By Joseph A. Harrison, CFA, Partner

When the second quarter began, the economy was expanding briskly. The Federal Reserve Board seemed relentless in its pursuit of higher rates and tighter credit conditions. The equity market had nearly completed a breathtaking switch from “the forces of the new economy”, as measured by the NASDAQ, to “the perceived stability of the old economy”, as measured by the Dow. In spite of continuing monetary pressure, longer-dated bonds began to stabilize in early May, suggesting some anticipation that the steady tattoo of rising short rates might be nearing an end.

---

“Manufacturing orders posted the most severe drop in 10 years . . .”

---

Transition Underway
The quarter was filled with many signs that a transition is underway in the economy. Monetary authorities maintained pressure with a 25 basis point increase in April, then “kicked it up a notch” with a 50 basis point increase in May. Amid concerns about credit quality voiced by the Fed and some on Wall Street, lending standards were tightened by several banks, resulting in a clear slowing of loan growth. Announcements late in the quarter by a few banks of an increase in non-performing loans suggest the concern and the tighter standards had merit.

The second spike in oil prices from $24 per barrel in early April to $33 by mid-June was exacerbated by refining dislocations that resulted in a 54% increase in pump prices to more than $2 per gallon here in the Midwest. The impact of the higher gasoline price to a consumer would range from a $32 decrease in monthly disposable income, to as much as $100 for a two-car family.

Weaker Sales
With the pressure of higher interest rates, the de facto tax increase in the form of higher gasoline prices, not to mention a pinch to the wealth effect from lower equity values, it is not surprising that construction, vehicle and general retail sales weakened sharply in May and June. The consumer has not faced such a sharp change in spending power in ten years. While higher OPEC production and an easing of refinery dislocations may moderate the sharp swing in gasoline prices, home heating costs will keep the pressure on as winter approaches. Natural gas prices have increased even more sharply than gasoline and storage levels are low.

While the very weak employment report for May had some noise in it, the slowdown in consumer spending is also related to layoffs and reduced overtime. This suggests a slowdown may be more long-lasting than is currently expected. Layoffs in the auto industry are the greatest in seven years. Even the new Internet startups are cutting staff sharply in an effort to conserve cash. Manufacturing orders posted the most severe drop in ten years and capital spending expectations, as measured by the Philadelphia Fed, are also down sharply.

Higher Inventories
Most disturbing is the rise in inventories in the face of slowing demand. While not yet out of control by any means, the recent trend is the first sign that cyclical excesses may be forming. An interesting point is the reported optimism by corporate executives about the favorable outlook for sales in a recent Dun & Bradstreet survey. Such optimism is the stuff of continued inventory building.

A further disquieting factor is the change in currency markets. The strength of the dollar over the past two years may be giving way to an undervalued Euro and the cumulative effect of our very substantial trade deficits. A weaker dollar would have an inflationary bias from increasing import prices, which may encourage monetary tightness even in the face of slowing demand. If the Fed’s flexibility is limited, a soft landing would be at risk.

Economic Clouds
For the first time in nearly a decade, economic clouds can be seen on the horizon. Positive expectations for corporate profits do not reflect an economic slowdown or the pressures of higher interest rates and energy prices. Increased volatility in the equity market should continue until this transition in the economy is resolved. A cautious attitude seems the prudent course.

---

Perspective is published quarterly by Midwest Investment Management LLC, Cleveland, Ohio for its clients, friends and members of the business community. All information contained herein reflects the opinions of the authors and does not necessarily constitute investment advice. Past results are no guarantee of future performance. ©2000, Midwest Investment Management LLC. All rights reserved.