Economic and Market Outlook Fourth Quarter, 1999

Economic strength is apparent across the board. Despite tightening financial conditions, signs of a domestic economic slowdown are few. The United States economy continues to fire on all cylinders, keeping financial markets on edge about the possibility of overheating and further restraining actions by the Federal Reserve. Home and automobile sales remain near record levels. The latest figures for retail sales point to a large increase in the third quarter. Industrial strength also is adding impetus to our surging economy. Factory orders gained over 2% in the latest report and are up about 7% over the past year. Moreover, with many U.S. trading partners showing signs of recovery, manufacturers should begin to benefit from faster export growth. Surveys of purchasing managers support the optimistic view of our manufacturing outlook in the months ahead.

These trends caused a great deal of nervousness in the latest period, a condition which was fanned by the actions of the monetary authority. The Federal Reserve Board increased short-term rates by one quarter of one percent in June and again in late August. The August increase was accompanied by a hike in the discount rate as well, accentuating the angst of the financial markets. Despite an admission of price stability by the Fed the policy maneuvers were taken out of a concern that wage based inflation could result from current tight labor conditions. By inference, the Fed believes that the healthy productivity gains of recent years may not be sustainable.

By almost any measure inflation is barely visible on the U.S. financial scene. What trace elements exist are transitory or are clearly one time events. In fact, deflationary conditions still persist in many sectors both in the United States and abroad. The most visible inflation index, the consumer price index, was up 0.3% in August. This modest rise includes a huge increase in gasoline prices and drought induced increases in food. Both are not likely to recur. Excluding food and fuel from the calculation the core consumer price index showed a gain of 0.1% in the latest month, and only 1.5% for the year. Even this low figure is held up by large increases in tobacco prices as manufacturers passed on the settlement costs to the smoking public in advance. The producer price index confirms the low inflation scenario. Despite price increases in oil, food, and tobacco, producer prices show a rise of only 1.3% in the past year. Excluding these items the PPI is actually down 2% over the past year.

In our judgment, inflation is likely to decline in the months ahead, and deflationary pressures will intensify. Increases in gasoline prices such as the 9% rise in August are not likely to repeat. Drought conditions already have shown some improvement. Industrial commodities prices, having rebounded from depression levels, are held in check by plentiful and readily available supply increments. Moreover productivity enhancements, the prime mover of our inflation free economic expansion, appear largely sustainable and are spreading to other developed economies. Capital spending continues to boom, adding capacity continuously to factory output levels. Technology capital spending is inherently deflationary. The resultant expansion in potential output is reminiscent of the 1950’s and early 1960’s, when sustained growth was possible with limited inflation pressures.

Trends elsewhere support a sanguine view toward inflation. By and large European governments are pursuing strong anti-inflation efforts. In these countries structural reforms are being instituted, deregulation is spreading, business consolidations are accelerating, and price competition is taking hold. Several Euro countries have already announced plans to reduce corporate taxes while adhering to maximum debt levels allowed under the European Union rules. In other areas of the world competition and excess capacity are preventing price increases even as the economies slowly recover.

Beneath the surface evidence of deflation persists. A host of consumer products from automobiles to textiles have declined in price this year. Over time we believe deflation conditions will reassert themselves, leading to lower interest rates in the United States. The standard mechanism for all equity market corrections has been a rising interest rate environment. The rise in interest rates in the third quarter affected many stocks severely. Nevertheless the fundamental backdrop for the financial markets i.e. low inflation, solid business prospects, and excellent corporate earnings, are highly favorable for U.S. financial assets.

We are aware that additional concerns are weighing on investors currently, such as Y2K issues. High among the worries is the merchandise trade deficit, which is at record levels and rising. Also, the external value of the dollar has been weak against the Japanese Yen. Pessimists will point out that foreigners may no longer be willing to finance our trade deficit or to invest in U.S. securities if these trends persist, causing a sharp rise in interest rates and an abrupt cessation to our consumer led expansion. These imbalances are already reflected in the market in our judgment. While potentially upsetting, they cannot be measured in isolation. The key to a salutary outcome of these imbalances is inflation. As long as inflation remains contained, the United Sates will remain a magnet for global investors seeking a safe haven and access to leading technological innovations. The recent default by Ecuador, even though it is a small country, illustrates once again the deep longing for a safe currency throughout the world. Investors should look upon the current period of heightened uncertainty as an opportunity to acquire those high quality stocks of companies that will be in the forefront of the excellent worldwide growth which lies on the horizon.

THE INVESTMENT POLICY COMMITTEE
Alfred A. Lagan, CFA, Chief Investment Officer
September 30, 1999