RateWatch #247 - Is the Telecom Debacle a Prelude of Recession?
April 21, 2001
by Dick Lepre

What's Happening?

The bull market for bonds will end soon. If you want to refinance, the clock is ticking. The technical end of the bull market will likely occur at the end of this month. This will not be delayed by this week's Fed move.

On Wednesday the Fed announced a surprising out-of-cycle 50 basis point decrease in both the Fed Funds and Discount Rates. 

What is interesting about this move is that one would be disposed to think that the Fed is acting not to please Wall Street but because their view of the economic forecast is truly gloomy. The markets - both equities and bonds - need some time to digest this one.  The big question remains: what is the probability of recession?  Clearly, today's action by the Fed indicates that they are more concerned than they were a short while ago. 

Telecom Problems - A Prelude of Disaster?

Here are the Fed's own words explaining the move: "Nonetheless, capital investment has continued to soften and the persistent erosion in current and expected profitability, in combination with rising uncertainty about the business outlook, seems poised to dampen capital spending going forward. This potential restraint, together with the possible effects of earlier reductions in equity wealth on consumption and the risk of slower growth abroad, threatens to keep the pace of economic activity unacceptably weak. As a consequence, the Committee agreed that an adjustment in the stance of policy is warranted during this extended intermeeting period."

The most obvious sector that has been hammered is telecommunications. Companies like Cisco, Lucent and Nortel have been hit hard.  This as a sector that has some inherent problems.  Infrastructure is expensive.  Companies had invested in high-speed lines only to see the prices of such lines plummet.  The price, for example, of a DS-3 line has dropped by 50%.  This has had a lot of ugly repercussions.  First of all it is not producing the necessary cash flow.  Another effect is that some ISP's got locked into contracts at above market prices and found that they could no longer compete.

The dot-com fallout has had an effect of these companies. The demand for their switches and routers has fallen precipitously. In addition, they were doing business with companies that were, to put it politely, shaky.  Cisco, Lucent and Nortel all provided credit to their clients who may not have been able to get it from a bank.  Now they are faced with the potential of holding bad debt.

Cisco announced this past Monday that is was taking a $2.5 Billion write-off in the value of its inventory. 70% of this write-down was related to the service provider business -- a failure to get orders from cash-starved phone and Internet access companies. This serves as a nasty reminder that high-tech equipment - though not as prone to spoiling as produce - can have an extremely short shelf life. Cisco,caught in the spot of fearing that it would get behind in its deliveries, decided to make forward commitments to purchase components.  The market dried up rapidly and they are "caught holding the bag".  Only problem is that the bag contains minus $2.5 billion.

In a sense, Cisco was not so much a victim of the slowdown but of the rapid rise in demand. The feel-good message of Cisco's success was pervasive.  Cisco became a daily leader in equity trading volume and had a market cap of some $600 billion.

A problem that exists is that the dampened capital spending that the Fed alludes in regards to the telecommunications industry is not going to be helped by a 0.5% reduction in the Fed funds target. The real issue is "when, if ever, will demand pick up again"?

The Bigger Issue

This leads to the bigger issue of the whole economy.  It's all about demand.  The Fed now needs to keep the public confident enough that they do not stop spending.  If they can pull that off then we will avoid recession.  The telecom companies may be hurting because no one is buying routers but this does not imply that individuals are going to stop buying cars, clothes and DVD players.

To receive this free RateWatch newsletter each week by e-mail, click here.
To view the archive of RateWatch newsletters, click here.