Software Vault: The Diamond Collection/The Diamond Collection (Software Vault)(Digital Impact).ISO/cdr14/mkt221.zip/MKT221.TXT

Text File | 1995-02-22 | 15KB | 296 lines

 ECONOMIC AND MONETARY TRENDS

 Mitchell J. Held

            SMITH BARNEY FORECAST SUMMARY

 Growth:        Momentum likely to moderate during 1995. GDP growth in
                 1994 about 4.0%, cooling to around 2.0% by second half
                 of the year. Recession fears by mid-year?

 Consumer:      Structural factors are still working against "normal"
                increases in consumer spending. Still very price conscious,
                with some tentative signs of a reduced willingness to
                borrow and spend.

 Housing:       Starts were 1.45 million in 1994, up from 1.29 million in
                 1993. We are projecting about 1.40 million in 1995.

Autos:          Light vehicle sales were 15.1 million in 1994, up from
                13.9  million in 1993. We are projecting about 15.5
                million for 1995.

Capital Spending: Outlays were up almost 14% in 1994. We are projecting
                another 10%+ gain this year in light of capacity constraints
                and the continued emphasis on enhancing productivity.

Trade:          Terms of trade favor U.S. manufacturers. U.S. export
                growth has been strong but will be crimped by the economic
                adjustments underway in Mexico. Our thirst to import
                should slow as inventories are built up and spot shortages
                are met.

Inflation:      Some upward creep is likely because of diminished slack,
                but cyclical upswing to be relatively muted. CPI: probably
                in the 3.0%-3.5% range in 1995, following 2.6% in 1994.
                "Value pricing"" strategies to help. Lower inflation
                becomes institutionalized.

Budget Deficit: FY92: $290B: FY93: $255B (first drop since 1989):
                FY94:$203B (first "repeat" since 1973-74);
                FY95 estimate: $165B (first "three-in-a-row"
                since 1946-48). Another round of deficit-
                reduction measures would help the Fed moderate economic
                 growth and be constructive for the rate outlook.

Profits:        After-tax profits were up roughly 11% in 1994. We
                anticipate a slowing to about 6% growth in 1995, S&P
                 earnings (before write-offs) were $30.75 in 1994. We are
                 estimating $32.25 for 1995 and $31.25 in 1996.

Short-term rates: The degree of slowdown in the economy will determine
                 how much higher real rates need to rise. A gradual
                 slowing may require some encouragement from another
                 rate hike by the Fed (more likely at its May meeting
                 than at the March meeting). A gradual slowdown would
                 limit the Fed's latitude to ease back from a restrictive
                 stance later this year.

Long-term rates: Recent signs of some slowing in economic activity prior
                 to clear evidence of an acceleration of inflation have
                 kept alive the "soft landing" scenario. This has allowed
                 rates to move lower. In an up market, the 10-year/3O-year
                 spread is likely to widen.

Dollar:          Look for some appreciation as belief in the soft landing
                 results in stronger capital flows dollar-denominated
                 securities.

 TREASURIES

Douglas Schindewolf

Data released this week lent to the view that
economic growth is slowing and the market built on its recent
gains. In the process, the yield curve flattened further, with
the yield spread between the three-month bill and the newly
auctioned 30-year bond narrowing to roughly 165 basis points.
This is the narrowest this spread has been since  the Fed began
the campaign to tighten its policy stance one year ago. At
midday Wednesday, the yield on the long bond stood at 7.55% down
about 60 basis points from the high of early November and the
lowest level since 1994.

The first estimate of retail sales in January showed
a 0.2% increase overall and a 0.4% gain for non-auto sales,
along with small upward revisions to November and December
figures. After accounting for the revisions, the level of retail
sales in January was a bit higher than generally expected.
Nevertheless, the modest gains during the past three months
suggest that the pace of consumer spending has slowed.
Similarly, the Fed reported a widespread slowing in
manufacturing activity during January, with its index of
manufacturing output increasing by 0.3% compared with monthly
average increases of 0.8% during the fourth quarter.

These indications that the economy may be beginning
to roll over allowed the market to be more forgiving of the
inflation indicators released during the week. In particular,
the CPI core rate registered a 0.4% increase in January,
resulting in a jump in its year-over-year change to 2.9% from
2.6% in December. In addition, the capacity utilization rate for
manufacturing industries inched up another 0.1% to 85.1% in
January - another reminder of the diminished slack in the system
and the importance of a significant slowdown in economic
activity. (We note that in our judgment, the economy is
operating above its full potential and the risk of overheating
remains significant.) Part of the slowdown in the months ahead
should come from a slower pace of inventory accumulation, but
data released this week indicated that business inventories
increased by only 0.2% in December while sales surged 1.3%
Consequently, there does not appear to be a large overhang of
inventories that would tend to hinder the upward momentum in
industrial production in the months ahead -- slower production
will hinge on a sustained falloff in final demand, which still
is an open question at the moment.

In congressional testimony a few weeks ago, Alan
Greedspan indicated that there are some tentative signs of
moderation in economic activity, a concept that also appeared in
the announcement that accompanied the last set of rate hikes on
February 1. Next week, Greenspan will have an opportunity to
amplify on this notion when he presents the Fed's semi-annual
Humphrey-Hawkins report to Congress on Wednesday, February 22,
and Thursday, February 23.

CORPORATES

Diane Garvey

New issuance of corporate debt securities fired up on
the 14th with over $800MM issued for the day. Rockwell
International issued a two-part deal totaling 500MM with a 7
5/8% of 2/17/98 at +33BPs and 7 7/8% of 2/15/05 at +43BPs.
Norwest Financial 7 7/8% of 2/15/02 at +42BPs and Southwestern
Public Service 8 1/2% of 2/15/25 at +85BPs to comparable
Treasuries.

Secondary marker activity was fairly brisk for the
week. As for industrials, investors continued to exhibit strong
demand for Time Warner paper, causing spreads to tighten by an
additional 5BPs. Lower rated industrials remained active with
strong demand for RJR Nabisco paper causing spreads to tighten
by at least 10BPs. Airline paper tightened by 5BPs due primarily
to strong investor interest. Short paper under 5 years in
maturity continued to be in demand with firmer spreads reported
across a variety of industries. Bank spreads remained tight
through mid-week after a short lived widening of JP Morgan paper
as a result of the Moody's downgrade of its senior debt to Aa2
from AA1. I general, Yankee paper remained unchanged with
relatively little market activity, although China 10-year Global
paper tightened by 15BPs mid-week. On the utility front,
investors remained focused on single-A intermediate paper,
although spreads remained unchanged.

*  Smith Barney usually maintains a market in the
securities of this company. #  Within the last three years,
Smith Banrey, or one of its affiliates, was the manager
(co-manager) of a public   offering of the securities of this
company or an affiliate.

MUNICIPALS

The municipal bond market rally that began in
mid-November was still very much in evidence on Wednesday
morning as we went to press. Yields are down 90-110 basis points
from their highs at the time. The municipal futures contract is
up a whopping nine points since November 17. The demand side of
the market appears to reflect both a rate shock and a sense of
urgency driven by excruciatingly tight supply. Municipal yield
as a percentage of Treasury yields are reaching "nosebleed"
levels, particularly on shorter maturities. And yet these ratios
seem destined to stay low, since supply will remain very light
and the greatest historical source of shorter paper pre-refunded
bonds is dwindling. We would guess that by the end of 1996, well
over half of the volume of pre-re's outstanding at the peak in
late 1993 will be gone, and they aren't being replaced. On the
long end, we are hearing anecdotally that demand for municipal
bond funds is beginning to turn the corner, although it isn't
showing up in the numbers yet. If that pattern continue, we
could see further flattening of the long end of the yield curve,
since funds tend to focus on long-term paper, and there isn't
much to go around.

Accrued Market Discount: We're not out of the woods
yet..

But we're heading in the right direction. On
Wednesday, February 8, Rep. Ben Cardin (D-Md) and Rep. E. Clay
Shaw (R-Fla) introduced legislation in the House to repeal the
1993 law requiring market discount on municipal bonds purchased
after April 30, 1993 to be subject to taxation as ordinary
income. The new legislation would restore capital gains
treatment of market discount. While this is without question a
positive development, the introduction of the bill is only the
first step in what could be a long, slow journey through both
houses of Congress, probably attached to other legislation,
Executive approval and incorporation in the Tax Code. Still,
we're somewhat confident that Congress will eventually succeed
in repealing the ordinary income tax treatment of Accrued Market
Discount (AMD). We note that on Tuesday, February 14, Rep.
Cardin suggested that enactment this year was a possibility, but
also warn that it is only likely if there is more than one tax
bill in 1995.

The necessity for repeal is a topic we've covered at
length in the past. The AMD tax has damaged liquidity in the
secondary market for municipal and arguably worsened the
municipal market's slide in 1994. But it is an ill wind that
blows no good. Hopefully, the one lasting effect of the AMD tax
after its repeal will be a heightened awareness of After-Tax
Yields.

When the ordinary tax treatment of AMD treatment took
effect the market has in the final stages of a tremendous bull
market, and there were no market discounts in the municipal
market. (Which does make us wonder about the assumptions
underlying the original revenue number associated with the tax
in the budget. We would only note that revenue estimation
usually smacks more of art -- and artifice- than it does of
science.) When the market turned in February 1994, and created a
plethora of market discounts, much confusion ensued, much of it
revolving around After Tax Yield (ATY) -- how to calculate it,
what it means, how to apply the de minimus rule, and how to
handle ordinary income in "tax-exempt" bond funds or back common
trusts. Finally, we have yet to find an accountant that can
handle the complexities of calculating the tax effect of AMD on
bonds bought and sold in the secondary market -- or who cares to.

After Tax Yield Still Matters

The irony of all this, as we have pointed out in the
past, is that the marginal effect to after tax yield of treating
accrued market discount as ordinary income instead of capital
gain was quite small -- significant only for short and
intermediate maturities.

Effect of Ordinary Income Tax Treatment of Accrued
Market Discount



           Current Discount  After Tax Yield     After Tax Yield Spread
Years      Coupon  Coupon
Maturity   Yield             28%   36%   39.6%  28%  36% 39.6%
3          5.45%  4.45%      5.21%  5.14% 5.11% -24  -31  -34
5          5.60%  4.60%      5.38%  5.32% 5.30% -22  -28  -30
10         6.00%  5.00%      5.84%  5.79% 5.77% -16  -21  -23
15         6.25%  5.25%      6.13%  6.10% 6.08% -12  -15  -17
20         6.40%  5.40%      6.31%  6.29% 6.28%  -9  -11  -12
30         6.45%  5.45%      6.40%  6.39% 6.38%  -5  -6   -7

As the table shows, capital gains (28% tax rate)
treatment of market discount has a significant effect on ATY
greatest for shorter maturities, but still appreciable for the
longest maturities. The incremental effect of treating discount
as ordinary income, is significant principally for shorter
maturities in high tax brackets -- 36% or higher. The lesson:
Don't forget how to calculate after-tax yield in the event that
the 1993 law is repealed.

                                            Bert Mosley
                                  George D. Friedlander

Following the Fed tightening on January 22nd many
additional buyers have begun to shift away from the extremely
short term issues into longer term notes and bonds due to the
perception that the Fed may be done tightening. In recent weeks
this has meant a renewed interest in the 1 year to 18 month
sector of the market. This additional demand has caused this
"SUPPLY STARVED" sector of the market to trade richer as well as
allowing any new issues to receive very strong bids. Currently.
one year tax-exempts are trading at 4.70% which represents 70%
of underlying Treasury Bills and 18 month bonds are trading at
4.80% which is also 70 of underlying Treasury notes. These
sectors of the marker have been trading as cheap as 75% of
Treasuries. One issuer who was able to benefit from the strong
demand was the City of Milwaukee which sold $81 million of one
year promissory notes at 4.81% and were re-offered as rich as
4.72%. One short-lived theory that died in Wednesday's rally was
that pressure from First Boston's exit from the municipal
business would cheapen yields.

The strong demand is surprising because historically
February is when the market experiences a pull back as customers
sell notes and bonds coming into corporate and individual tax
payment dates. The short term marker could still experience a
sell-off as the market's current rich levels cause holders of
short term tax exempts to take profits or if the market
perceives that me Fed may tighten again.

                                             Mark Matthews

For more of these reports, go to internet address of omnifest.uwm.edu,
log on as a visitor, then type 'go finance'.