A Current Ecomonic View. 9/10/1998

A lot has happened recently which has caused the stock market to decline sharply. In view of the magnitude of the decline and the extremely negative interpretation of current events by the news media we felt some comment is necessary.

From its high of 9337 the Dow Jones Industrial Average has declined 18% to 7640 recently. The immediate cause of the decline was the decision by the Russian government to devalue the ruble and suspend debt payments. The latter action constitutes a default on its external debt obligations. The immediate effect of these actions was to cause a flight of foreign money out of Russia. Other developing nations, all of which are dependent on foreign money for development, also saw a mass exodus of foreign capital in a worldwide flight to quality and safety. The flight to quality and the desire for liquidity has been most manifest in U.S. Treasuries and consequent decline in interest rates since the crisis burst on the scene.

By itself the Russian collapse, while a disaster for that country, has only a small impact on the world economy. Of more consequence, it extends the crisis that began in July 1997 with the collapse of the Thai baht and the rapid spread of devaluations and recession through the economies of East Asia. Russia’s troubles point again to the danger of countries that run unacceptably large current account deficits and have weak banking regulations. Almost all the countries whose currencies have collapsed have some combinations of these unsound practices, further aggravated by enormous levels of dishonesty.

Thus far the status of the U.S. economy has been only slightly altered by the various national and regional economic travails. Our economy grew at a rate of 3.5% in the first half of 1998. The growth rate is higher than the historic norm, and higher than the Federal Reserve Board in its collective wisdom thought desirable. The second quarter growth rate was considerably reduced from the rapid first quarter rate due to the erosion of foreign trade caused by the Asian weakness and the GM strike. Despite these factors the domestic economy remained healthy in the second quarter with real final sales expanding at a strong 4.4% rate. The United States entered the second half of the year in a state of virtual full employment, with high consumer confidence, declining interest rates and low inflation.

In the absence of a catastrophic external event the outlook for the U.S. economy is excellent. We had been of the opinion that U.S. economic growth would slow due to weakness in Asia and a natural moderation of domestic activity. As a result of the spreading crisis, we now expect growth to moderate further. Exports will be softer longer and the trade balance worse than would have been the case. Other problems have surfaced. American farmers are experiencing one of the worst summers in many years due to extreme weather conditions, plummeting crop prices and reduced foreign demand for American agricultural products. While these factors bear watching, one should not assume that an economic catastrophe lies ahead for the United States economy. Our outlook remains bright and worldwide events do not derail the outlook. Low interest rates, strong capital spending especially for productivity enhancing technology, buoyant housing activity, continued surplus and stable government spending are meaningful bulwarks against a serious decline. Our economic prospects are predominantly based on domestic spending, and services constitute a large part. Services are basically unaffected by worldwide events. It remains to be seen if the American consumer adopts a more conservative spending pattern, but a dramatic change is not apparent.

It is very difficult to generalize about events in Russia and around the world leading to the decline in the stock market. Other forces are also at work and at any time one or another is ascendant. One approaches an analysis with humility recognizing that any outcome is hidden in the complexity of the issues and still unfolding events. Today there is a willingness to overlook the enormous strengths of the U.S. economy, and its many positive attributes. Recognizing our limited insights we do not interpret recent events as harbingers of a recession or a prolonged bear market. For most investors remaining patient and true to their goals and disciplines is the best course.

THE INVESTMENT POLICY COMMITTEE
Alfred A. Lagan, CFA, Chief Investment Officer
September 10, 1998