ago, while that of cement manufacturing equipment jumped 59 percent during the period… Companies such as Shanghai Huayu Real Estate Development Co., a privately owned developer, are expanding even as the government tries to stem credit to property companies out of concern that an asset bubble may be building. Huayu plans to develop a 300 million yuan villa project in Kunshan, near Shanghai, and is seeking bank loans to finance construction. ‘Why should the government restrict lending to real estate companies if we can sell all the houses we build and make huge profits?’ said Fan Haixin, the company’s development manager.  ‘There’s a real demand for new houses in Shanghai.’ Shanghai’s housing prices jumped 24 percent last year…” April 8 – The (Hong Kong) Standard (Raymond Wang):  “The gap between capital gain and rental growth of luxury properties is widening so much that rental yields have fallen to as low as 2 per cent… Prices of luxury residential properties have soared by more than 30 per cent since the beginning of the year. But at the same time the rents of luxury apartments have increased by only 3.4 per cent, Jones Lang LaSalle head of research for Greater China Nelson Wong said… In the mass residential property market, Wong said prices have been surging since last September at a pace unseen even in the pre-1997 years, growing 35 per cent between last September and February. April 6 – Bloomberg (Clare Cheung):  “Hong Kong’s retail sales had their biggest gain in four years in February as tourist arrivals surged and gains in stocks and property prices boosted consumer confidence.  Sales increased 13.2 percent from a year earlier…” April 6 – Bloomberg (Francisco Alcuaz Jr):  “Philippine inflation accelerated in March at its fastest rate in more than two years after the peso fell to a record, making imports more expensive and raising the chances the central bank will move interest rates higher.  Consumer prices rose 3.8 percent…” Global Reflation Watch: April 8 – Financial Times (Peter Smith):  “Private equity investment in the Asia-Pacific region rose 91 per cent to a record $17.5bn last year, as part of a global surge in private equity deals… Growth in Asia outstripped that of the US and Europe - the world’s two most developed private equity markets. Private equity investment in the US rose by 67 per cent to $108bn.” April 7 – Bloomberg (Bharat Ahluwalia and Anand Krishnamoorthy):  “India’s growth in bank loans has been ‘vigorous’ because of demand from homebuyers and other individual borrowers, Reserve Bank of India Governor Y.V. Reddy said in New Delhi.  Bank loans grew 38 percent since September, Reddy said… Loan growth has picked up because interest rates at a 30-year low are encouraging consumers to buy homes, cars and other durables with bank finance.” April 5 – Bloomberg (Abhay Singh):  “India will raise its economic growth estimate for the year ended March 31 from an earlier forecast of 8.1 percent, the Press Trust of India said on Saturday, citing an interview with Finance Minister Jaswant Singh.” April 8 – Bloomberg (Wahyudi Soeriaatmadja and Shanthy Nambiar):  “Indonesia’s economy may have expanded 4.8 percent in the first quarter, its fastest pace in more than three years, as low interest rates helped boost consumer spending, the central bank governor said. ‘Growth will continue to be heavily driven by consumer spending, and will also be helped by exports,’ Burhanuddin Abdullah, governor of Bank Indonesia, told reporters in Jakarta. Southeast Asia’s biggest economy will probably expand as much as 5 percent this year…” April 5 – Bloomberg (James Cordahi):  “The economies of Saudi Arabia, Iran and 10 other Middle East countries grew the second-fastest in the world last year driven by higher oil revenue and lower interest rates, Standard Chartered Plc said in a quarterly report. The region, which includes the United Arab Emirates, Kuwait and Egypt, grew by 5.9 percent, surpassed only by China and north-east Asia…” April 7 – Bloomberg (Romina Nicaretta):  “Brazilian new vehicle registrations rose for the first month in three after the central bank cut the country’s benchmark target rate to a three-year low, sparking consumer spending on high-value goods such as cars. Registrations of new cars and trucks made in Brazil and imported rose 38 percent in March…” April 7 – Bloomberg (Dylan Griffiths):  “South Africa’s annual house price inflation accelerated to a 21-year high in March, after the central bank cut interest rates five times in 2003, said Absa Group Ltd., the country’s biggest home-loan provider.  The average price of a home climbed 22.7 percent…” California Bubble Watch: April 8 – “The percentage of households in California able to afford a median-priced home stood at 24 percent in February, a 6 percentage-point decrease compared to the same period a year ago when the Index was at 30 percent, according to a report released today by the California Association of Realtors (CAR)… CAR’s monthly housing affordability index measures the percentage of households that can afford to purchase a median-priced home in California… The index is the most fundamental measure of housing well-being in the state.  The minimum household income needed to purchase a median-priced home at $394,300 in California in February was $91,690, based on a typical 30-year, fixed-rate mortgage at 5.74 percent and assuming a 20 percent downpayment. The minimum household income needed to purchase a median-priced home was up from $77,220 in February 2003, when the median price of a home was $326,640 and the prevailing interest rate was 5.93 percent.” April 6 – Bloomberg (Michael B. Marois):  “California’s medical costs for prisoners jumped almost 150 percent over four years while the state relies on a 30-year-old law that allows health contracts to be awarded without competitive bids, a state audit found.  California, with the largest budget deficit of all U.S. states, paid $239 million, up from $96 million four years ago, to hospitals, clinics and laboratories for inmates medical care in the fiscal year that ended June 30, according to the report by the state’s Bureau of Audits.” U.S. Bubble Economy Watch: April 8 – Dow Jones (John Connor):  “The U.S. government ran a $297 billion budget deficit in the first six months of fiscal year 2004, the Congressional Budget Office estimated.  ‘Although revenues have risen by 2.5% compared with their level in the first half of last year, outlays have grown more quickly, increasing by about 6%,’ CBO said in new monthly budget review report.  CBO is forecasting a budget deficit of $477 billion for the 2004 fiscal year. The Bush Administration is projecting a $521 billion deficit. Last year’s deficit was $375 billion, the biggest ever in absolute dollar terms… CBO estimated that defense outlays through March were about 18% above the amount spent in the first six months of fiscal year 2003… The budget office said Medicaid outlays were 12.4% higher in the first half of fiscal 2004 than in the first half of fiscal 2003.” April 5 – Bloomberg (Kathleen M. Howley):  “The average price of a New York townhouse rose to a record $4.04 million in 2003 as Wall Street executives, buoyed by stock market gains, spent more money on larger luxury homes.  The average price for a single-family house in New York’s most expensive borough increased 10 percent from $3.67 million in 2002, according to a report from Miller Samuel Inc., a Manhattan real estate appraisal company.” Freddie Mac again raised its estimate for 2004 household mortgage debt growth, this time to 12.6% from 12.2%.  And the National Association of Realtors raised estimates slightly for both new and existing home sales. Ideologues and Quagmires: “The lid of the pressure cooker has come off,” U.K. Foreign Secretary Jack Straw said today on the BBC.  As an analyst, I feel compelled (but still hesitate) to address the unfolding quagmire in Iraq for the first time since my “Off Topic” piece from about one year ago.  Hopefully, the recent escalation is in reality a “flare up” by a limited number of “thugs and terrorists” - as Department of Defense officials claim – that will be assuaged over the coming days and weeks.  But my sense is that something much more problematic and momentous – having festered for 12 months and generations – is now surfacing. I fear we have plunged unexpectedly into an altered and uncertain environment that poses heightened risk to U.S. and global financial markets.  The Nikkei today dropped 1.6%, apparently in response to the taking of Japanese hostages in Iraq.  The deteriorating situation will surely play a major role in the unfolding U.S. political season, as it may globally.  There is also potential for the Iraqi situation – with daily “body-counts,” likely hostage situations, the rising cost of a larger occupying force - to be a major polarizing force for an increasingly divided country.  This type of environment is conducive to bear markets (although market weakness and uncertainty would likely keep the Fed on hold and calm the Treasury market).    Only a few short weeks ago, it appeared that the U.S. strategy of training Iraqis for self-policing and security was on track.  This was allowing the American military to assume a much favored role as a less conspicuous occupying force.  Months of progress had been made in “winning the hearts and minds” of a majority of Iraqi people.  And while insurgents throughout the Sunni Triangle kept American forces on constant edge, coalition partners worked in relative calm in many cities throughout the country.  A relatively smooth transition to the June 30th transfer of “sovereignty” appeared possible.  As such, Iraq was a moot point to financial markets fixated on buoyant U.S. and global economies, liquid international markets, a timid Fed and notions of an election year bull market.  Much has changed and is changing and is unknown. The brutal murder and mutilation of four American civilians in Fallujah last week forced abscesses to a head, while altering the course of the Iraqi conflict.  Markets, assuming at the time that the act was a horrific but random act of violence, were content to ignore the significance of developments.  Now, however, the firm that employed the security contractors is claiming that their workers “were in fact lured into a carefully planned ambush by men they believed to be friendly members of the Iraqi Civil Defense Corps” (from David Barstow’s story today in the New York Times).  In Fallujah, as well as throughout cities struck by the uprising of the followers of Shiite cleric Muqtada al-Sadr, the Iraqi police and security forces generally retreated from or even aligned with the insurgents.  American Coalition Partners in numerous instances proved incapable of maintaining order and control, and they are today ill-prepared for the hostile environment.  Abruptly, and with significant uncertainty and risk, a new direction is required.  The decision was made by our military and political leaders to move decisively to restore order and quash the uprising.  A Marine unit engaged the insurgents in Fallujah, in a deadly urban battle that has enraged the Arab community.  Public outcry has included members of the U.S.-appointed Iraqi Governing Council.  Concerns also mount that recent events have united the causes of both Shiite and Sunni extremists.   There is also the recognition that the past twelve months have provided the opportunity for the resistance movement to arm and become better organized.  Reports have insurgents well-supplied with rocket-propelled grenades and even plastic-explosive “suicide belts,” while employing increasingly sophisticated tactics.  Fortunately, the Marines are said to be “winning every firefight,” although costs in lives and otherwise are high and mounting.  On a local level, some U.S. military personal bemoan the now wasted months of arduous work to forge ties and improve the lives of the people of Iraq.  Apparently, American construction projects are also targets of the insurgency.  For too many Iraqis, the initial elation and incited expectations from one year ago have given way to faded hopes, despair, and rising animosities. Meanwhile, Arab television goes around the clock with footage of dead Iraqi civilians, with gruesome images of the babies and children caught in the crossfire.  “The Siege of Fallujah” is quickly becoming a uniting symbol of resistance for Iraqis and even the greater Arab community.  And while the comparison to Vietnam incites heated political debate here at home, vocal Arab critics are increasingly drawing parallels between the U.S. occupation of Iraq and the interminable Israeli and Palestinian conflict.  Washington’s vision of a free and democratic Iraq as a model for the region seems, at least for now, little more than wishful fantasy.  The potential for the country to disintegrate into a hopeless caldron for crime and disorder, anti-Americanism, and terrorism is very real.  There will come a time to ponder myriad questions:  What is our exit strategy?  To what cost is the American public willing to pay for a “free and democratic” Iraq?  How long will it make sense to ordinary Americans to “stand fast and not bow to threats” associated with occupying a hostile country on the other side of the world? And with the recent escalation of hostilities comes the tactic of hostage-taking.  This troubling new development is, perhaps, an emulation of previous perceived achievements in Lebanon and Iran.  There are now American, Japanese, Italian, Canadian, German and British hostages, as the specter grows that civilian contractors and aid workers are today at great risk throughout the entire country.  And with threats to burn the three Japanese citizens held hostage if their nation’s forces do not leave Iraq by Sunday night, the political fate of (another) American ally Japanese Prime Minister Koizumi now hangs in the balance.  Citizens and politicians around the world are keen to the risks of being an American ally.  Ominously, the Iraqi resistance and global anti-American extremists would likely be emboldened by the consequences of the Madrid terror attack and Iraqi instability.  They will surely be only more resolved to inflict damage upon and humiliate the coalition. And while the risk of Iraq sinking into the abyss of mayhem and violence certainly cannot be ruled out, it appears even the best-case scenario is radically less optimistic than what seemed possible only a few short days ago.  “Winning hearts and minds” and instilling confidence are crucial.  Yet how is this possible when the security situation is so precarious?  And having the military take a more active role in trying to police and restore order only places our troops in harms way.  Many more troops may be necessary.  Understandably, the military is today resolved to apply overwhelming force to crush the insurgency.  But there will be only losers in house-to-house urban warfare in an Islamic nation in the context of current Arab angst and rabid anti-Americanism.      Addressing National Security Advisor Rice at yesterday’s 9/11 hearings, former Nebraska Senator Bob Kerrey made what I found quite thought-provoking observations:  “I believe a number of things.  I believe, first of all, that we underestimate that this war on terrorism is really a war against radical Islam.  Terrorism is a tactic; it’s not a war itself.  Secondly, let me say that I don’t think we understand how the Muslim world views this, and I’m terribly worried that the military tactics in Iraq are going to do a number of things, and they’re all bad… And I think we’re going to end up with civil war if we continue down the military operation strategy that we have in place.  I say that sincerely as someone that supported the war in the first place. Let me say secondly that I don’t know how it could be otherwise, given the way that we’re able to see these military operations, even the restrictions that are imposed upon the press, that this doesn’t provide an opportunity for al Qaeda to have increasing success at recruiting people to attack the United States.  It worries me, and I wanted to make that declaration… I think the military operations are dangerously off track.  And it’s largely a U.S. army – 125,000 out of 145,000 - largely a Christian army in a Muslim nation.”   And I can’t help but to ponder comments made by former Treasury Secretary Paul O’Neill.  From one of Ron Suskind’s final paragraphs in “The Price of Loyalty”:  “One day in November (2003), as questions swirled about the justifications for the costly U.S. occupation of Iraq – what they may have been and what Americans were told – [O’Neill] recalled a conversation he and I had on a Sunday afternoon in the spring, a few weeks before the invasion.  We sat on the porch at the Watergate, high above the Potomac, which was bursting with the flows of early spring.  O’Neill, who had sat through scores of [National Security Council] meetings, was deeply fearful about the United States ‘grabbing a python by the tail, by dropping a hundred thousand troops into the middle of twenty-four million Iraqis and an Arab world of one billion Muslims.  Trust me, they haven’t thought this through,’ he said.  He was still hoping there would be a ‘real evidentiary hearing and a genuine debate’ before troops were committed.  He knew that wasn’t likely. ‘When you get this far down the path,’ he said after a long silence, ‘you want to have a heavy weight of evidence supporting you.  If the action is reversible, or if a generation can erase its effects, it’s different than if you bring the world to the edge of a chasm.  You can’t go back.”  Concluding, I would like to share additional Mr. O’Neill comments.  And I will add that I believe these insights have great pertinence today, helping to explain why there are so many things that just don’t add up – a peculiarity of today’s troubling times.  These include the unfolding quagmire in Iraq; years of flawed economic policies from Washington; the current embarrassing state of economic doctrine; the disastrous course set by the Greenspan Fed; and the amazing wholesale acquiescence of the ongoing financial mania.  Distressingly, I sense that O’Neill “hits the nail on the head,” addressing what I will refer to as The Powerful Force Behind the Iraq and Greenspan Quagmires. “I think an ideology comes out of feelings and it tends to be non-thinking.  A philosophy, on the other hand, can have a structured thought base.  One would hope that a philosophy, which is always a work in progress, is influenced by facts.  So there is a constant interplay between what do I think and why do I think it…  Now, if you gather more facts and have more experience, especially with things that have gone wrong – those are especially good learning tools – then you reshape your philosophy, because the facts tell you you’ve got to.  It doesn’t change what you wish for.  I mean, it’s okay to wish for something that’s, you know, outside your facts realm.  But it’s not okay to confuse all that.  Ideology is a lot easier, because you don’t have to know anything or search for anything.  You already know the answer to everything.  It’s not penetrable by facts.  It’s absolutism.” (From earlier in the book) “Such men (“ideologues”) are not inclined to seek a middle ground so much as build a fortress at one pole or the other, hoping to create a place that will attract adherents until the midpoint, wherever it came to rest, ended up in their front yard.  Only they, the ideologues attest, are truly driven by ideas. Big ideas that tend to explain history and human behavior and the way things are.  They tend to stick with their own, find information that supports a wider view.”