Economic & Market Outlook Third Quarter 2001

Economic growth has slowed to a crawl. The constant stream of economic statistics shows a highly divergent pattern among its various components. One can highlight almost any series to make a point, either positive or negative, all of which proves that the economy is changing and the outcome is uncertain. Despite the uncertainty, our conviction is high that the cyclical trough in the economy and in corporate profits is upon us now and is unlikely to get any worse. We believe that a gradual improvement in business conditions and profits will become increasingly apparent as the year progresses. However the recovery will be subdued, giving optimists and pessimists alike opportunities to claim bragging rights.

The clearest signs of recession conditions are in the industrial sector. The index of industrial production has now fallen for eight consecutive months, most recently a sharp 0.8% drop in May. While the decline in manufacturing is widespread, the severest drop is in high technology equipment notably communications equipment, computers, and semiconductors. This is the sector which enjoyed the most rapid expansion in 1999, and represents the area of most severe contraction now. There are no signs that the recession conditions here are abating. Demand remains slack, pricing is soft, and layoffs are a common occurrence. Other manufacturing industries seem to have stabilized although inventories remain high and new orders, particularly for export, are weak.

Externally, the economic picture provides little comfort. Japan is in a recession with tepid domestic demand and rising unemployment. Weakness in the Japanese economy is retarding growth of developing nations in Asia. The euro area also is clearly struggling and has no momentum. A weak currency has not benefited exports from Europe, which amount to an estimated 15% of the combined European economies. With a declining population, inflexible economic and regulatory structures, high tax rates, and a rigid central bank, Europe is unable to provide the economic lift necessary to overcome a slowdown in the United States economy, or to realize its inherent growth potential.

Outside of manufacturing business conditions are not so bad, and in some areas are very positive. Job gains in services and construction have offset most of the drop in manufacturing employment. Employment is the principal determinant of income, and both employment and incomes have held up reasonably well overall. Consumer confidence has remained high and consumer spending, while decelerating in the latest quarter, is still advancing.

The bright spot in the U.S. economic picture is housing. Buoyed by declining mortgage rates, relatively full employment, rising real wages, and an influx of immigrants, housing has remained strong throughout the downturn. The outlook for continued strength in this sector is very positive. There is a natural desire for home ownership in virtually every working family. This desire arises from the human spirit itself and is independent of any cold, quantitative economic analysis. In the current circumstance of low inflation, a large minority and immigrant population, and plentiful employment opportunities, many working families see the realization of their dream a distinct possibility. The actualization of this dream is made possible today by the abundant availability of credit on flexible terms for minorities and low income families. This is why housing will continue to be a positive stimulus, and strength in the housing market will continue to confound economists. It is one of the primary reasons why the U.S. economy is unlikely to slide into a recession despite weakness in some major sectors.

Final demand will remain the arbiter of whether the economy continues on a positive track or slides into a recession. Ultimately, final demand is determined by the interaction of numerous elements including confidence in the future, incomes, inflation, and other tangible and intangible factors. The outlook for inflation is tame and allows the Federal Reserve to pursue monetary policy free of inflation fears. If conditions remain slack additional interest rate cuts on top of the six already made this year are probable. As already mentioned, consumer confidence remains high. We believe the accumulating impact of aggressive interest rate reductions and modest tax relief will tip the balance to the positive side. As economic demand stabilizes and inventories are whittled down production statistics will improve and a healthier overall economic picture will emerge.

The return of the business cycle last year after years of smooth sailing has unnerved investors. The suddenness and severity of the contraction, and its concentration in a sector which seemed impervious to cycles, made it especially damaging to investor psychology. On a daily basis investors are reminded of the erosion of profitability as company after company confesses to reduced expectations. In such a negative and short term environment it is important not to lose sight of the great attraction of U.S. financial assets generally and high quality stocks in particular. Declining interest rates, low inflation, rising personal incomes and virtually full employment, make a powerful backdrop for U.S. equities and for eventual economic recovery as well. Add to this the fact that domestic markets are compellingly attractive when compared with alternatives. Our technological leadership, flexible economy, political stability, growing population, and productive workforce, have made the U.S. economy and financial markets the most appealing in the world. These attributes will be recognized again when the business cycle improves. We believe the outlook for high quality stocks is very attractive and that patience is called for.

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