Economic and Market Outlook First Quarter, 1998

The United States economy is about to slow. Not only is the slowdown the result of an overachieving economy in 1997 and a return to trend, but the contractionary influences from Asia will also exert downward pressure on economic activity. The extent of the slowdown will depend primarily on the depth of retrenchment by the consumer, and by still unfolding worldwide events. Nevertheless the prognosis is for a positive, albeit muted, rate of domestic expansion in 1998. While fears of a financial collapse continue to affect the financial markets, the United States is entering the eighth year of expansion in excellent overall condition.

By any measure, the domestic economy turned in a stellar performance in 1997. Real growth averaged about 3.8% while inflation has risen about 2% over the same period. Employment has been very strong. Given the age and strength of the expansion, the virtual absence of inflationary pressures has confounded most economists. Unfortunately this exceptional balance is not likely to persist. A tilt toward a moderation of growth is the most likely outcome. Real consumer spending, the driver of this expansion, grew at an unsustainable 4% rate over the first nine months of 1997, well in excess of income growth. Consumer euphoria was fueled by increasing employment, lower interest rates, perceived bargains in a no price increase era, and a reduction in savings. The consumer has turned decidedly more cautious in the fourth quarter. Automobile sales have slowed and consumer credit growth has declined. Retail sales were unimpressive over the holiday season. All this is evidence of a consumer whose preference has turned from consumption to rebuilding savings and reducing debt. These are sensible choices, and provide positive support for the future, but they do not add to economic growth, at least not in the short term.

Inflation, hardly visible now in the production chain, is about to take another turn down. Prices of industrial commodities have been eroding all year. With worldwide supplies plentiful and increasing, prices of everything from aluminum to oil will decline. Retail prices will also be under pressure. With the collapse of Asian currencies and a strong dollar, Asian producers have every incentive to ship goods to the United States. In short, rather then the much feared resurgence of inflation, global deflation pressures are intensifying. Deflation represents the most serious threat to the world economic order, in our view. Coincidentally, the strong dollar, healthy United States economy, and recession-like conditions elsewhere, point to a sharp increase in our merchandise trade deficit in the coming year.

By contrast, foreign economies are ending 1997 on a weak note. European economies appear to be improving modestly. The financial turmoil in Asia and the reduction of that region’s growth outlook removes a large part of the worldwide boom which many anticipated, and more than a few feared would rekindle worldwide inflation. The major economies in that part of the world are indeed in serious financial straits. Japan and Korea are probably in the early stages of a recession, while development in other countries will be seriously curtailed. At the margin, these trends will affect our own economy by reducing our shipments of capital equipment. This in turn will cause a reduction in U.S. production of capital goods. In fact, the most recent reports of new orders for capital equipment reflected beginning signs of softness. It is important to put Asian developments in perspective however. Despite the fact that the United States is the largest importer and exporter in the world, foreign trade represents less than 15% of our gross domestic product. Trade with Mexico and Canada, which remains healthy, represents the largest slice of foreign trade. Because of our predominantly domestic economic environment the financial turmoil in Asia will have more notable effects elsewhere. We are not immune to Asian developments, nor are we seriously impaired by them.

We believe strongly that the attraction of the United States financial markets is enhanced by current trends. The siren appeal of glitzy global markets, so prevalent in 1997, has left many investors sadder, wiser, and somewhat poorer. Confidence in foreign economies and currencies is badly shaken. The United States economy represents an oasis of non-inflationary growth and stability in a world economic environment which is racked by turmoil and fear. These qualities support our positive outlook for the financial markets in 1998.

THE INVESTMENT POLICY COMMITTEE
Alfred A. Lagan, CFA, Chief Investment
Officer December 31, 1997