Economic and Market Outlook Second Quarter 2001

The state of health of our economy is the lead story on every nightly newscast, and the first item on the morning news as well. Much of it is negative, focusing on lay offs, weakness in some economic numbers, or poor earnings pronouncements from well-known companies. The speed and intensity with which bad news is disseminated today has heightened emotions, caused fear, and put many investors' nerves on edge. We believe that the drumbeat of negative news presents an unbalanced picture of our economic situation. A more detached and dispassionate reading of the current state of the U.S. economy reveals a mixture of both positive and negative trends. By no means does it add up to an economy in the grips of a downward spiral. In the balance, it points to an economy which has passed through a tough adjustment from a too rapid pace to a slow, albeit underachieving, rate of advance.

It is helpful to review our path to this point. At the end of 1999 the United States economy was growing at an unsustainable pace. Real gross domestic product in the final 1999 quarter expanded at a rate of 8.3%. The rapid advance was attributed in large measure to a burst of spending on technology and telecommunications equipment, as well as to an excess of consumer spending. In response to what it perceived as an accumulation of excesses, the Federal Reserve Board raised its key interest rate several times, culminating in a rise of one half of one percent at its May, 2000 meeting. The subsequent deceleration in the fourth quarter of 2000 was unusually abrupt in its onset and deep in its magnitude.

At the end of the first quarter of 2001 it appears to us that the adjustment process is well along. From an economic point of view the previous imbalances, identified so clearly by hindsight, have been mostly addressed. Capital spending, mainly technology and telecommunications spending, has clearly receded. The virtual collapse of new orders for technology and telecommunications equipment exposed the fact that the sharp rise in orders in 1999 represented a borrowing of orders anticipated in the future. As production schedules rose and inventories were built up, the subsequent curtailment of orders was extraordinarily sharp. Investors and companies alike felt the pain of the cutbacks. Other sectors also retreated as 2000 wore on. Weakness in industrial production and in manufacturing still persists, but it is a known and measurable variable. Consumers, too, have become visibly more cautious in their spending levels and intentions.

In short, the negative aspects of our economic circumstances are well publicized today. They are offset by some positive trends which, in our view, are less well recognized but are gaining in impact. Lost in all the hyperbole is the fact that new job creation is still rising as of the latest reported period, and incomes are also rising. Spending is still positive, but no where near the exuberant levels of one year ago. Finally, the United States banking system is very sound, and credit is available to quality borrowers. Other periods of economic stress which led to recession were almost always accompanied by deteriorating credit conditions and a negative banking environment.

The immediate time ahead will benefit from other factors. Three interest rate decreases by the Federal Reserve in less than three months attest to the seriousness with which the monetary authority viewed the broad downturn late last year. Odds are very high that there will be further reductions in the immediate future. Those who belittle the importance of decreases in interest rates choose to overlook the very stimulative effect declining rates have on important sectors of our domestic economy. Low mortgage rates are supporting strong housing activity, and will continue to support it. The decline in mortgage rates has already sparked a brisk business in mortgage refinancings, providing immediate benefit to consumers in the form of lower monthly bills. Finally a tax cut is a certainty. Only its final shape is debatable.

The first quarter of the year has seen an extraordinary amount of activity in the financial markets. Reflecting the high tension and emotion surrounding the stock market, investment grade bonds have been the instrument of choice, while stocks have been treated as if they had contracted a form of mad cow disease. To some extent expectations for stocks are still being marked down, as company after company publicly acknowledges soft demand conditions. In the current environment, earnings have replaced inflation as the major source of financial market angst. In this case however, perception is not reality. The United States economy has already adjusted to a slower path, but growth remains and will remain on a positive slope. Energizing forces, notably sharply lower interest rates, declining energy costs, declining inflation, and a reduction in tax burdens, are present or imminent. Unlike foreign countries, the United States economy is flexible and blessed with the most productive workers in the world. American businesses are resilient, well managed, and adjust quickly to demand conditions. In our view, the current pessimistic outlook will eventually give way to a recognition of the healthy forces at work below the surface. We believe the outlook for high quality financial assets is very attractive, and that patience is called for.

Investment Policy Committee
Alfred A. Lagan, CFA, Chairman
March 28, 2001