Economic and Market Outlook Second Quarter, 1998

There are powerful crosscurrents at work in the U.S. economy. On the one hand, a record number of employed persons, low inflation, and low interest rates underpin a booming consumer led expansion. On the other, evidence of a slowdown in the industrial economy is mounting, and the plunge in commodity prices worldwide raises the fear of deflation. The outcome is subject to varying interpretations. At this time, the probabilities of either overheating or plunging into a recession seem to be well counterbalanced and contained. The denouement is likely to be benign to U.S. economic prospects, in our opinion.

The manufacturing sector is clearly slowing. Industrial production is only slightly higher than in the fourth quarter. The impact of the turmoil in Asia is just becoming visible. It is most evident in manufacturing where orders are flat, production has slowed, and both new hiring and hours worked are decelerating. Even without the influences from Asia, a slowdown in industrial production was probable. There was a huge buildup of inventory levels last year especially in the fourth quarter. This pace of accumulation -- $74 billion annual rate in the final quarter -- is clearly unsustainable, and points to a caution sign immediately ahead, as inventories are worked down. The inventory overhang, combined with deteriorating trade with the Asian countries, will result in significantly slower industrial production in 1998. To an even greater extent than usual, therefore, the prognosis for the U.S. economy in 1998 will depend on the consumer, and his perception of his economic well being.

The American consumer is in good shape. The U.S. economy generated 3.2 million new jobs last year, and income growth was healthy. Along with strong employment and income growth, retail bargains in stores were very visible. Home ownership reached record high levels in 1997 buoyed by low mortgage rates and high consumer confidence. Many of these positive forces will remain in effect although there is little if any room for improvement. Growth of new jobs will probably moderate considerably and with this moderation, income growth also will slow. Pent up demand for consumer durables is probably tapped out and new housing is reaching its natural demographically contained limits. The overall picture remains healthy, but a repeat of the 1997 domestic economy is not likely to occur.

We expect inflation to continue to decline. The tight labor market is the most threatening potential source of inflation, in an otherwise deflationary pricing environment. If growth of jobs remains at current levels, about 300,000 per month, the Federal Reserve Board would undoubtedly feel the need to maintain its credibility as an inflation fighter. In this scenario, the Fed would raise interest rates, probably around year-end. We believe this occurrence is highly unlikely. Almost all other potential sources of inflation are calm or declining. The recent attempt to raise oil prices by several leading oil producing nations may succeed in arresting the free fall of oil prices, but it will not push prices up even to the average levels of 1997. In fact, the decline in gasoline prices this year will increase disposable income for the American consumer, just as effectively as a tax decrease. The fact remains that deep structural changes in the organization of the world economy make a new breakout of inflation very unlikely. Worldwide competitive pressures have intensified in the 1990’s, and are unabating. Rapid technological change, globalization, and deregulation all contribute to this increase in competitive pressures. For the vast majority of industries this means price increases are impossible to obtain and attempts to raise prices results in immediate loss of market share. Thus corporations are pursuing productivity gains intensively. True productivity gains generate excess cash flow and higher earnings. Presently, there do not appear to be any forces underway powerful enough to change these trends.

These financial trends are highly favorable for the financial markets. We continue to believe interest rates will decline throughout the year and that the outlook for the stock market is favorable. There will be corrections, perhaps severe, just as in 1997. Nevertheless, we believe underlying trends are highly beneficial and focusing on the long term, rather than protecting against temporary corrections, is the best course.

THE INVESTMENT POLICY COMMITTEE
Alfred A. Lagan, CFA, Chief Investment Officer
March 31, 1998