Economic and Market Outlook First Quarter, 1999

Rarely is there such dramatic change in one quarter. The fourth quarter of 1998 was the exception, with major policy developments in several arenas providing at least partial relief from the tensions festering at the end of September. Domestically, the Federal Reserve Board reduced its federal funds rate by one quarter of one percent on November 17, the third reduction in eight weeks. The uncharacteristically bold action by the Federal Reserve Board signaled that they understood clearly the threats to the financial markets by the bankruptcy of Russia and the rapid collapse of a very large hedge fund and several smaller ones which had bet heavily on emerging market debt.

Internationally, positive developments also were evident. Following the Russian and hedge funds debacles many feared that Brazil would be forced to devalue its currency, posing serious financial and economic risks to all of South America. While not out of the woods, the positive election result in Brazil and the formalization of a substantial international loan to that country, combined with the steadfast defense of its currency, relieved these stresses. Another major area of concern contributing to the pessimistic view of the world financial order is Asia. Asia has not yet recovered from the recession brought about by the series of devaluations in the last half of 1997. Here too, progress was notable, and unexpected. Japan, the lynchpin of the region, appears to be reflating its economy as evidenced by the central bank’s recent fiscal package and the plan to add capital to the largest domestic banks. The specter of a devaluation in China was reduced by the successful sale of one billion dollars of new debt, the first such issue in over a year. Economically, the recent increase in Chinese industrial output may signal that the economy is no longer contracting. Korea too reported positive news by repaying three billion dollars of IMF loan ahead of schedule. Finally an unexpected, coordinated interest rate cut by ten European nations, led by Germany’s central bank, signaled the intention of the new Euro block to support the worldwide recovery necessary to offset the global deflationary undertow.

These developments dispelled the gloom so visible at the end of September and relegated the condition of the United States economy to a secondary consideration. We believe that the status of our economy is going to return as the major determiner of the course of the financial markets in 1999. All accumulating evidence indicates that the United States economy remains healthy, but that a slowdown is at hand. Manufacturing production is leading the slowdown. With exports remaining in the doldrums and capacity increasing rapidly, the result of technological advances, the slowdown in manufacturing will persist throughout most of 1999. The lack of pricing power and collapse of commodity prices is also causing a new round of consolidations and mergers, and layoffs are accelerating. Despite this weakness in manufacturing, domestic consumption will remain a positive force in the coming year. The good news is that total employment is growing as new industries such as data services expand. In the past three years real wages have been rising. Interest rates are lower and many households are refinancing, adding to disposable income. Housing remains strong, and consumer confidence is high. These are not conditions which give rise to a consumer led recession. An economic slowdown, not a recession, is the likely outcome, in our judgment.

The outlook for interest rates is for further declines over the course of 1999, although the magnitude of declines will not be as great as this year. In recent months fluctuations in U.S. Treasury prices were driven primarily by a flight to quality and liquidity. This is the direct result of the default by Russia and consequent collapse of the hedge funds. Interest rates in the coming period will be influenced by economic developments. Specifically, we expect the economic slowdown to become increasingly visible and to exert downward pressure on rates. Short-term interest rates especially have held up higher than economic conditions call for. This is the direct result of fears that some dark force lurking immediately ahead will unexpectedly cause a worldwide financial debacle. As rationality returns, the fear premium in short-term interest rates will also recede, perhaps sharply.

In our opinion the outlook for equities is positive. After three years of significantly above trend returns, it is not difficult to postulate a decline in equity values. At the very least a corrective phase after the earlier overachievement seems a reasonable expectation, and inflammatory headlines constantly offer a rationale for things going dreadfully wrong. Headlines make very poor investment strategy. The gains in stock values in recent years reflect fundamental developments, all of them positive for equity valuations. These include the declines in interest rates and inflation, technology induced capacity increases and productivity gains, excellent corporate earnings, huge cash flows into mutual funds, and the first government surplus in a generation. Politics and the sustainability of a government surplus are always wildcards, but many of these fundamental forces remain firmly in place. Stock values will increasingly follow their individual company and industry fortunes within a generally favorable overall environment for financial investments.

As we view the worldwide financial condition we find the view of some that the rise in the price of financial assets represents a bubble about to burst, improbable. At virtually full employment, with rising real income wages, declining interest rates, and placid inflation conditions, the forces underpinning the rise are impressive. Despite political controversies, the United States remains an island of stability and a paragon of growth and opportunity in a destabilized world. This does not mean the coming year will be free of crises and just as in the past three years, sudden and steep corrections will occur. A focus on the fundamentals and a longer term horizon will serve investors best in this environment.

THE INVESTMENT POLICY COMMITTEE
Alfred A. Lagan, CFA, Chief Investment
Officer December 31, 1998