Economic and Market Outlook, First Quarter, 2000

At the millennium the United States economy is in high gear. Signs of a domestic economic slowdown are few, and in some sectors our economy appears to be gaining steam. Our robust economic progress is the envy of the world and has brought incalculable benefits to us as a nation. It is however, a cause of concern to the officials of the Federal Reserve Board, who worry that excessive growth will cause a shortage of resources, primarily labor, and ultimately a return to inflationary price increases. Government policy, including the potential response of the monetary authority, is the most direct threat to the health of the financial markets in the New Year.

The driver of the U.S. economy has been and remains the consumer. Despite three rate increases since mid year, consumer sentiment remains ebullient. It is most notable in retail sales, which are booming. Consumer spending has grown at a 5% rate for the past two years and at a 4.5% rate in the third quarter. It probably rose at a 5% pace in the fourth quarter also, and exited the year at full steam. This rate of growth, if it persists, is clearly unacceptable to the Federal Reserve Board.

We believe that natural forces will eventually act to restrain consumer spending, but they may not materialize early enough to prevent another interest rate increase. Consumer spending has been buoyed by rising employment, rising real incomes, and perceived excellent bargains. In recent months, however, job growth has slowed perceptively. As a result, growth of wages is also slowing. Slower income growth will reduce the growth rate of spending sooner or later. Higher energy prices are also a drag on disposable income, and there is also the lagged response to the three increases in interest rates already initiated. Increases in rates act on the economy with a delay, and are only now beginning to have an effect. The result is visible primarily in housing, which appears to have peaked. Housing starts actually declined in November to a 1.6 million-unit rate. This is still a healthy pace, but obviously housing is no longer positively impacting economic growth.

While consumer spending may be impeded somewhat next year, other sectors are not. Capital spending will remain strong. Driven by technology spending and software, capital spending now accounts for 10% of our gross domestic product. In particular, technology spending has been continuously accelerating for a decade and may actually pick up further. In recent months spending on technology equipment has increased an average of 19% over last year. This extraordinary increase is the result of Y2K remedial efforts to some extent, but it is far more than a one time event. Both old industries (represented by telephone companies) and new industries (represented by Internet companies) have discovered that the application of new technologies is the only path to survival and growth. As a result, technology spending is increasingly influential in the domestic business model. It will remain a powerful force leading to a more rapid sustainable growth path of the U.S. economy. Capital spending is also a powerful deflationary force because it creates more capacity and increases productivity.

Productivity is the true Unsung Hero of this extended period of inflation free expansion in the United States. It is the primary reason why our capacity utilization rate is only 81%, well below the level which signals tightness and higher prices, despite the super charged economic expansion of recent years. The government estimated that third quarter productivity grew at a 4.9% rate and at a 4.1% rate over the past two years. Even allowing for the difficulty of measuring productivity, these are impressive advances. In our view technology capital spending is in the early stages of acceleration. New technologies are just now taking hold and software is improving, leading to more general usefulness and acceptance. The United States is in a leading position in this movement, although other major countries are working very hard to modernize. In an era of accelerating productivity advances it is hard to see where the increase in inflation will come from.

Outside the United States a global recovery is underway. In Europe unemployment is declining somewhat and consumer sentiment is high. Mainstream Europe is benefiting from the collapse of the Euro relative to the dollar, with exports leading the recovery. For the European economy the predicted recovery, however modest, represents light at the end of a very long tunnel. The recovery of the Japanese economy appears to be taking hold thanks to massive government expenditures. The new millennium promises a more balanced global economic growth path. This is a welcome development and all countries, not the least of which is our own, will benefit from this improvement.

After nine years of excellent growth it pays to be a little cautious. However, the signs of the times point to another year of economic growth in the United States, augmented by an improvement overseas. If anything, the tilt of the economy away from the consumer to manufacturing imparts a welcome balance to our growth prospects, and strengthens the case for a continuation of low inflation. Likewise, the financial markets are basically healthy. Despite all the sound and fury the secular impact of the technology revolution is in full bloom, creating new industries, obsoleting old ones, driving productivity, and putting a cap on inflation. We believe the millennium year will be another year of strong growth, low inflation, and sizeable earning gains. It is important that investors stay focused on the very positive fundamentals, and look upon the current period of heightened uncertainty as an opportunity to invest in those high quality financial assets which will benefit from the powerful forces supporting the United States economy.

THE INVESTMENT POLICY COMMITTEE
Alfred A. Lagan, CFA, Chief Investment Officer
December 27, 1999