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Integrity
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A number of factors are contributing to the strong recovery. Unlike previous recessions, housing and consumer spending were unaffected in the current downturn. Housing and consumer spending seem poised to remain supportive of the recovery, even though the pace will slow. Mild weather certainly benefited the housing market in the first quarter, but the primary driver was the sharp decline in mortgage interest rates last year. The rise in mortgage rates lately is probably not severe enough to deter an anxious homebuyer. Retail sales have also remained brisk. In addition to a timely tax rebate last year, which benefited holiday sales, real wages, i.e., wages adjusted for inflation, rose impressively in 2001. Moreover unemployment never reached the level of previous recessions, and recent claims data suggest that job losses are declining. The result is a consumer who has not lost his/her confidence in the future. The resurgence in manufacturing is the new element adding lift to the renewed economic growth this quarter. Manufacturing activity declined every month last year. The sector bore the brunt of the sharpest reduction in inventories on record and the collapse of telecomm and internet infrastructure spending. In the fourth quarter alone inventories declined about $121 billion, a staggering but unsustainable drop. Inventory liquidation reversed dramatically in February, and anecdotal evidence suggests that accumulation continued into March. The authoritative Institute for Supply Management reported its overall manufacturing index rose in February to the highest reading since April 2000. Moreover, payrolls gained in February by 66,000, the first increase since last July, with most of the increase coming in manufacturing. An improvement in manufacturing is clearly a major positive for balanced economic growth going forward. It should be good news for certain foreign countries also. Mexico, in particular, has a significant American manufacturing presence. Europe also appears headed for a modest recovery and will certainly benefit from a more broad based economic recovery in the United States. As welcome and timely as the resurgence in the manufacturing sector is, we believe its prospects are muted. Much of the improvement in the first quarter is a snap back from the severe drop last year culminating in the fourth quarter collapse. As inventories approach levels supportive of final demand manufacturing is likely to throttle back. Capital spending, a major influence on manufacturing, remains weak. Faced with excessive levels of underutilized capacity and pressure to dress up its balance sheet, corporate America is very reluctant to embark on a renewed spending spree. In fact there has been some evidence of additional reductions in capital spending plans by some major corporations. Congress recently passed and the President has signed a stimulus package, which provides incentives for capital spending. While helpful, the bill by itself is not likely to reverse the weak outlook for business investment. Some moderation in the rapid recovery in manufacturing is the most likely outcome, in our opinion. The increase in productivity is one of the most encouraging signs emerging from the devastation of the domestic economy in the fourth quarter. Productivity growth in the final quarter of 2001 was 5.2%, an acceleration from previous reports and an impressive number in any period. The superb performance caused a decline in unit labor costs in the quarter even as real wages rose. It is apparent that American manufacturing efficiency entered a new and higher plateau during the 2001 downturn. We believe the new paradigm is sustainable and that higher productivity will have a meaningful influence not only on corporate profitability but on inflation expectations as well. Profit growth is very sensitive to growth of productivity. Despite current expectations to the contrary, we expect profit margins to trend higher as the year progresses. We believe also that the current inflation scare will prove illusory. Price competition will not abate, and success in the corporate world will continue to go to the low cost producer. In this environment, the Federal Reserve will be very slow to raise interest rates despite the highly publicized fears arising from Wall Street. What is truly remarkable about the American people is the ability to recover from grief and move forward with confidence into the future even in the face of lingering fears. Never has this quality been more evident than in the past six months. Reflecting this wholesome ethic, our economy also has taken severe hits and yet is well on the road to recovery. A hallmark and distinguishing characteristic of our economy is the flexibility of our economic system. This flexibility enables a natural cleansing of excesses and results over time in a return to a growth orientation. We are in such a period now. Economic expansion has resumed and will persist throughout the year. It will be accompanied by attractive fundamentals. Liquidity is ample, corporate profits will improve, inflation will remain muted and interest rates, while higher, will level off. These are solid reasons to be optimistic about the course of the financial markets this year. Investment Policy Committee Alfred A. Lagan, CFA, Chairman March 26, 2002
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