Wednesday's Brew Ja 17

After starting the day broadly lower, major U.S. equity indices, excluding the NASDAQ, are mostly higher this afternoon. Greater than expected growth in PPI put a damper on the market early, but it has found hope in low oil prices and the industrial production and capacity utilization improvement also reported this morning. The market is now clearly focused on tomorrow's CPI report and corporate earnings releases now in full swing.

OVERSEAS MARKETS

Ahead of tomorrow's key decision on interest rates in Japan, the NIKKEI 225 appreciated 0.34% today. The Hang Seng edged higher 0.18%, while the SHSE-SZSE 300 Index declined 1.91% today. A change in tax policy that will likely increase the collection tally, and hurt property owners, was indicative of yet another restrictive Chinese policy. The Chinese are well aware of the dangers of inflation, and are actively seeking to cool the market and economic growth. We continue to advise investors to consider taking some capital off the table from mainland shares in the very short term, after a significant rise to start the year. The ship is big though, and thus hard to turn, so we expect any decline will be short-lived, and we are keen on investment in mainland shares. So if I had to term it, I would say my recommendation over the short term has decreased to outperform, from buy, for mainland China. We are proud to have recommended investment in the mainland shares and those in Vietnam since early this year, as the two have been the best performing markets in the global scheme in 2007. We remain positive on the Bulgarian and Romanian markets as well, due to their recent initiation into the EU.

Shares in the Euro region were mostly lower today, with the DJ STOXX 50 slipping 0.54%, the CAC 40 down 0.53% and the DAX drifting 0.23%. The FTSE 100 declined 0.18% on the day, likely impacted by the American PPI data. After the Bank of England raised rates, and with expectations of a rate hike from the ECB before the end of March, European markets are weighing concern for tightening liquidity with the possibility of continued global growth and Euro area M&A activity.

ECONOMIC DATA & ANALYSIS

Three key reports headline the economic newswire on Wednesday. The federal government reported the December producer price index, with consensus expectations for an increase of 0.5%, compared to a 2.0% increase in November. December PPI showed a rise of 0.9%, exceeding expectations, and excluding volatile food and energy, Core PPI increased 0.2%, compared to a consensus view for a 0.1% rise, based on Bloomberg News data. The news was a mild negative factor for the market today, as it indicates inflation remains a risk. Especially concerning to us, the price of foods rose 1.7%, reflecting higher corn and surrogate prices due to a weaker than anticipated harvest and strong ethanol demand. The freeze occurring in California, which is severely damaging citrus production, will only add to the pressure on food prices. It's worth considering how this might impact the margins of unhedged restaurant companies and grocery chains.

December industrial production and capacity utilization were reported at 9:15 a.m. The consensus expectation for industrial production, as polled by Bloomberg News, was for an increase of 0.1%, as compared to 0.2% in November. Production actually increased 0.4% last month, and the Fed will likely be enthused by the number, as production nearly kept up with the pace of average hourly earnings (reported up 0.5% in December). This growth in production offers the potential to partly offset pressure from wage inflation, though the manufacturing segment is not nearly as significant as the service sector in the U.S.

December capacity utilization was seen measuring 81.7%, compared to 81.8% in November, and the report showed capacity utilization increased more than expected, rising 81.8%. This is a good sign for inventory levels, which had been expanding.

Two important housing readings became available on Wednesday as well. Foreclosure rates increased 35% in December, when compared to a year ago. A growing number of homeowners are finding themselves in trouble, as many ARM loans are resetting in 2007, and so homeowners find themselves in a position where proceeds from a pressured sale would fall short of the amount owed on them. Foreclosure rates are expected to increase, and if the Fed's forecast for a slowing rate of economic growth in 2007 is realized, it portends higher unemployment and further increasing pressure on homeowners.

Sub-prime lenders are finding tough times, as evidenced by Indymac's (NDE) earnings warning Tuesday. NDE fell 7% on the news. Today, CIT Group (CIT), which participates in many commercial and consumer lending segments, raised its guidance for 2007. However, it did note higher home loan charge-offs. CIT seems likely to recover some ground and possibly drive the shares of other lenders today. We think this might offer other short opportunities. For instance, today, Washington Mutual (WM) reports on its most recent quarter and has experienced negative EPS estimate momentum in its recent past, due to housing related weakness. Recall, a few months ago we recommended shorting the lenders that are susceptible to the weakening housing market.

Mortgage applications for the week ended January 12th decreased 0.6%, on higher interest rates in the period. The four-week average rose 0.8%, as it is less reflective of the short-term interest rate sensitivity of refinancing and purchasing applicants. In the weekly period, refinances increased as a percentage of total mortgage applications, reaching 49.9%, from 48.4% in the previous week. This afternoon, the National Association of Home Builders will post its housing market index.

The Treasury Department released its data on net foreign purchases of U.S. securities in November. Previously we stated our view that capital was not just flowing out of dollars, but out of American securities all together, due to the U.S. standing in the global community and concerns about where the situation with Iran is heading. However, recent emerging market blow ups in Venezuela and Thailand have highlighted the higher degree of risk inherent in emerging markets. We feel it's more likely that if capital were flowing out of the U.S., it would find its way into the Euro region and Japan.

Investment in long-term U.S. assets like equities, notes and bonds, slowed in November to a net $68.4 billion, compared to a revised October level of $85.3 billion. We believe the slowdown was influenced by the weakening dollar and by speculation concerning U.S. plans for Iraq and Iran. Money effectively shifted into shorter term securities, as those flows increased to $74.9 from $60.4 in October. Also, after stellar performance in a good deal of European and emerging markets last year, capital flowing from the U.S. into foreign stocks increased in November to $21.2 billion, marking the third month in a row of such increases.

The market will pay close attention to the Fed beige book, due out at 2:00 p.m. EST, for signs of what the Fed may decide to do at its next open market committee meeting. On the Fed tour marquee today, San Francisco Fed President Janet Yellen is scheduled to address a group in Scottsdale, Arizona, while St. Louis President William Poole is set to speak in Missouri.

COMMODITY MARKETS

Foods futures are leading the commodity market on the upside today. A series of data are behind the move, including the recent government report showing a weaker harvest for corn than was expected. The price of corn and its surrogates, wheat and soybeans, have been on the rise since the report release. Also, today, the PPI report indicated that price inflation existed in foods in December.

Citrus prices are skyrocketing after news that up to 1/4 of California's citrus crop has been impacted by a strange cold wave. Again, we would look immediately to the shares of restaurants and grocery chains, where unhedged companies should see margins pressured in the future. Corn is up 3.91% today, while wheat is 3% higher.

Gold is moving upward today, on dollar weakness, rising 1.2%. Natural gas is declining today, after rising yesterday on weather considerations, but heating oil is relatively flat.

STOCK SPECIFIC NEWS
Reporting earnings on Wednesday are JPMorgan Chase, Apple, Washington Mutual, State Street, Mellon Financial, Kinder Morgan, Northern Trust, Southwest Airlines, Synovus Financial and Parker-Hannifin Corporation. Washington Mutual's earnings report should provide some insight into the state of consumer credit. The company has recently seen trends in its EPS estimates declining, due to what we believe was some exuberant lending during the building of the housing bubble. Indymac (NDE) warned the market yesterday that it's earnings would fall short of expectations due to housing related weakness. We expect Washington Mutual to post similar results today after the close.

Intel warned that its margins were impacted by pricing competition, and at the same time, the EU is alleging that Intel is employing anti-competitive tactics, similar to its argument against Microsoft. INTC shares are 5.5% lower today as a result.

(disclosure)