ALM First Financial Advisors
First Quarter 2001 Economic Overview


Prepared by: Thomas Manley, CFA

April 11, 2001

Introduction
$4 trillion! As of about two weeks ago, that was the estimated value evaporation suffered by those that owned stocks. That is, of course, the change in value of the stock market from its peak to its close a couple of weeks ago.

It is our feeling that the effects of this will be profound. The effects have an obvious direct impact to us as credit unions on two levels. First, from the economic view, those considered to be owners of stocks are really you, your grocer and your neighbor. Just about everyone has at least some exposure to the stock market in the year 2001. This has not always been the case but it is today.

Just as the longest bull run in market history fueled the longest economic expansion in history, a sharp reduction in equity values will, and has, dropped the economy.

It is a general fact that the consumer drives two-thirds of the economy. When he or she (you and me) opens that 401K statement at the end of the quarter, the sticker shock has lasting impacts to his or her affinity to spending capital on expensive purchases. This, of course, starts the economic cycle of a reduction in jobs, hence a reduction in consumer spending, hence a reduction in economic growth, hence lower investment yields as the Fed tries to spur economic activity by lowering the Fed Funds and Discount rates.

Secondly, from a much more tangible perspective we are impacted as the demand for consumer loans stagnates and falls which in turn of course limits union. This is coupled by an increase in investment cash flow, which finally leads to inflated cash positions and compressed earnings as our asset-earning yield is lowered.

Ok, that is a quick, gloomy synopsis of what has happened to date but what should we expect? Well as they say, "recession is a state of mind", and let me tell you my friends historical evidence is building that we have certainly suffered a significant slowdown. Some are stating that we are already in a recession and that we just do not have the numbers yet to show it.

As in past Economic Overviews, we will review the latest economic releases to try to gauge our "state of mind".

First Quarter Review
The fundamental understanding that you must have prior to evaluating the economic data is know why we as investors care about economic growth. Gauging economic growth is important to us at this point in time for two reasons.

First and always, it is expected that economic activity will maybe give us, as investors of contractual cash flows, an expectation for future inflation. The theory from Economics 101 was that growth in an economy outside its ability to increase productivity was inflationary. Inflation is bad because it eats away at the real rate of return of a contractual cash flow. Of course, contractual cash flows are the predominant asset form found in credit unions. So, measuring one economic release or another is all in an effort to estimate one thing, unexpected inflation.

The second reason, and current issue related to measuring economic activity alludes to the equity market impact described above. Obviously to derive a stock price one must make a forecast on earnings on which to apply a multiple. That earnings forecast is predicated on an economic environment that will produce a gross sales forecast. Certainly, any upset to this forecast will have a profound impact on a market whose valuations can only be described as optimistic. Indeed, this has come to pass.

Even after the tremendous sell off in the equity markets to date, valuations are just now beginning to approach normal levels. Therefore, any unexpected, negative economic signals will send the stock market down further. As described above this impacts us as credit unions in a number of ways.

Consumers
The consumer is doing his best to keep things running along. This is important as was noted above that consumer activities account for approximately two-thirds of the U.S. economy.

Consumer Confidence is a great indicator for the "state of mind". Indeed, it is well known that Consumer Confidence is one of Chairman Greenspan's favorite releases to monitor. As can be seen in the accompanying graph, Consumer Confidence entered the year 2000 in a strong position. Then about the time that the nation entered the electoral crisis in November 2000 the index had a significant drop of approximately 40 points. This corresponded to a significant drop off in economic output as measured by GDP and to the continued slump in the equity markets (please see graphs on the previous pages).

The index has had a slight rebound of sorts in the last part of the 1st Quarter of 2001, but it is easy to see that we are well off the peak. In fact, the last five times Consumer Confidence has fallen by more than 30 points the U.S. economy has entered a recession.

To extrapolate further on the attitude of the consumer we may look at some of those items that may affect his or her well-being and consumption behaviors. Obviously, the employment picture will give us a strong clue to the consumers' position in regards to job security.

Unfortunately, a review of the growth in jobs as measured by the change in non-farm payrolls is not encouraging. Indeed, a review of the data shows that beginning about the summer of 2000 job growth diminished significantly. Year-over-year growth stands at 1.3%. The past five times job growth was this weak we had a recession. In fact, this indication has called a recession correctly dating back to 1970.

Consequently, the lack of job growth has translated, along with other factors, into an up tick in the psychologically important unemployment rate. Since the winter of 2000, the unemployment rate has increased from its cyclical low of 3.9% to 4.2% for March 2001.

Again, keeping in mind that reviewing this data is in an effort to gauge inflation we will look at our first inflation indicator; the Employment Cost Index, or ECI.

The ECI is a quarterly release and as can be seen has been increasing at a decreasing rate. This would imply to the market and the Fed that wage inflation does not appear to be a problem.

Coupled with an increase in uncertainty related to job formation and security, the consumer's spending habits have become erratic. By looking at the monthly change in retail sales we can see that again starting in the summer months of 2000 that the percentage change in retail sales has moderated and indeed has had four negative growth months in the last six.

Evaluating consumer activity in purchases of a little larger magnitude is also a useful exercise. Again, going back to the summer of 2000 the number of new, domestic car sales dropped off significantly, reaching an annualized low of 5.8 million units in December 2000. It is also easy to see that beginning in the First Quarter of 2001 car sales have spiked upward reaching 7 million last month. The spike upward sends a conflicting signal. A lot of that spike, however, is related to dealer incentives provided to the market. Nevertheless, a good showing for car sales has been experienced over the last two months and hopefully will provide some relief to the economic environment.

One part of the consumer story that has received a lot of attention has been the never-ending appetite for consumer debt. A review of this graph clearly indicates the trend upward. The high level of consumer debt translates into a high level of debt service. Currently, debt service as a percentage of disposable income has reached 14%, a level not seen since 1984. After hitting this high in 1984 debt service moved lower over the next several quarters culminating into the recession of 1990.

Wholesale Productions

Reviewing economic releases specific to consumers, it is easy to see the slowdown in the retail sector of the economy. With the exception of a short term increase in car sales and continued strength in housing activity there are plenty of signs that we should again expect to see reduced growth in the 1st Quarter that will lead into the summer months of 2001.

On the wholesale side there are also some alarming statistics coupled with rays of hope. Most alarming on the production level is in the area of Capacity Utilization. Again beginning in the summer of last year this index began a steady march downward reaching a low of 79.4%. In four of the last five recessions Capacity Utilization slumped to 80% or below.

Also on the dark side of the forecast is Industrial Production. Industrial Production has been negative the last four months culminating with a negative 0.6% change for each of the last two months. This equates to almost a 7.4% annualized reduction in Industrial Production.

With a slumping economy, however, there are benefits that are derived. One of these benefits is a reduction in the value of the respective currency. The good thing about a cheaper Dollar is that it makes the cost of our goods and services cheaper on the global market. By looking at the Japanese Yen and the Euro we can see that indeed the Dollar has fallen in value. This could presage a pickup in export activity that could help strengthen the economy in the coming months.

Second Quarter Forecast

We expect that the U.S. economy will continue to cool and quite possibly enter a recession within the next couple of months. This will of course cause problems in the equity market as described above and could exacerbate the economic condition. Keeping an eye on inflation we like to go back and look at the price of oil and gold. From the accompanying graph we can see that after peaking at approximately $33/bbl. in the summer and again in November that the price of oil has moderated in the year 2001 to $25. Gold too has continued to fall from the beginning of 2000 to its current cyclical low of $260/oz.

This commodity price action coupled with the docile indications from CPI and PPI gives the Fed's FOMC some room to cut interest rates. Indeed, today we are 200 basis points from an effective zero cost Fed Funds rate. With this latitude most Wall Street economists are estimating that the Fed Funds rate will be at 4% by year-end. With two FOMC meetings scheduled for the 2nd Quarter of 2001 we expect that the Fed Funds rate will be at 4.25% by the end of June. This will translate into a two-year Treasury yield forecast of 4.40% on the high side to 3.80% on the low side.