Earthquake rocks Taiwan and US markets

Every little thing rocks the markets in today's environment
Stock prices fell on economic news (the international trade deficit), news of disaster (earthquake in Taiwan), and remarks made by a businessman (Steve Ballmer, president of Microsoft claimed that tech stock prices were overvalued and likened it to the "gold rush.") Was it reasonable to see declines in the Dow of more than 200 points on each of these factors? Perhaps. But maybe market players are over-reacting to bearish news these days, just as they were "irrationally exuberant" on bullish news.

When market activity has overextended its bounds, minor reasons are necessary to lead to price declines. These days, market players are anxious that the Federal Reserve will tighten monetary policy further soon. The Fed could raise the federal funds rate target as early as October 5 when it meets for the next FOMC meeting. Most economists are not predicting a rate hike at that time. Many analysts expect the Fed to wait until the November meeting.

It almost would be better, for the sake of the market, if the Fed did raise rates in October and be done with it. If the Fed doesn't raise rates, market players will only increase their uncertainty - and anxiety - level. This means that a skittish stock market with sharp moves in either direction are a strong possibility in the next several trading sessions.

There is no question that the market showed a healthy correction this week in stock prices. Those investors who got in the market in the final two weeks of August can't be too pleased with their stocks underwater. But long term investors will focus on the market's climb since the end of last year. No matter how you slice it, the NASDAQ composite is still zooming at breakneck speed even after this week's 130-point correction. The Dow is up 12 percent since the beginning of the year - a respectable showing. The broader S&P 500 index is not performing as well with about a 3.9 percent gain since the beginning of the year. But the loser is clearly the Russell 2000, which measures small capitalization stocks. It now stands 1.2 percent below the December 31, 1998 close!

Treasury market not putting high probability on Fed rate hike now
The slide in stock prices helped to propel the bond market at the end of the week. Once again, the yield on the long bond dipped below the 6 percent mark. Professionals in the fixed income market are placing smaller bets that the Fed will raise rates as soon as October 5. Moreover, since the Fed has expressed its concern over the high stock price valuations, a drop in the stock market makes it less likely that the Fed would raise the federal funds rate target right now.

Trade deficit frightens market players
The international trade deficit on goods and services widened to $25.2 billion in July after June's surge in the deficit to $24.6 billion. Many analysts thought that the June jump in the deficit would be partially reversed in July, but that wasn't the case. The chart below depicts the year-over-year changes in imports and exports, along with the monthly trade deficit. The deficit has increased dramatically in the past twelve months, moving in tandem with the yearly gains in imports.

In the past few months, import demand has shot up even more dramatically with a 3.9 percent hike in June alone. July's rise in imports appeared more moderate at 1 percent. One would expect that the latest gains in imports were coming from higher crude oil prices. Actually, the recent gains in crude oil or petroleum products are not the bulk of the demand. Consumer goods (both auto and non-auto) account for a big portion of the rise. Capital goods and industrial supplies also have contributed to the demand for imported goods. This explains why the domestic manufacturing sector was sluggish in the past year and is only beginning to recuperate.

Exports have posted modest gains in the past several months. The chart above reveals that export demand bottomed out in mid-1998. After a minor plateau earlier this year, export demand has resumed its growth. This is coming from improved economic conditions in Europe and Asia.

The stronger economic activity in Europe and Asia will further help boost exports in the coming year. The dollar has weakened in the foreign exchange markets - particularly against the yen. A weaker currency helps to spur exports and hamper the demand for imported goods (because these become more expensive). Typically, a lag of six to eighteen months exists before the weaker currency translates into stronger exports and weaker imports. Initially, though, the weaker dollar will generate a larger trade gap because the trade deficit is measured in dollars. It will take more dollars to pay for the goods that were already ordered months ago.

The bottom-line on the trade deficit? The larger trade deficit has advantages and disadvantages. In the short run, it implies a larger drag on GDP growth and means slower domestic production. That would be favorable if it meant slower economic growth on the whole. However, the weaker dollar implies inflationary pressures, which could worry the Federal Reserve, and create an environment for higher interest rates.

Federal budget surplus higher than last year
The federal budget deficit was a meager $2.5 billion in August after a larger shortfall of $25.2 billion in July. The deficit was weaker than normal for this time of year. Looking ahead to the last month of the fiscal year, September typically records a surplus for the month because of estimated tax payments made by individuals and corporations. The surplus for the fiscal year to date (through August) is $66.6 billion, up from $31.8 billion for the same period last year. Most economists are estimating that the surplus for the entire fiscal year will top $100 billion.

The bottom-line on the federal budget? This will be the second year in a row in which the US has experienced a budget surplus. It has created some interest in tax cuts in Congress, although Clinton has promised to veto the Republican-based plans. A surplus implies reduced borrowing needs by the Treasury. The US Treasury has already reduced various issues of Treasury securities in the past two years. As the supply of Treasury bills, notes and bonds diminishes, the fixed income market will find upward pressure on the prices of these securities and downward pressure on their yields.

Looking Ahead: Week of September 20 to 24
We use the Market News Service survey of forecasts to describe the market consensus.

Tuesday
Economists are predicting that the Conference Board's consumer confidence index will increase moderately in September to 136.5, from the August level of 135.8. Despite the slide in stock prices, the job market remains robust and inflation is low.

Wednesday
Financial market players are looking for durable goods orders to decrease 1 percent in August after a 3.6 percent hike in July. This reflects strength in the hard core components of industrial machinery, primary and fabricated metals, electronic and communication equipment. However, the volatile aircraft component should drop from the previous month's level and push down total orders.

Thursday
Market participants are expecting new jobless claims to jump 28,000 in the week ended September 25 from last week's 272,000. The data will be skewed by the aftermath of Hurricane Floyd. We may see a few weeks with a spurt in new jobless claims.

Economists are predicting no change to the final estimate of real GDP growth for the second quarter. Last month's estimate showed a 1.8 percent rate of growth for the period. Market players will be focused on growth for the second half of the year. They are concerned about the uncertainties surrounding Y2K planning.

The Chicago purchase managers index is expected to increase marginally in September to 56.7. While the overall level of activity is important, market players will also monitor the prices paid component, which stood at 63.8 last month.

New home sales are predicted to decline about 3 percent in August to a 950,000-unit rate. Housing activity has surprised economists and market players for its strength in the past year.

Friday
Personal income is expected to rose 0.4 percent in August after a more moderate 0.2 percent gain last month. Last month's income growth was hampered by a drop in farm subsidy payments. Wages and salaries, the major portion of personal income, maintain their strength. Personal consumption expenditures should rise 0.7 percent for the month. The larger rise in consumption over income continues to depress savings levels. In August, consumer expenditures were boosted by robust motor vehicle sales.

The NAPM index is expected to remain nearly unchanged in September at 54.5 - compared with the 54.2 level in August. The level of activity will worry market players less than the level of the prices paid index. In August, the price index stood at 59.8. An increase in this index would be bearish for the markets.

Construction expenditures are expected to edge up 0.4 percent in August. This reflects a partial offset to last month's drop, which had taken economists and market players by surprise.