Setting the Stage for a Fall Recovery

Over the course of the Spring we have seen unemployment claims begin to trend downward, with an associated decline in corporate layoff announcements. The Christmas retail season came in much stronger than expected, and the consumer confidence numbers have held up throughout this financial contraction - significant evidence that this has been an earnings recession.

We have, under the economic shadow of the Enron collapse, seen significant profit surprises from the Q4 01 earnings announcements - with major upside announcements exceeding major downside announcements by almost three to one. While we expect the earnings outlook to remain choppy on the short term, historically profit recovery cycles lift both employment and capital expenditure cycles.

To meet any increasing demand, we have two items that bode well in a recovery cycle. The industrial inventory levels currently are the lowest in years - The combination of slashed production levels in 2001 coupled with final demand growth that held up far better than anticipated have left an environment where there are virtually no excess inventory issues (sans telecommunications, which ancillary evidence indicates may disappear much more quickly than conventional wisdom anticipates) to hinder expansion. Additionally, manufacturing capacity utilization rates stand below 70%, which allows the economy significant room for expansion without running into capacity speed limits.

Yet because productivity is still increasing at over 3% annually - and one can legitimately argue that government figures consistently underestimate this figure - and because CFO's have curtailed cap-ex spending for the past 24 months, we expect increased cap-ex spending long before capacity utilization rates approach 85%. In most recovery cycles, productivity approaches 6%. It can be reasonably expected that the next recovery may indeed exceed that number.

Additionally, there is very little evidence of systemic inflation. It is noteworthy that we went through the largest economic expansion in history, with a decade of GDP growth averaging over 3% and hitting 4% for over a two-year period, and watched as employment fell below the accepted NARU of 5% for an extended period of economic expansion. Confoundedly, in defiance of most economic thought widely held prior to this expansion, this economy ended not in inflation but rather with a broad-based deflation. In other words, the Nineties gave us a decade of data that suggests that the natural growth rates of an increasingly knowledge based economy may be significantly higher than past industrial economies.

So for the first time we exit an economic contraction with no significant inflation. Interests rates are low, yet the real rate of interest - Fed Funds less CPI - is in a historically normalized range. This is a very good harbinger for economic growth and the equity markets, while at the same time may present a challenging environment for fixed income portfolios. Again, unlike any previous period, we exit we exit this contraction with relatively inexpensive oil - although we expect this to be a volatile commodity. But we note that the world has more proven reserves readily accessible than ever before, which will pressure the Saudi's to keep oil around $25 or risk energized exploitation of the oil assets of Africa, Russia and The Gulf of Mexico.

We also have in place tax relief that should continue for the foreseeable future. Tax receipts as a percentage of GDP by 1999 had become the highest in our nation's history - more burdensome than the war economy of WWII. Notably, this tax burden was more a result of bracket creep induced by the Nineties economic expansion than any significant policy change. Historically, tax cuts have been very favorable to economic growth - a concept embraced by both John Kennedy and Ronald Reagan shortly before significant economic expansions of their own.

In our econometric model, gold returning to $300 is a positive development, in that it demonstrates a return to the equilibrium of money to commodities, an equilibrium fractured in 1996 and again in 1999. Commodities across the board - which had been down anywhere from 25-50% over the last 5 years - have already shown signs of reemerging from the profit squeeze of declining pricing, which will relieve significant economic pressure on large parts of the global economy, including Asia, South America and Africa.

Monetary policy has been restored, with significant expansion of the money supply. The highest tax burden in our nation's history is in the process of being relieved. We have low interest rates, favorable inventory levels, a strong consumer sector, and a government actively embracing growth while accelerating high tech spending at an enormous pace to upgrade military and security capabilities. We believe that this sets the foundation for a significant and prolonged economic expansion, and will be especially rewarding to growth-oriented businesses that are positioned to take advantage of an environment of historically low interest rates, increasing demand and an incentive to innovate.

Allen Tye

April 1, 2002

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