Economic & Market Outlook Fourth Quarter 2001

The country's heartbeat stopped on September 11, 2001. Extreme shock will have that affect. The entire country was stunned, and the numbness has persisted for two weeks. But the shock is slowly wearing off, and a plethora of emotions is swirling through the American psyche. Deep sadness at our losses, anger at the perpetrators of the foul deed, simple awe at the courage of the fireman and others, recognition that our response is grounded in moral rectitude and that our nation is capable of overcoming the evil done to us, a coming together of all people to put the common good ahead of self interest, all are evident in the responses to the tragedy. Finally and meaningfully, a desire to rebuild is taking shape and will show to the world that the American spirit can be bruised but cannot be buried and will rise again.

The economy too was stopped in its tracks on that fateful Tuesday. While economic signs were mixed, the attack choked off what appeared to be several positive indicators of a recovery that had surfaced since the end of June. The index of leading economic indicators, intended to signal turning points in the business cycle, rose for three consecutive months through June. The inventory overhang, a primary cause of the slump, appeared poised to show improvement. The downward revision to the second quarter Gross Domestic Product was caused by a further substantial decline in inventories. As a consequence the manufacturing sector, the main weak spot in our economic picture, was showing signs of stability. Manufacturing activity was flat in July, the first time in ten months it had not declined. The National Association of Purchasing Manager's index increased to its highest level in nine months, and new orders also signaled growth. The improvement was driven by the success of individual companies in liquidating inventories. Anecdotally, several bellwether companies cautiously announced that they expected sales to be flat in the third quarter, a welcome improvement over the depressing announcements in the first half.

All this changed on September 11, 2001 and the disruptive effects are considerable. Retail and automobile sales, which had been stronger than anticipated, dropped sharply after the attack. The tourism industry is at a standstill, and commercial aviation came to a complete halt. Layoffs have spread and will depress consumer spending for a while. The combined effect will certainly cause GDP to decline for the third quarter. Virtually all economists now expect a decline in the fourth quarter also.

Without being disrespectful to the victims of the tragedy we are obliged to attempt to gauge the lasting impact on our economy, and to provide a reasoned guess about the outlook for the financial markets. Some clues are evident. Inflation as measured by the Consumer Price Index peaked in May at a 3.6% increase, year over year. Since then it has been trending down and under current conditions is slated to recede substantially. An unexpected result of the tragedy has been the decline in the price of oil and natural gas, apparently the result of fears that the world economy will sink into a deep recession. This decline in energy costs will drive inflation even lower than anticipated, at least for a while.

Early indications are that consumer spending is making a modest comeback.. As the shock and sadness wears off we expect the consumer to began spending again, initially on essential items but more broadly as confidence returns. Business confidence also will receive a boost from the rapid and proactive response of the government. Aid to stricken industries was passed very quickly.

The amount of stimulus provided during this time is enormous and is very supportive of the economy. The $40 billion emergency package already enacted and the $15 billion airline relief bill will probably be followed by more spending. There is a reasonably good chance of further tax cuts. Interest rates have been reduced sharply, and are likely to come down even more. Collectively these aggressive fiscal and monetary actions will underpin our economy, forestall any deterioration which might otherwise result, and provide the lift needed to get the stalled domestic economy moving again.

The steepening of the yield curve since September 11, 2001 is one of the key factors supporting the call for a gradual return to trend growth and a recovery in corporate profits in 2002. In the two weeks following September 11 short term interest rates declined sharply, as money was pulled out of the stock market and invested temporarily in short term instruments. At the same time, the yield on long term bonds rose as investors anticipated a substantially smaller surplus. Declining short term interest rates will lead to improved business confidence, reduce the daily cost of doing business, and set the stage for a recovery in both real growth and profits. If it counts, history indicates that an upward sloping yield curve forecasts a return to positive economic growth.

This is a time of high emotion and deep national sadness. In the presence of so many imponderables much that has been written about the financial markets since these events has been driven by fear. As the situation evolves, especially on the international front, things will change. However the enormous and well coordinated response of the federal government gives confidence that a permanent deterioration of our economy is not going to happen. Longer term positive attributes, such as the continuing growth of productivity and low inflation, have not been eliminated. As confidence returns we expect the stock market to recover, perhaps quite sharply. In the increasingly disinflationary environment worldwide the bond market also remains attractive, although the recent dramatic rise in prices leaves little room for appreciation. We are confident that the American people, steeped in optimism, courage, and hope, will pass this test of our resolve, and that a return to our basic principles of fairness, justice and concern for the common good will arise from this tragedy.

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