Economic and Market Outlook Fourth Quarter, 2000

Third quarter economic numbers paint a picture of a slowly changing economy. There is mounting evidence that the economic expansion has moderated from the breakneck pace that prevailed earlier. While this trend should be welcomed by the financial markets, two areas of concern have spread confusion among investors, and caused turmoil especially among stock prices. These areas of concern are the fallout from the new energy crisis, and the possibility of declining corporate earnings in the event a recession comes to pass. While we recognize the potential of both areas we believe that ultimately neither will prove lethal to the very positive forces which underlie the outlook for the financial markets, especially those in the United States.

Evidence that the economy has moderated is unambiguous. New job creation has been declining all year to the slowest pace since 1995, and the unemployment rate has nudged upward. Retail sales have cooled from the superheated levels earlier this year. Leading indicators of economic activity have declined for three consecutive months. Construction spending, including residential construction, has slipped noticeably from prior high levels. The industrial side of the economy has also softened, as measured by production indices. Moreover, it appears that foreign economies, especially in the Euro area, are also experiencing some headwinds. There is every indication that economic expansion throughout the industrialized world is throttling back.

These figures point to a moderation of economic activity but a still very healthy domestic economy. Some moderation is welcome and attests to the even handedness of the Federal Reserve Board actions this year. The reality of the sharp rise in oil prices has caused investors' attention to turn from a healthy moderating trend now in place to fear of a recession, and renewed inflation.

Much has been made of the recent rise in oil prices. The raw numbers are indeed scary. Oil prices have risen by a factor of over three since the end of 1998. Investors, especially professional investors, have long memories and are conditioned by past experiences. Higher inflation and recessions followed the aggressive oil price hikes in 1973, 1979 and 1990, the latter representing the last time our economy suffered a recession. At first blush the current episode seems like a re-run of previous oil crises, with both a recession and renewed inflationary spiral in the offing. These fears are contributing in no small measure to the current volatility of the stock market.

Many things have changed since the last oil crisis however, and the outcome of the current price rise is not likely to have the same impact as previous episodes. Primary among the reasons is that industrial nations are less reliant on oil. Following the first oil shock in 1973 producers had little choice but to pay up for more expensive energy if they wanted to increase production. In the ensuing years alternative sources of energy have come into broad use and more efficient means of production were instituted. Each succeeding oil shock has had a reduced effect on the world’s industrial economies. Today economists estimate that the United States produces about twice as much industrial output per unit of energy as in the early 1970’s. Europe, which is more reliant on imported oil than the United States, has seen a 30% improvement in production relative to energy use.

Other evidence supports the view that the oil price rise is far less ominous than in previous decades. In today’s extremely competitive pricing environment corporations are far more aggressive at reducing costs when demand falters as compared with prior business cycles. Capacity utilization is a more vulnerable statistic than profit margins in this environment. There is also no current indication of sympathy increases in the price of other industrial commodities, as happened in previous periods. In fact, industrial commodities generally have come under renewed pricing pressure, attesting once again to the strong deflationary undertone of the worldwide economy.

The rise in the price of oil has had little effect on overall inflation. The so-called Core Consumer Price Index rose only two tenths of a percent in August, and is up 2.7% over the past year. Most of even this modest rise represents price increases in tobacco as the companies passed on the settlement costs to smokers. Moreover a forward view of inflation indicates a declining, not a rising trend. A slowing economy will mute any latent inflation tendencies that exist, and the moderating employment picture will act as a barrier to aggressive wage gains. The strength of the dollar implies that the domestic financial markets will remain the investment of choice for overseas investment funds.

This salutary inflation outlook illustrates a sea change in the infrastructure of the domestic economy, a metamorphosis which has been temporarily obscured by the oil situation. Our economy is now driven by a rising technology contribution to our economic growth path. Adoption of technology spending as a staple of corporate capital spending is so widespread that no company can afford to reduce its commitment. The surprisingly strong 5.3% rise in second-quarter output per man-hour was a dramatic illustration of the effects of this change. It was the best productivity showing in twenty years and judging from the public comments of its leading members, even got the attention of the Governors of the Federal Reserve Board. As a result of the stellar second quarter performance unit labor costs actually fell in the past year. We believe these productivity trends will continue, keeping inflation at bay and resulting in higher endemic profitability for corporate America.

The most likely result of the rise in oil prices and fears of earnings shortfalls will be an increased risk aversion among investors. This was increasingly evident in the latest quarter by the violent price reaction to individual company announcements. A healthy caution especially in investing is a good thing. As we have pointed out many times however, immediate reactions to headline events are poor substitutes for a rational investment program. Investors must remain focused on macro forces to stay the course with core investments. Under present circumstances, these forces, including but not limited to buoyant productivity gains, moderating domestic demand, ongoing debt paydowns and a salutary inflation picture, point to a healthy and attractive outlook for the U.S. economy and financial markets.

Investment Policy Committee
Alfred A. Lagan, CFA, Chairman
September 28, 2000