Economic and Market Outlook Third Quarter, 1999

The United States economy is healthy. Inflation is barely visible, capacity is plentiful, and domestic growth is solid and broad based. In contrast, the level of anxiety in the financial markets is high leading to volatile behavior of the bond and stock markets. This anxiety in the face of a positive economic backdrop arises from the continuing strong domestic economic growth and fears that, sooner or later, the growth will result in a reversal of the extended period of benign inflation and low interest rates. Increasingly during the second quarter, these fears were expressed publicly by officials of the Federal Reserve Board, driving interest rates to the highest level of the year. The Board officially sanctioned the increase in market interest rates by raising the federal funds rate one quarter of one percent at the end of June.

The crux of the Fed’s position is that demand conditions are so strong they pose a threat of intensifying imbalances to our economy. Potentially, these imbalances could result in a new inflationary spiral that would then require draconian steps to bring under control. The Board has targeted employment, or in the Chairman’s terminology, “the decreasing pool of available workers”, as the potential source of this new inflation threat. Thus, the Federal Reserve Board, with encouragement primarily from Wall Street economists, felt an increase in interest rates was appropriate as a preemptive measure.

Whether this is a question of perception overwhelming reality, only time will tell. Try as one might however, it is difficult to find any evidence of incipient inflation in the economic growth pattern of the past three years. Growth of jobs has been at very high levels over this entire time. Yet reported wage gains have been modest and have been more than offset by rising productivity. Government figures for productivity growth, admittedly difficult to measure, show a dramatic acceleration in recent years. The government estimates that productivity growth averaged 1% a year in the twenty years to 1993. Since then productivity growth has averaged 2% per year, and in the first quarter of 1999, the government measure of productivity growth showed an advance of 4%. Judging from the superb non-inflationary growth the United States has experienced over the past three years it is likely that public measures of productivity growth underestimate its real rate, especially in the service sector.

Nor is there any evidence currently that inflation is stirring beneath the surface. Despite high growth, capacity utilization remains below the 80% rate, due to technological advances throughout the chain. The producer price data for May did not show any deterioration in core inflation trends. Core prices for finished goods barely moved in May, and for the year so far core price inflation at the wholesale level has been zero. The consumer price index for May also showed no increase and for the year shows an increase comfortably below 2%. Even this modest gain is due in part to the cigarette price increase resulting from the tobacco settlement.

Domestic economic growth moderated a little in the second quarter from the rapid pace at the start of the year, but remains robust. Gross Domestic Product is estimated to have expanded at a 3% rate in the latest period down from the 6.7% pace of the initial 1999 period. Growth remains robust however, and the deceleration in the second quarter is not sufficient to satisfy the monetary authorities. As in the previous quarter the expansion is being led by household spending. The consumer is benefiting dramatically from full employment, rising real wages, and the virtual absence of inflation. Even home sales have been relatively firm in the face of a sharp increase in mortgage rates in recent months. Surveys of consumer sentiment confirm the general optimism of the American consumer.

We continue to believe that consumer spending will moderate from natural causes as time goes on. Consumer spending is outpacing income growth, a situation that cannot persist for too long. There is little likelihood of a serious economic shortfall even if the consumer pulls back however. The strength of the United States economy is broad based. Capital spending has been healthy, and appears to be gaining strength. Exports of manufactured products, previously weak due to the serious recession in Asia, have been improving as the economies of these countries show renewed life.

The indications of continuing strong forward momentum in the economy added to the anxious atmosphere in the financial markets in the latest quarter. We believe that the inflation fears are groundless, and that the outlook for domestic financial markets is very positive. Declining interest rates and inflation, technology induced capacity increases and productivity gains,0 and excellent corporate earnings and cash flows, all paint a highly favorable backdrop 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 avoiding instant and possibly inappropriate reactions to headline events and dramatic sounding pronouncements.

THE INVESTMENT POLICY COMMITTEE
Alfred A. Lagan, CFA, Chief Investment Officer
June 30, 1999