Economic and Market Outlook Third Quarter, 2000

Two factors are combining to slow the United States economy. Six increases in interest rates by the Federal Reserve in less than one year, the last one an aggressive one half of one percent increase to 6 1/2%, has caused consumer spending to slow. Of at least equal influence, the rise in energy prices and especially in gasoline has also impacted consumer sentiment. While confidence remains high, the fact is that discretionary spending is reduced by these cost increases. The dampening affect on overall economic activity is clear. What is unclear is the magnitude of the slowdown.

There is growing evidence that the economy is slowing. The weakness in new home sales in April suggests that higher mortgage rates are tempering housing demand. New home sales peaked in February at a rate of 1.8 million starts, and are now running below the rapid pace of one year ago. In another sign that interest rates are acting as a depressant on housing, the value of new construction has eased for several months with the softness coming in the residential sector. Housing figures themselves are unreliable because they vary widely, but they are an important swing factor because of their influence on the purchase of a host of durable goods such as appliances. Retail sales also have declined for two months and automobile sales pulled back from peak levels even before the recent surge in gasoline prices. In the corporate sector, over the past quarter factory orders were lower, and banks instituted more restrictive lending practices. Most importantly from the Fed’s point of view, the unemployment rate rose from a 30 year low of 3.9% to 4.1%, suggesting that the tightness in the labor market is easing somewhat. If true, the threat of wage inflation is less menacing.

The upward move in energy prices has acted as an additional headwind on the economy. Oil has climbed from about $10 per barrel early last year to around $30 per barrel currently. As higher energy costs absorb increasing amounts of a consumer’s budget, discretionary income is obviously reduced. To this point however, the increase in prices has not had a broad impact on inflation. Both the Consumer Price Index and the Producer Price Index have been advancing very modestly this year. In fact, the outlook for inflation remains salutary, in our judgment.

The pattern of interest rate increases has had a clear impact on the financial markets. Bonds have been under pressure for the past year, as rates were increased steadily by the Federal Reserve. Recently however, bond prices showed some improvement. The stock market has remained volatile and declined in the latest quarter. The sell off in stocks may be viewed as acceptable by the Federal Reserve. The central bank has been concerned that the “wealth effect”, spurred by appreciating equity prices, has been unduly driving consumer spending. With a decline in stocks some of these concerns are mitigated. In particular, margin borrowing for share purchases has tumbled and new offerings of Internet companies have also contracted.

Against this background, it is our impression that the Federal Reserve has largely finished boosting interest rates. The central bank may keep a further one quarter point increase in reserve, but its program of tightening should be near an end. We believe that the unexpectedly sharp rise in fuel prices essentially does the work of the Federal Reserve by imposing an “energy tax” on consumers. Time will tell if the slowdown is sufficient to satisfy fully the central bank’s inflation fears. The Federal Reserve is likely to remain on the sidelines for a while to see if the economy has, in fact, throttled back, or if the slowdown is only a seasonal give-back.

The emerging picture is one of a still healthy economy that seems to be slowing down after its record setting run. The secular trend remains highly promising. A serious bout of inflation is unlikely in the current environment, dominated by global liquidity, worldwide competition, accelerating budget surpluses, and new technologies. We remain very positive on the outlook for U.S. financial assets.

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