SEPTEMBER 11, 2001 WILL LONG BE remembered for its impact on the American way of life. In addition to the terrible loss of life, the U.S. economy and financial markets were also damaged. Only the passage of time will reveal the full extent. Yet despite the uncertainty surrounding the state of the economy and the specter of military engagement, some changes are relatively clear.

First, September brought a dramatic change in the role of the federal government in the economy. As the month started, some in Congress questioned the President's tax cut. Was now the time to revive stimulative fiscal policy at the expense of the surplus?

By month end, the consensus held that the government should do whatever was necessary to help keep the country out of recession. Not only did this include talk of further tax cuts and

Falling Prices

Source: Baseline Just a year ago the Fed was raising rates to head off inflation. Now after 12 months of falling commodity prices (as measured by the CRB Index), deflation and a recession are at hand.

extended unemployment benefits, but also direct aid to the industries most negatively impacted by the acts of war.

Keynesian economists will tell you that government spending helps stimulate demand that can keep the economy from falling into recession. Supply-side economists argue that government spending draws capital away from the private sector, ultimately slowing economic growth. We suspect they're both right.

In the short-term, government spending in specific industries and defense can help create demand. But in the longer-term, continuing higher levels of spending will reduce the amount of capital available to private businesses, the source of innovation and economic growth. In addition, government spending must be financed, either through deficit spending or higher taxes. Both are a drag on the economy.

Running Out of Room

Following the attacks, everyone agreed further easing was necessary. The Federal Reserve was

Flatter and Fewer

Source: Baseline Normally when the yield curve flattens as it has over the past six months it's signaling either rising interest rates at the short end or less risk at the long end. This time it's neither. Rates may still have another half point to fall at the short end and while risk hasn't diminished at the long end, supply of 30-year bonds has. With fewer long-bonds available, investors must pay higher prices and receive lower yields.

part of that consensus, not only injecting liquidity into the market on a daily basis, but by cutting rates an additional ½% before the resumption of trading on September 17th.

Short-term Treasury securities were one of the few beneficiaries, rallying to levels not seen for decades. Throughout September the Treasury yield curve steepened. Short-term rates fell in anticipation of additional Fed easing. Prices, which move inversely with yields, moved to new highs.

The long end of the curve (15-30 year maturities) is a different story. Rates remained stubbornly high since investors who purchase securities in this range demand an additional premium for the greater risk exposure over the longer time periods. There's little question that risks increased after September 11th. Not only is the economy weakened, now there's the possibility of war and inflation from increased government spending.

But the long bond joined the party on October 31st. The Treasury sprung a Halloween surprise by announcing that 30-year Treasuries would no longer be issued. Given this newly imposed limit on supply, the price jumped over 5-1/4 points and the yield fell from 5.22% to 4.88%. Uncertainty didn't decrease, but supply sure did.

Recession Progression

The economy bore a second consequence of September 11th. Prior to that date, many felt a recession could be avoided. We were among them, thinking corporate earnings would bottom in the third quarter and a turnaround would begin in the first quarter of 2002 if not the final quarter of this year. But now, any tangible improvement will be delayed at least another quarter or two.

The airline, leisure, and insurance industries felt the immediate impact of the attacks, but as time passes, almost every sector will be slowed. Perhaps the greatest damage has been done to

Lack of Confidence

Source: Baseline Looking back over the past 20 years, recessions have tended to begin when consumer confidence falls to the 80 - 85 range on the Consumer Confidence Index. In October the value fell to 85.5. You do the math.

consumer sentiment and consumer spending, the only things that had kept the economy out of recession. This will negatively affect retailers, automobile manufacturers, the travel industry, and derivatively, just about every part of the economy.

Which brings us to the third result of the September attacks: Industries that had remained relatively healthy throughout the economic slowdown are now teetering on the edge of their own recessions. Obviously equity investors will need to rethink their strategies.

Prior to September 11th, it appeared that Financials, Consumer Cyclicals, and Cap Goods, the usual early recovery leaders, were poised to again play that role. Small and mid cap stocks were better positioned to lead the recovery than still over-valued large caps. But all that changed when the towers came down.

With recession now a real possibility, Financials and consumer-oriented stocks will struggle, not lead. When investors do return to the equity markets, they'll seek out the liquidity, stronger balance sheets, and perceived safety of large caps. Valuation is now less of an issue, especially following the steep declines when trading resumed after the attacks.

Opportunity Knocks

This quarter will be volatile, but will offer some opportunities. Third quarter earnings will be lower than previously expected. By the same token, investors may be more forgiving. Earlier in the year, companies falling short of quarterly expectations found their stocks cut by 20, 30, even 40 and 50%. This quarter, investors may be more understanding. In light of the potential "free pass", companies may be inclined to get all the bad news out now, clearing the decks for a better start in 2002.

Nevertheless, there's opportunity here for long-term investors. While it's doubtful the market will turn on a dime this quarter, this is a good long-term buying opportunity. Quality stocks have fallen right along with those of lesser value. Patient investors have the opportunity to purchase quality issues at prices not seen in five or even ten years.

While there's yet no compelling reason to rush into the market, there's even less reason to be a seller. If September didn't take us to the bottom, it certainly brought us a lot closer. Given that the bond market has already rallied, investors have few alternatives.

Many things changed on September 11th, but economic market cycles weren't repealed. For patient investors, next year will be better.

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