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Integrity
Performance Service
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The bond market, and specifically U.S. Treasuries, is receiving the full benefit of the flight to safety. Over the course of the latest quarter the yield on the benchmark U.S. Treasury ten year note has declined in excess of 25% to 3.70%, a level last seen in 1961. The yield on treasury maturities out to two years is now below the yield of the major stock market indices. The dramatic flight from risk is evident also in the record wide yield spreads between treasury and corporate debt obligations, especially low quality debt. Investors are clearly drawing money out of stock funds to seek haven in the highest quality investments, despite the lowest interest rates in over forty years. From an overall perspective nothing in the U.S. economic picture warrants the current condition of the financial markets. Since the tragedy of September 11th, our economy has recorded three consecutive quarters of expansion, although at widely varying levels of output. The present quarter now drawing to a close is likely to have experienced an acceleration of growth to over 4%, from a rate of about 1% in the second quarter. Retail sales have been rising steadily, automobile sales are strong, and sales of new and existing homes are at record levels. Cargo volumes turned up vigorously in the latest quarter, indicating that some industrial companies are experiencing improving trends. Other vital signs of economic health, such as the level of inflation, real wages, and productivity, are salutary. There is nothing in the wings which poses an imminent threat to a continuation of the expansion. We are cognizant of the current apprehension surrounding the outlook for the consumer. We point out that in addition to a lower effective tax rate this year, the current round of mortgage refinancing is adding over $150 billion to households spendable income, by some estimates. Some of this “cash out” is being used to retire credit card debt, but if history is a guide, much will also be spent. Retail and factory inventories are at very low levels. With demand clearly rising, inventory rebuilding will bolster production in the fourth quarter. Productivity trends also remain very strong. Productivity is growing at the fastest pace in over forty years, and promises to remain high. It is difficult to be pessimistic about our economy in light of the unprecedented level of productivity advances surging through the domestic economy. As this trend continues, it is a matter of time before corporate profitability ratchets upward sharply, capital spending improves, and the pace of new hiring picks up. The productivity performance of the United States economy contrasts with the situation in Europe, where productivity is declining. European economies, in fact, are struggling to stay above water. Employment appears to have stalled, and unemployment is rising again in a few notable countries, raising once again the specter of Eurosclerosis. Unemployment in our country remains at 5.9%, and has shown no overall improvement this year. Listless employment trends are a serious concern. The extended round of corporate restructurings and downsizings, frequently accompanied by layoffs, has caused the sticky unemployment situation, and resulted in a great deal of angst. Ultimately an improvement in employment is a prerequisite to a higher sustainable growth rate. A continuation of the present trends of growth and productivity would result in a return to high levels of new job creation. For now, consumers generally have ample cash flow. Their actions do not indicate an overriding fear of large scale unemployment. Recognizing the potential threat to our economic well being from sticky unemployment, the United States economy is healthier today than at the end of the second quarter. From trends currently in place the expansion will continue. As indicated above, we believe it will broaden to include manufacturing and the industrial economy. However the stock market is not focused on the economy. There are plenty of other developments that are disturbing, and collectively they are dominating investor psychology in the current tense environment. The duplicity and blatant greed of some high profile business leaders, instances of accounting fraud and conflicts of interest, a daunting geopolitical situation including the possibility of war, daily reminders that we are the primary target of terrorists, all weigh heavily on the American psyche. In our judgment these have overshadowed the debate about the strength of the economy, and collectively are the reason for the terrible stock market action. We do not pretend to know the final denouement of these issues, and it would be wrong to imply that they will dissipate in the near term. It has been our experience however that uncertainty of the outcome is often more damaging than the outcome itself. Once a potential threat or danger is actualized it becomes a known situation. It can then be assimilated and the severity and longevity can be put into perspective. Such will be the case with these external dangers as time goes on. Issues of corporate and personal malfeasance are, unfortunately, all too common in a free society. The fact that the perpetrators of these actions have been exposed is evidence of a society and institutions with self cleaning mechanisms in place. Hidden from view by the detritus of the market collapse is the fact that the United States economy is again exhibiting its firm underpinnings and great resilience. They will outlast the current period of distress with all of its fearsome threats. With the dramatic adjustments in values over the past quarter we believe the stock market is significantly more attractive than the bond market. Investment Policy Committee Alfred A. Lagan, CFA, Chairman September 24, 2002
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