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ECONOMIC AND MARKET OUTLOOK
HALF FULL OR HALF EMPTY

Economic signs remain positive, in spite of higher energy prices and rising interest rates. The stock market however has taken little notice of the healthy economy. Instead, the financial markets are focused on a lengthy list of concerns. In first place is the price of oil, whose rise seems relentless. Related to this is the daily evidence of continued instability and the rising death toll in Iraq, and saber rattling over Iran’s nuclear ambitions. Interest rates provide another major source of worry. As a result of the Fed’s policy of "measured" increases the cost of consumer loans, from home equity loans to credit cards to automobile loans, is steadily rising. The outlook for housing is also muddled by the Fed’s goal of cooling this sector, and in the current anxious mood, the sustainability of employment has been called into question also. The negative effects of our current trade and budget deficits are often the subject of economic commentary. The list of worries goes on, and in the current state of high anxiety no end is in sight.

The fact is that the domestic economy is doing really well, with virtually every sector in a positive mode. Leading indicators rose again in July after a strong surge in June. Housing activity remains robust. The labor market is strong and future indicators are very positive. Claims for unemployment insurance remain low, and new jobs creation is rising. The signals from the industrial sector of our economy are inconsistent but orders in the capital goods and technology portions are strong. Moreover the various regional surveys of industrial activity substantiate a positive outlook for the industrial sector.

The rising trend of inflation caused by high energy prices is a legitimate cause for concern. The Consumer Price Index rose 0.5% in July after being unchanged in June and declining slightly in May. The Producer Price Index for finished goods surged 1.0% in July after being unchanged in June, and declining slightly in May. The Federal Reserve and the financial markets have focused more on the non-food, non-energy portions of the price indexes, in the belief that wide swings in food and energy distort the true underlying inflationary trends. On this core basis inflation is milder, up 0.1% for the CPI and 0.4% for the PPI in July. Headline numbers of inflation will remain scary due to energy price increase. We believe, however, that the Fed will succeed in preventing energy price hikes from becoming embedded in the general price level. While the Fed’s strategy implies further increases in the Federal Funds rate it holds out the promise of avoiding excesses which can cause serious economic harm later.

The question for investors today is will the overhang of high oil prices and rising interest rates overwhelm the positive economic direction of the U.S. economy. We think not, and that our economy will continue to grow at a healthy rate. The notion that $66 a barrel oil will have no affect on our and the world’s growth prospects is dreaming, of course. Nevertheless, U.S. growth prospects are soundly based on a healthy consumer, increasing employment, rising wages, and solid industrial sector. Our economy is biased toward growth for many reasons, but high among them is the immigrant culture which holds the hope of reaping just rewards for hard work. Moreover evidence is mounting that economic prospects are picking up elsewhere. Japan, the second largest worldwide economy, has finally exited the deflation spiral it was trapped in for over a decade, and is expanding again. Surprisingly Germany, the largest euro economy, appears to be slowly improving with rising industrial production based on exports of capital goods. The significance of these events is that growth among industrialized nations is no longer dependent on the U.S. alone. It is spreading out, first to other industrialized nations and then, hopefully, to less developed and poorer countries. One should not underestimate the significance and positive implications of a more balanced world growth scenario.

Most observers of the oil markets have been humbled by the relentless rise in oil prices this year. It is foolish to guess how high they will go. We continue to see evidence of high speculation in the oil markets, and this speculative activity is increasing. It has been estimated that over $22 billion of net new investment has entered the oil futures market this year, and that today 50% of all trading in energy futures is being done by financial institutions, not by industrial companies hedging their costs. With this type of feverish activity surrounding oil markets worldwide we find predictions of substantially higher prices implausible. At some point in the future, admittedly unpredictable, oil prices will decline, removing one of the major impediments to a better stock market. When that happens the fall will be hard.

Investment Policy Committee
Alfred A. Lagan, CFA, Chairman
August 26, 2005


The opinions expressed herein are those of Congress Asset Management and are subject to change without notice.

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