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Economic & Market Outlook
First Quarter 2002

A year clouded by tragedy is finally drawing to a close. The longest expansion in recorded economic history is over, a victim of the attacks on New York and Washington on September 11th. Prior to the terrorism, an economic slowdown in progress seemed poised for improvement. Industrial production had stabilized, and the reduction of inventories held out the promise that production and manufacturing employment were headed for a welcome lift. Foreign economies however were continuing to deteriorate, and the anticipated economic improvement promised to be a faint shadow of the rapid growth economy of the late 1990’s. All expectations of economic stability were dashed on September 11th. The resulting disruption was considerable. Retail sales declined 2.4% in September, and industrial production fell to its lowest level in many years. Tourism and commercial airline travel virtually evaporated. Layoffs proliferated and hours worked receded sharply. Economic weakness immediately after the attack was broad based, prompting many economists toward dire predictions of an economic "black hole."

This did not occur, and recovery is visible on the immediate horizon. In some respects our economy is back to the conditions which prevailed immediately prior to September 11th. Signs of stability in the manufacturing sector have reemerged. The Commerce Department reported that orders for durable goods, i.e., major products expected to last three years or more, rose at a record pace in November. Various surveys by industry trade groups as well as the Federal Reserve indicate that new orders and backlogs have risen slightly. The rate of layoffs in manufacturing also seems to be receding. Anecdotally, numerous company managements have expressed a cautiously optimistic view lately, providing a welcome change to the dreary pronouncements of the fourth quarter generally. While manufacturing does not carry the weight that consumer spending carries in our domestic economy, it is nevertheless an influential swing factor with implications for employment, incomes, and consumer attitudes.

There are other signs that the economy has arrested its slide. Consumer sentiment has improved since the events of September, and spending has been remarkably resilient. Automobile sales especially have been robust reflecting generous financing incentives, but other spending also has reflected an underlying optimistic bias. Lower gasoline prices have given everyone an unexpected and immediate boost in income. The stock market too rebounded in the fourth quarter. While admittedly inconclusive, it is clear that an economic "black hole" never materialized, and that ordinary people are getting back to doing ordinary things.

In the confusion and lingering anxiety that defines the present state of the American psyche, a number of factors and trends are emerging with implications for the direction of our economy in 2002. The financial news media reported that a record amount of nearly $4.29 trillion is parked in money market funds at various savings institutions. In many cases the funds are earning around 2% or even less. This "war chest" obviously augments a low national savings rate, and also provides a healthy antidote to the high level of consumer debt. Consumer spending is not likely to receive the benefit of this nest egg for a time, as long as the unemployment rate is rising. At some point however, as the level of comfort in the economic situation rises so too will a more normal pattern of spending and saving, including investing.

What needs to be underscored in the present state of the economy is that inventory liquidation has been underway for more than a year. To illustrate that magnitude of the swing, in the second quarter of 2000 inventories were added at an annualized rate of $79 billion. In the third quarter of 2001, inventories declined by $39 billion. In other words, our economy absorbed about $118 billion swing from accumulation to destocking in a little more than one year. Another more modest decline in inventories is likely in the fourth quarter. In effect the cupboard is bare, and production has little room to fall. A healthier picture of industrial America is highly probable in the new year. The inflation outlook in the New Year is also favorable. Reflecting the impact of lower energy prices, economic slack, and additional intense price completion, the consumer price index will show a sharp decline from an already low rate.

So, what lies ahead for the American economy? At the risk of oversimplifying an economy of great complexity we believe recovery has begun and will persist. Both fiscal and monetary policies are highly supportive of a more stable environment and the full impact of these actions has yet to be felt. Housing, the jewel of the American economy, will remain strong, supported by favorable demographics, low mortgages rates, and an innate yearning inside every family for a place of their own. As mentioned, inventories will have a positive influence next year reversing the severe wallop in 2001. The transition to a growth path is unlikely to be smooth, however. A rise in unemployment will continue to breed understandable caution among many, and fear of further terrorist activity creates a salutary wariness. The external environment also will remain clouded. Simply put, foreign economies are generally weak with Japan in a deep recession. Overall, we expect the domestic economy will experience an improving trend throughout the new year marked in the initial phase by stability, and a gradual strengthening as time goes by.

History shows that all economies adjust to current realities. In American financial experience crises have been more common than otherwise, and the adjustment to the current environment is well along. America’s great wealth of human and natural resources combined with a flexible economic system and highly productive and energetic workforce provides an overwhelming basis for optimism. We believe this optimism will be reflected in the course of the financial market in 2002.

Investment Policy Committee
Alfred A. Lagan, CFA, Chairman
December 26, 2001