Economic and Market Outlook Fourth Quarter, 1998

The consensus view has changed dramatically over the course of the past quarter. The unbridled optimism of the first half of the year has given way to a gloomy view of the world’s economic condition. Further economic deterioration in Japan, the Russian devaluation and default on its external debt, and fears of a chain reaction occurring in other emerging nations such as Brazil, are high among the worries which have contributed to an extremely volatile stock market. The near collapse of a large hedge fund, Long Term Capital, has added to the current anxiety. These developments have caused a worldwide flight to quality and safety most evident in the U.S. Treasury market and consequent decline in interest rates.

Until recently the U.S. economy was only marginally affected by declining business conditions oversees. Strong domestic demand sustained our economic advance, and seemed to insulate the U.S. from worldwide events. Our economy grew at a rapid 3.4% rate in the first half of 1998, strongly influenced by a 6% increase in the rate of consumer spending. This continuing expansion was sufficient to elicit a steady stream of warnings from the Federal Reserve Board about the dangers of a new inflationary spiral and threats of an impending increase in interest rates. The events of the third quarter changed this picture. The Federal Reserve Board is now more focused on a developing slowdown. By reducing the discount rate one quarter of one percent on September 29th, the Fed signaled its opinion that domestic demand pressures are receding substantially. Most economic observers agree, and expect further reductions in interest rates in coming quarters. Reductions in interest rates in other industrialized nations are virtually assured by the Fed’s action.

Evidence of a broad slowdown in U.S. economic growth is beginning to be visible on the horizon. The industrial sector of the U.S. economy has been stalled since late last year, an early victim of the crisis in Asia. This resulted in a decline in factory employment over the past two quarters, poor exports, and deterioration of our foreign trade balance. Obviously, these trends will not show any improvement over the near term. Aside from exports, other sectors which were strong previously have begun to ebb. The buoyant pace of new home sales is certainly receding and will be held in check by poor housing demographics. New commercial construction is trending down also, and the momentum of capital goods spending is slackening because of a lack of global opportunities and new worries about earnings.

In addition to these trends, new job creation is not as strong as previously. In the year to date, payrolls have expanded more than 200,000 per month, an attractive pace but well below the average monthly rate of 1997. As jobs expanded personal income also grew at a healthy 3% rate. Bolstered by growing incomes, declining inflation and an optimistic outlook, consumer spending expanded even more strongly. Consumer spending grew more than two percentage points faster than income over the past year. This pace of spending is unsustainable. The consumer is likely to become more cautious in his/her spending habits as job creation and income growth slow.

These trends are well understood by those who deal in the financial markets. The tendency is to extrapolate the current trends, and in the present circumstances projections and expectations have taken a dramatically negative turn. While recognizing the fragility of the world economy, we are suspicious of the widespread predictions of a pronounced economic slowdown in the U.S. The strength of the U.S. economy is broad, deep, and predominantly domestic based. It did not evaporate in the third quarter. Perhaps the most compelling factor keeping the domestic expansion on a positive track is the remarkable performance of inflation. Producer prices fell 0.4% in August and consumer inflation remains well below 2%. This favorable inflation trend and the recent decline in stock market values provides the Fed leeway and incentive to cut U.S. interest rates further. The extremely low level of inflation also provides the consumer with a steady increase in real wages and the almost unique ability to purchase more than the basic necessities of life, if he or she chooses.

In our view, a domestic recession is not in the cards over the next year. The fact remains that the U.S. and European economies are basically healthy and global disinflation continues to benefit consumer demand and interest rates. The outlook for the stock market has been tainted by the tensions created over the past quarter, and especially by the stream of disappointing earnings from American corporations. The resulting severe declines have restored market values in our judgment, albeit at a price. The volatile environment is likely to persist until the financial markets become comfortable with reduced earnings expectations. Beyond this present uncertainty however, the outlook for American corporations and financial markets is very bright.

THE INVESTMENT POLICY COMMITTEE
Alfred A. Lagan, CFA, Chief Investment Officer
September 30, 1998