Economic and Market Outlook Third Quarter, 1998

Continued worries about the Asian economies are haunting the financial markets. In the eleven months since the crisis erupted, Asian nations are witnessing further erosion of their currencies and are sliding deeper into recession. Concerns are rising that these conditions will spread to other developing nations throughout the world and will cause some economic distress in the industrialized nations also. In an otherwise placid environment, the extent of a spreading of the Asian malaise to the rest of the world is the most critical risk today on the global economic scene. Japan is at the center of these worries. It is in a full-blown recession for the first time in many years, and a recession in Japan is a serious development especially for its neighbors in Asia and other countries also.

Japan is the economic lynchpin of Asia, accounting for 70% of the region’s economic output. As its economy contracts, other countries which count heavily on Japanese trade and investment for their growth and well being necessarily feel the pain. The recession further aggravates the turmoil in the region brought about by the real estate collapse and poor lending policies of the banking system, which gave rise to the Asian crisis of the last half of 1997. In the face of these mounting problems, Japanese government policy has been gripped by paralysis causing a serious loss of confidence in its currency. Its unwillingness to address its internal problems has created a negative momentum, which often feeds upon itself, causing deeper economic woes than necessary. Such appears to be the present case in Japan.

As serious as it appears, the problems in Japan are not insolvable. Japan is still fundamentally a rich country with enormous reserves of wealth, and real potential for restorative policies. Moreover, the concerted efforts of other nations to influence Japanese government policies seem to be bearing fruit. Most importantly however, it is extremely unlikely that the Asian problems will infect the U.S. and European banking systems. As long as the U.S. and European banks are not drawn in, it will remain a localized problem albeit a serious one.

In sharp contrast to the recession in Asia, our own economy is very strong. Consumer confidence remains high, buoyed by rising incomes, full employment, and low interest rates. In some respects domestic economic activity appears to be gaining momentum. Personal consumption expenditures grew at a 6% pace in the first quarter, the fastest pace since 1992. Available evidence indicates that the second quarter also will be very strong. New home sales, an excellent indicator of the consumers’ willingness and ability to spend, have consistently been higher than expected, and mortgage applications remain at a high level. The positive factors present in the American economy are present also in the European economies. These include a drop in inflation, robust corporate profitability, slowly improving employment, and optimistic consumer attitudes.

The strength of the domestic economy has raised fears that the Federal Reserve Board will increase interest rates as a preemptive strike against a possible rise in inflation later. We view this as unlikely, at least in the near term. The problems in Asia and the strength of the dollar will hold the Fed in place until more evidence of an acceleration of economic activity is obtained. There are also divergent trends that mitigate the consumer spending spree, and which bear watching. Much of the economic surge in the first quarter was caused by the huge increase in inventories. Inevitably, the pace of inventory accumulation must slow. If consumer expenditures recede, the high level of inventories will accentuate the economic slowdown that follows. Moreover, the manufacturing sector is beginning to feel the affects of the Asian recession. Industrial production has been more or less flat for four months and manufacturing employment has declined for several months. Deteriorating trade with Asia will continue to exert a negative influence on the manufacturing sector and provide another reason for the Fed to remain neutral.

Inflation remains barely visible in the economic statistics despite the strength of the domestic economy. In fact there is some evidence of deflation at the wholesale level, especially in industrial commodities such as oil. Recent attempts in many quarters to raise prices have been unsuccessful, or have faltered after initial apparent success. Deflationary winds blowing out of Asia will continue to exert a dampening influence on inflation.

Through all these cross currents the trend in corporate profits remains satisfactory, and the quality of profits is high. Debt restructuring and relatively restrained corporate demand for new borrowing, combined with strong internal cash flow, has resulted in a strong improvement in corporate balance sheets. This is reflected in the steep drop in corporate debt to net worth over the past four years. In short, credit concerns are not evident in the U.S. economy.

We remain convinced that the environment strongly favors financial assets, and specifically U.S. financial assets. The greatest impediment to full participation in the attractive environment is the tendency to adopt a short-term attitude brought about by lack of long term conviction. An economic environment characterized by virtual full employment, low interest rates, low inflation, and healthy corporate profits, is a favorable one indeed for stock and bond investors.

THE INVESTMENT POLICY COMMITTEE
Alfred A. Lagan, CFA, Chief Investment Officer
June 30, 1998