ALM First Financial Advisors
Economic Overview


Prepared by: Angela Calvert

Fourth Quarter 2000

Introduction
Let me begin by saying that writing this commentary has proved to be quite a difficult task. In the years past, explaining and predicting changes in the market seemed a much easier feat than it does today. Mr. Greenspan said it best when he made reference to the underlying performance of the US economy by calling it "an environment with so little historical precedence." In spite of that, the term "New Economy" had begun to seem over used and sort of like a cliché. But as each day unfolds, this term is proving to be more accurate. Who needs Disney World when you live day to day in a market with more unexpected ups and downs than Space Mountain? After the presidential race/marathon (don't even get me started on that!), we all thought it was time to take a breather. After all, which one of us didn't blame a lot of the strange and unusual twists in the equities and fixed income markets at least partially on the election. Out of the frying pan and into the fire, as they say!

Let us jump right in by summing up some of the major changes that have occurred just over the last twelve months:

• The Fed Funds Rate increased by 100 basis points.
• The FOMC's economic assessment had moved from neutral to inflationary to economic weakness.
• The worries of inflation have moved onto worries of a recession.A new President, along with a new political party is on its way into office.

Past Quarters
In December of 1999, there was a Fed Funds rate of 5.50% with a neutral economic bias from the FOMC. The tightening mode began in February 2000 with a 25 basis point increase. By mid year, the economy remained robust but inflation seemed contained. Throughout the course of 2000, we would see funds continue upward to 6.50%.

Looking at the yield curve, from the beginning of September 2000 investors had begun to sit on the sidelines. The two-year slipped below 6% as more and more money poured into the fixed income market from an out of control stock market. Nearing the end of the third quarter came the first signs that things were really about to change. During this time, all eyes and concerns were zeroing in on inflation. It seemed nothing but bad news and poor earnings could come out of an already volatile equity market. From there, bond prices soared as yields continued to plummet. From third quarter to year-end, the yield on the two-year Treasury yield dropped like a rock. As bond buyers held their breath and waited for the hopeful "correction", it never came. But no one, if we are all honest, saw the next event coming. (Well, at least not from a timing perspective!) In mid-day trading on January 3, 2001, at an unscheduled meeting, the Fed lowered rates 50 basis points.

The two-year that had been flirting with a 5% handle in December, has now dated it, married it, divorced it, and moved on to the 4% handle! The yield on the two-year Treasury Note dropped from the 5.90% range at the end of October 2000 to 5.10% at year-end. By mid January, the yield had dropped another 22 basis points to 4.88%. The long end of the curve, which is no longer inverted, has returned to its more "normal" shape. The ten-year moved from 5.04% in December to 5.24% just 14 days into the New Year. That flat curve that many investors were complaining about suddenly doesn't sound so bad to a short-term investor.

Growth, or is it the Lack of?'
One big concern in the market place is that all of the Federal Reserves hard work may have paid off too much. Over the past quarter, the goal was to keep the economy's expansion, which is in its record 10th year, steady while keeping inflation in check. Around November, as the economy began to show signs of slowing, the concern shifted that it may be slowing too much. With a revised, third-quarter, real GDP falling to 2.2%, the suddenness and degree of reported weakness was startling. The leading indicators suggest a fourth quarter continued downward trend with an expected GDP of 1.5%. With November and December weather being the coldest

since 1895, the problem may be exaggerated somewhat, but the extent of new layoffs and corporate credit problems argue that the potential for real trouble is brewing. The risk of outright recession has now moved to 50% and a hard landing is not out of the question. For 2001 as a whole, real GDP is expected to be 2.0% or lower on a calendar average basis.

Inflation: Active or Dormant?
The hot topic last year was the ever-soaring price of oil. OPEC took us on a roller coaster ride from promising increases in oil production to not promising enough. Oil hit an all time high in November, as many of us have felt from our heating bills. By December the price had dropped again, but that joy was short lived. Crude oil soared almost 7% the first week into 2001, after colder-than-normal weather

reduced US heating oil supplies. Inventories of the fuel fell 4.60%, leaving them 19% lower than one year ago. Crude oil for February delivery rose $1.84, or 67%, to $29.48 a barrel. Prices have risen in January by 10% after dropping 21% during December. Another inflationary indicator is gold.

Contrary to oil, the price of gold has continued to decline since September of 1999, minus a few spikes here and there. While December's PPI rate was unchanged, its core rate, which excludes

food and energy, rose an unexpected 0.3%. The Consumer Price Index has remained fairly docile except for the small spike in September, and is expected to remain unchanged in December at 0.2%.

More Bad News
In the first week of the new year, the monthly Purchasing Managers' survey, which Greenspan has often cited as one of the most reliable indicators of manufacturing activity, showed a sharp plunge in December to 43.7 from 47.7 - a level not seen since the recession of 1990-91. Also that week, auto sales were reported and fell off the proverbial cliff. The auto industry is one area that impacts a lot of segments of many different industries. Demand for everything from electronic components to textiles to leather and leather products to petroleum is influenced by the ebb and flow in the auto industry. Following a two-year boom that hoisted annual auto sales to more than 17 million units annually, sales came back to earth, leaving auto inventories at their highest level relative to sales since 1996. In turn, the slowdown in auto loans will surely continue.

Employment Concerns
With recent layoffs and the downward trend of manufacturing, the needle naturally falls toward unemployment. The December

employment numbers, coupled with the weakness in the factory sector, are the primary reasons the Fed cut interest rates so quickly. In December, Non-Farm Payrolls rose by 105,000 and the US unemployment rate held constant at 4%. Put another way,

the number of people entering the labor force in December matched the number of people who found employment. The interesting twist was that businesses added the fewest workers in four months. Companies created 49,000 jobs last month, after adding 111,000 in November, the Labor Department said. Also noted was a gain in wages last month as average hourly earning rose 0.4%, after a 0.6% in November. It is important to remember that the unemployment rate is a lagging indicator and may take a few months to respond to the recent layoffs.

Consumer Concerns
Although retail sales showed that Santa did still make his rounds this year, a 0.1% increase makes us believe that maybe either his elves didn't work as hard during the year or there weren't enough good boys and girls to justify a lot of presents! This number also shows weakness in key sectors such as General Merchandise (chain stores) at -0.5% and "Eating and Drinking" places fell 0.4%.

Another key issue to keep an eye on is Consumer Confidence, which has been taking a hit since midyear. With 44% of banks tightening credit and a stock market more volatile than a volcano, the consumer has reason to sway from its recent enthusiasm.

Consumer Credit continues to give support to the theory that the shopper might be a little down, but by no means out.

Which is the drug of choice?
With the economy in an obvious slowdown and the remedy appears to be some sort of a boost to the consumer, which is the more appropriate medicine, a tax cut or a rate cut? Some speculate that the unexpected interest-rate cut during the first week of 2001 was Alan's way of telling George W. "Hands Off! I have things under control!" Whether there was a hidden meaning or not, President-elect George W. Bush's advisers are now facing their first big economic policy challenge - how to speed up the tax cuts he has proposed without creating friction with the Federal Reserve. If Bush was to stick with the original plan, $1.3 trillion over 10 years,

The Forecast
Although the economy appears to be slowing rather rapidly, the Fed has taken quick and immediate steps to intervene. During the first quarter of 2001, we expect another 25-50 basis point ease from the FOMC, followed by another 25-50 by midyear. The two-year Treasury should trade between 4.30% and 4.65% through the 1st Quarter of 2001.