Economic and Market Outlook Second Quarter, 1999

The U. S. economy continues to boil. Fourth quarter Gross Domestic Product was revised upward to a 6.1% rate bringing growth for all of 1998 to 4.3%. This was the strongest performance in over a decade and provided a vibrant springboard into the new year. Indeed, early signs indicate that growth in the first quarter has maintained a robust pace. Consumer spending is the primary driver of our expansion but growth is coming from many sources, providing a healthy and balanced economic landscape. Retail sales remain strong, new housing starts hit a modern high in January and remained strong in February, and automobile sales maintained a positive momentum. Construction spending also was strong in the first quarter. And, recent statistics suggest that manufacturing is recovering from its mini recession caused by international economic upheavals last summer and fall.

These indications of strong forward momentum upset the expectations of many of a near term slowdown in our economy. Fears of scarce resources and increasing credit demands caused a substantial rise in interest rates in the quarter. Despite the late quarter surge in stock prices, equities reacted to these fears of a more competitive interest rate environment with very volatile behavior. Anxiety best describes the mood of the financial markets throughout the first quarter. As we enter the second quarter of 1999 many economists continue to expect an increase in interest rates as the year progresses.

While acknowledging that the domestic economy is stronger than anticipated, it is highly unlikely that it is the runaway locomotive so feared by many economists. In fact, a modest slowdown in the domestic economy appears imminent. With evidence of a slowdown in domestic activity, we believe normalcy will return to the bond market. Our firm belief is that interest rates will resume their decline in the months ahead. This assumes no further international monetary crises as happened in Brazil late last year and in Russia earlier. The primary reason to expect a near term economic slowdown is the housing market. New building permits have declined for more than three months and the rate of new home sales show increasing evidence of softness. Mortgage applications have actually plunged recently. Whether in reaction to demographic forces or to the rise in interest rates since November, the slowdown in housing will have a meaningful influence on domestic interest rates. At some point also consumer spending generally will slow, if only because recent increases have been so strong. Other previously strong sectors such as capital spending show early indications of moderating trends as well.

These trends all point to the probability of a slowing of domestic economic activity in the second quarter. Our economy remains very well balanced however, and there is little likelihood at present of a serious economic shortfall. The fact remains that the United States is experiencing a deflationary boom characterized by excess supply of resources. Real growth is strong primarily because prices are falling for all commodities except oil currently, and for many services also. This is not a “demand pull” economy but one that is stimulated by lower prices. The result is the opposite of inflation. The application of new technology has reinforced the deflationary trend. Technological advances are the reason why manufacturing capacity is growing at an annual rate of 4.8% even as plant capacity utilization is at recession levels. This illustrates the stunning increases in productivity which technology has brought to the manufacturing process. These forces will not evaporate quickly.

Other factors bearing on the outlook for the financial markets appear satisfactory. After declining last year for the first time since 1990 corporate earnings should show a respectable advance this year. Severe pressure on industrial commodities including oil was the cause of last year’s deterioration in corporate earnings. While many industrial companies will continue to suffer, the broad earnings declines are probably over. American corporations are generally quite healthy with improving cash flows and conservative, forward looking management philosophies. A broad improvement in corporate earnings this year will have the wholesome effect of broadening the market advance, and is supportive of stock market valuations. The economic environment internationally also appears to be showing some stabilization, if not outright improvement. While European economies continue to slowly erode, some positive progress is visible in Asian countries. Even Brazil, so maligned just one quarter ago, appears to be benefiting from its painful remedies and the international cooperation afforded to it.

The outlook for domestic financial markets is very positive. Declining interest rates and inflation, technology induced capacity increases and productivity gains, and excellent corporate earnings and cash flows, all paint a highly favorable back drop for both equity and bond markets. We believe firmly that investors will be best served by accepting a long-term view of their investments and avoid reacting to headline events and dramatic sounding pronouncements.

THE INVESTMENT POLICY COMMITTEE
Alfred A. Lagan, CFA, Chief Investment Officer
March 31, 1999