Economic and Market Outlook First Quarter 2001

As 2000 draws to a close debate rages about the state of health of the United States economy. There are those who see the current slowdown as a harbinger of a serious recession, with all its hardship. Others believe our economic expansion will continue, albeit at a more muted pace then the previous two years. The range of opinions about the course of our economy in the New Year is as wide as it has been in many years.

After a year of intense volatility the stock market, especially the NASDAQ, will end the year on a down note, the first decline since 1990. Coming off an extended period of excellent returns for stocks and the longest expansion on record, it is relatively easy to speculate on a protracted turn for the worse. Signs of stress are easy to discern and add to the anxiety. The collapse of the dot.com phenomenon in the second quarter highlighted the dangers of investing in companies which need constant infusions of capital to survive. Oil prices reached levels not seen since the oil embargo of 1978, and natural gas prices are at record levels as the country heads into winter. A growing number of companies have publicly confessed to pressures on profit margins, and lower then expected earnings. Finally as if economic insecurity were not enough, political change raises new fears of the unfamiliar.

Clearly the pace of the economy is receding. The evidence is not hard to see. Industrial production fell 0.2 percent in November, the second monthly decline in a row, as factories turned out fewer autos and other goods. The housing market has cooled as mortgage rates rose sharply in the second and third quarter. Retail sales have not been up to retailers' optimistic expectations. Business capital spending has also been backpedaling, and inventories rising. Initial claims for unemployment insurance are rising, indicating fewer new job creations ahead. Clearly, six interest rate increases by the Federal Reserve Board in the year ended this past July have corrected the excessively simulative policies the Fed had followed earlier. Combined with higher energy prices and the very high level of real interest rates the Fed has finally succeeded in slowing the excessive surge of the domestic economy. Current indications are that overseas economies are following in our direction.

In this context the New Year is beginning on an uncertain note. At this time, odds continue to favor a moderate slowdown. The likelihood of the retrenchment deteriorating into a recession is less than 50%, in our judgment. The fact that underlying inflation remains muted and probably will head lower has opened the door to reductions in interest rates early in the slowdown. We expect the Federal Reserve to begin reducing rates in the first quarter. In the past two months mortgage rates have fallen sharply, to around 7% from over 8%, bolstering the outlook for housing in 2001. Employment also remains healthy. Most importantly, the banking system is strong. Some observers have speculated that announcements of increased bad loans by prominent commercial banks is forecasting a weakened banking system, and a looming credit crunch. This is simply not true. Some large banks have experienced an increase in defaults, but the banking system generally has a very strong capital base. Many commercial banks instituted tighter credit standards when urged to do so by the Fed early on.

While fears of recession, inflation prospects, and potential credit problems grab the headlines productivity is often touched upon lightly, if at all. Just a few years ago most observers including the Fed estimated the trend of productivity in the United States at less than 2%. More recent estimates have centered around 3%. It is quite likely that even this increased estimate understates the trend in productivity in the U.S. Simply put, our ability to increase production of goods and services on very low labor force growth, at declining inflation rates, argues that productivity advances are greater than imagined. Nothing in the recent economic picture changes this. We believe productivity growth will continue to surprise on the upside, helping to keep inflation low and price competition intense.

In the final analysis, whether economic growth slows down, as we expect, or declines into a recession, depends on the consumer. Higher interest rates, higher energy costs, and the drumbeat of negative stock market news has taken its toll on consumer confidence. Personal debt levels are also elevated and the savings rate is quite low. Some retrenchment by the consumer is very likely, and is probably evident already in the trend of Christmas sales. The current pessimistic psychology however overstates the negative case. Employment remains healthy, real wages are rising, government surpluses will persist, and tax cuts are likely to be enacted early on. We view the New Year as starting at a low point in terms of U.S. economic activity, investor confidence, and the outlook for stocks. The new year will see gradual improvements as lower interest rates, lower inflation, and quite possibly lower energy prices, emerge. Corporate profits will improve also, as expectations for profit growth have been dashed in the current quarter. We do not know when the turn will come, but it surely will. Despite the disappointments of the year 2000, there remains a bright future for U.S. financial investments.

Investment Policy Committee
Alfred A. Lagan, CFA, Chairman
December 21, 2000