Financial Markets: Overview
Breaking through the wall of worry that slowed its advance in the third quarter, the U.S. stock market raced ahead in the fourth quarter to finish the year and the century at an unprecedented high. The S&P 500 Index ended just shy of 1,500, having gained 21.02% for the year, on a total-return basis. Indeed, by the time the stock market closed for New Year's Eve, all of the major averages had reached new high levels. The Dow Jones Industrial Average, reflecting the momentum of its large-capitalization stocks, registered an increase of 27.26% for the year.Most spectacular was the Nasdaq Composite Index, which rode the technology and Internet wave to an 85.59% gain in 1999, by all accounts the greatest annual increase of any market index in modern history.The Russell 2000, the index for small-capitalization stocks, also joined the rush to new levels, ending the year up 21.26%.Most of the year's gains took place in the closing months. The Nasdaq rose almost 50% in the fourth quarter alone. December witnessed the most powerful increases of all.

OPTIMISM. Clearly, investors were buoyed by optimism as anxieties over the possibility of end-of-the-century computer glitches rapidly dissipated. While retail and e-tail sales came in strong during the holiday season, and consumer confidence was running high, inflation pressures, as indicated by the Consumer Price Index, remained slight, the core rate having ended 1999 at only 1.9%, its lowest since 1965.

FED TIGHTENING. It was anticipated that, during 2000, the Fed would tighten 50 or possibly 75 basis points and that most of this action would take place in the early part of the year. Concern over the expected rate rise and its implications may have been a factor in the rapid correction the stock market sustained in the first trading days of the new year.

So, optimism ruled. Another Fed tightening would continue to hold inflation at bay. Profits, though not as strong as 1999’s, are likely to continue healthy in 2000. And the market’s upbeat trend seemed to be broadening, encompassing other countries as well as sectors that had lagged during 1999.

DISINFLATION. Whatever the movement in interest rates, the economy’s underlying trend remains disinflationary, as advances in technology and communications continue to improve productivity and strengthen the power of buyers to make informed purchasing decisions.

Technology stocks, in their rush to new highs, may have become overextended – another factor that could have contributed to the correction in the first week of January. But investors still appeared willing to accept volatility as the price of progress.

Here at Warburg Pincus, our equity investment managers remain committed to the approach that has produced outsized returns in the past year and over the long term: to seek out companies that can be most reasonably expected to participate most successfully in the growth of the world economy in the coming years.

For a closer look at our specific investment management categories in their transition to the new year, please read on.

Growth Equity
Riding the crest of the market’s rally, our U.S. growth portfolios made further gains in the fourth quarter, generally outperforming the broader market. Outstanding performances by a number of our holdings, especially in technology and communications, helped these portfolios close the year and the century on a rising note.

WIRELESS. Our largest weightings at the year’s end were in telecommunications and equipment, notably in companies that stand to benefit the most from the continuing growth of wireless in the U.S. With the introduction of more customer-friendly pricing plans, we are anticipating accelerating expansion of the wireless market.

We continued to maintain sizable weightings in the communications and media sector, including companies, that can take advantage of the healthy level of advertising predicted for this year. Radio broadcasters have become quite interesting as an ad medium for dot.com companies striving to raise their visibility among Internet users.

Our portfolios also maintained their positions in the cable industry, particularly content providers such as Liberty Media Group.

ELECTRONICS AND COMPUTING.. Reflecting our favorable view of wireless communications, we maintained significant weightings in the electronics area, and we continue to maintain a major position in computing, emphasizing leaders in software and networking.

In the pharmaceutical sector, which has lagged the overall market during the past year, we added a few stocks we found to be attractively priced. And we are giving increasing attention to biotechnology, where we expect to see accelerating development as progress is made toward solution of the human genome puzzle.

We have de-emphasized the financial sector since late 1998 based on our expectation that the strong economy would exert upward pressure on interest rates. This decision proved timely. Now, we see certain financial stocks becoming attractive again, especially those with strengths in foreign markets.

GROWTH FOCUS. In our overall approach we continue to focus on large- and mid-cap companies that demonstrate growth-generating qualities such as strong brand recognition, high returns on equity, healthy balance sheets, and promising new products and services.

As we advance into this new century, we find such qualities increasingly in the technology and communications sectors, in businesses capable of producing the most dynamic growth – business involved in the Internet, wireless telephony, biotechnology, advertising, the convergence of media.

These kinds of stocks currently make up 40% to 50% of our growth equity holdings and we expect they will continue to do so through the year ahead.

Small-Cap Equity
Despite the rise in bond yields during the fourth quarter, small-capitalization stocks shook off the doldrums of the third quarter and staged impressive gains, even outperforming large-capitalization stocks.

Small companies proved especially vigorous in the technology and communications industries, as worries about a possible Y2K computer meltdown finally petered out and general optimism about the earnings prospects of these companies rose.

COMPELLING VALATIONS. We agree with that optimism. Considering the historically low level of interest rates we have been enjoying, small caps are, on the whole, reasonably priced. As we see it, rates are most likely to remain at about these levels for some time, and serious inflationary pressures will continue to be most conspicuous by their absence.

Moreover, earning prospects for many small-cap companies appear to be quite strong. A number of analysts expect the profit growth of these companies to exceed that of large companies over the next one, three and five years.

ACQUISTIONS. Another stimulus for small caps is the rising level of acquisition activity. It reached a furious pace during 1999; we expect it to continue or even accelerate in the year ahead.

For large enterprises, the acquisition of small, young companies can be a cost-effective way of expanding business and invigorating competitiveness. Typically such acquisitions have taken place at a significant premium to the publicly quoted prices of the acquired companies’ stock.

OPPORTUNITIES. The largest gains during the fourth quarter of 1999 were attained by technology stocks, the sector attracting the greatest investor interest across the board. Many of the stellar performers of last year continue to have good growth potential.

We, however, also see interesting opportunities among the laggards. A number of these are high-quality companies with solid long-term earnings prospects. We find them in a wide range of industries.

So selection will again prove crucial. In the fourth quarter our small-cap portfolios had the advantage of strong showings from a number of their holdings, particularly in technology, communications, and business services.

We made only few changes in our small-cap positions during the quarter. We somewhat raised our exposure in the communications area, also in telecommunications and equipment. Otherwise, we continued our diversification across a wide range of sectors, including oil services, health care including pharmaceuticals, financial services, and business services.

International Equity
Stock markets around the world staged a strong finish in 1999, as concerns over possible interest-rate hikes were overshadowed by expectations of more supportive earnings going forward.

Japan, one of the few global stock markets to have rallied in the third quarter, continued its upward drive in the fourth. Other Asia-Pacific markets also turned in positive performances.

European markets advanced, too, though the results were dampened for U.S. investors by the continued weakening of the euro against the dollar.

Emerging markets scored impressive gains in all regions, defying expectations that Y2K breakdowns would hit them especially hard.

We had the added advantage of solid performances by a number of our holdings, most notably in technology in Japan and Europe and in our general positions in the emerging markets.

OUTPERFORMANCE. Overall, our portfolios outperformed their benchmark– the MSCI All-Country ex-U.S. Index.

Our regional weightings remained essentially unchanged, though we modestly raised our aggregate weighting in selected emerging markets. Our sector and industry allocations remain broadly diversified.

JAPAN. After years of sluggishness, Japan finally appears to be heading into recovery. Several factors support that view, but one of the most compelling is the extensive restructuring as Japanese corporations increasingly stress profitability and shareholder value.

In October, Nissan, the giant auto maker, announced a plan involving a one-third reduction in its work force and the sale of its shares in 1,400 of its suppliers.

Mergers and acquisitions, a relatively new concept for Japan, surged nearly four fold in 1999, indicative of the trend toward a more competitive culture. M&A activity was particularly heavy in the financial, transportation, and telecommunication industries.

There are still negatives, of course, one being the debt burden the Japanese government assumed in its efforts to support the banking industry. Nonetheless, we have become, on balance, optimistic about the potential of the Japanese market longer term.

We especially favor Japan’s "new economy" companies, one of the most advanced wireless telecom companies in the world. We also favor the financial sector.

ASIA. Outside of Japan, our Asia-Pacific exposure continues to include an overweighting in Singapore, where we find companies well positioned to gain from the recovery in the global economy.

We modestly increased our weighting in South Korea, optimistic about its robust economic rebound and rising exports. And we increased our exposure to Taiwan, taking a position in an underfollowed, rapidly growing maker of electronic components for the telecommunications industry.

EUROPE. In Europe, which has generally half of our international weightings, we see a number of improvements in the investing environment and might be increasing our exposure there in the near term.

For one thing, acceleration in the region’s economic growth is anticipated, which could trigger a rally, particularly in cyclicals. In 1999, the introduction of the euro spurred merger and acquisition activity. Consolidations have been most conspicuous in banking, energy, and telecommunications.

With unemployment still high – though declining – and with the central banks continually striving to maintain price stability, inflation is likely to remain modest. And the interest-rate backdrop should be supportive, with yields gradually declining at the longer end of the yield curve in most European markets.

Our largest weightings are in the United Kingdom and France. We modestly raised our weighting in Germany, encouraged by pending reform that will allow corporations to sell equity without incurring capital-gains liabilities.

We also increased our exposure in Italy in Internet, telecommunications and other areas.

In addition, we moderately increased our collective exposure to Europe's peripheral economies, most notably in Turkey.

Fixed Income
Ending the first bond bear market since 1994, our fixed-income portfolios continued to hold up relatively well in the fourth quarter.

In the taxable area, we continued our strategy of emphasizing the intermediate term (shorter durations meant lower volatility) and non-Treasury securities, especially mortgage-backed (prepayment anxieties were lessening).

We also held a sizable portion of high-quality corporate debt, which benefited from the general optimism over credit upgrades.

MUNINCIPAL BONDS. Tax-exempt bonds performed respectably, aided by the record surpluses that state and local governments accumulated in 1999. The fourth quarter was the 17th in which credit upgrades for general-obligation municipals were net positive.

We continued to emphasize high-quality bonds, rated AA and higher; yield spreads were still too narrow to justify the added credit risk of lower rated municipals. And we continued to focus on the intermediate term, typically in the four-to-six-year range.

Our sector allocation was a diversified mix of general-obligation and essential-services revenue bonds. One sector we largely avoided was health care, concerned as we were over the regularly backdrop of this industry. This proved positive for our portfolios since health-care bonds were among the poorest performers during the quarter.

SUPPLY DEMAND. Looking ahead, we believe municipal bonds could soon gain strength from a more supportive supply-demand situation. The supply, while still relatively high in historic terms, fell about 20% in 1999 and could go lower. The fiscal improvements achieved by municipalities will tend to reduce the need for debt financing.

Meanwhile, demand for municipals could improve in the next quarters; investors won’t be seeking to offset equity gains by tax-loss selling of bonds.

Notwithstanding expected interest-rate hikes by the Fed in the coming months, municipal bonds now offer very attractive yields on an after-tax basis. With the expectation that interest rates will stabilize or even decline over the longer term, we will be seeking opportunities to extend durations marginally to lock in these healthy yields.

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