Economic and Market Outlook Second Quarter, 2000

Fear and uncertainty characterize the financial markets as the first quarter of the new millennium draws to a close. It is not difficult to discern the reason for investors’ confusion. For the fifth time since last summer the Federal Reserve Board has raised its interest rate targets, to a 6% Federal Funds level and 5.5% discount rate. Moreover, the Board left no doubt that it was prepared to increase rates further, until it is satisfied that growth is within tolerable bounds. Investors unspoken fear is that the Board’s effort to slow the economy will, ultimately, cause a recession. Contributing to the confusion is the fact that the United States economy is in unchartered waters in terms of the economic cycle. Our economy has expanded for a record nine years now, with no signs of deterioration. There are no precedents for this superb performance. Its lack of historical comparability provides grist for every conceivable opinion, and in an environment of aggressive Federal Reserve tightening, many investors assume a negative outcome.

Monthly statistics aside, the United States economy continued its superb performance in the latest quarter, with few signs of tempering. With the exception of employment and housing starts, which appear to be plateauing at a high level, virtually every economic statistic released in the quarter has been stronger than expected. This high level of activity is likely to continue in the immediate future. Tax refunds are running larger and earlier than ever, bolstering the near term outlook for consumer spending. Led by technology, the industrial sector has accelerated since the turn of the year. Production of computers, communications gear and semiconductors has recovered sharply from its Y2K induced slowdown. For the year through February technology spending is up an impressive 47%, and every indication points to an acceleration. Other manufacturing sectors are also in an improving mode, due mainly to an upturn in foreign economies.

A near term slowdown of sufficient magnitude to satisfy the Federal Reserve Board is simply not in the cards. The gradualist approach to rate increases is very likely to continue, until it is satisfied that our economy has achieved a level of economic growth which, in its view, is non-inflationary. It is clear however, even to the Federal Reserve Board, that the high tech boom is having an increasingly positive impact on our growth rate. The entire increase in industrial production in recent years has been through gains in productivity. One indication of this trend is that capacity utilization, a method of measuring excess manufacturing capacity, has remained steady in recent years, despite large increases in industrial production. Another indication is the trend of unit labor costs, which remain muted even while real wages have increased. And, despite a near tripling of energy prices in the course of one year, the measured inflation rate domestically has remained low.

We remain very positive in the outlook for both bonds and stocks. To us, the evidence is compelling that the United States economy has entered a new era of higher sustained growth, high productivity, and low inflation. We believe we are in the early innings of this new paradigm. Gradually, and perhaps later than hoped for, our superheated growth rate will wind down to levels acceptable to the monetary authority. As that happens over the course of the year, the zealous pursuant of price stability by the Federal Reserve, worrisome now, will be viewed positively, particularly by the bond market. With a shrinking supply of government debt, high real returns, and huge savings flows, we expect interest rates to decline. Our view is that stocks also are attractive. We are conscious of the high level of volatility of the stock market in the latest quarter. Certainly the reaction of individual stocks to even minor disappointments has been disconcerting to many. Nevertheless, the fundamentals are strengthening, not deteriorating. Corporate earnings growth is accelerating, and despite some cost increases, profit margins also are improving. Business conditions throughout the world are gaining strength. American corporations are lean, and productivity driven. We view the future for U.S. financial assets generally as very positive, and believe that investors should not be distracted by short term concerns to the detriment of long term returns.

THE INVESTMENT POLICY COMMITTTEE
Alfred A. Lagan, CFA, Chief Investment Officer
March 31, 2000