July 7, 2004

To Our Clients and Friends,

THE MARKETS
We've seen volatility in the stock market throughout most of this year, which comes as little surprise, since the economy has been showing clear signs of improvement and investors have shifted their attention from fears of deflation to those of inflation. Corporate earnings have improved over the low levels seen early in 2003 - which is generally a boon for stock prices - but more recently this optimism has been tempered by fears that interest rate hikes are just around the corner. Lately, it seems that every bit of economic news triggers some sort of response.

INFLATION
We think the fears of runaway inflation are somewhat overblown. The CPI is currently at 2.3%, comfortably below it's long-term average of 3.0%. If the economy continues to stay on solid ground, this number will likely continue to creep upwards, but this is okay. In periods of strong economic growth, it is both natural and expected to see a modest increase in price levels, and this doesn't mean that prices are likely to skyrocket the way they did in the 1970's and early 80's. In our analysis, we believe that there are good reasons for both optimism and pessimism. First, let us look at some of the issues that suggest a higher - than - average risk of inflation.

Cyclical factors. The economy is humming along quite well, with recent GDP numbers showing solid growth. All other things being equal, this is generally associated with rising income levels and rising prices.

Commodity prices. Commodity prices have been increasing very quickly for the better part of two years. Higher raw materials costs for companies are typically passed along to consumers in the form of higher prices.

Fiscal policy. Increased spending and lower tax rates appear to have helped the economy, but the government is running a budget deficit in excess of $440 billion.

Current account deficit and the dollar. The U.S. current account deficit is roughly 4.5% of GDP, which is very high relative to historical levels. In order for this imbalance to be corrected, a sizeable currency decline is generally required. This makes foreign goods more expensive and allows domestic goods producers to raise prices.

Offsetting these concerns are several anti-inflationary forces.

Debt levels. Consumer debt is extremely high, although low interest rates have kept the cost of servicing that debt at a reasonable level. However, as interest rates rise, indebted consumers (and corporations) will have less disposable income to spend, which will put downward pressure on prices.

Global competition. The global economy is very competitive. Price competition has increased as the Internet has become more widely used and both consumers and corporations can seek the most attractive prices from around the world. Also, China and India with their cost advantage are able to export goods and services at very low prices. As such, the ability to raise prices is more constrained than it was in the past.

Central bank vigilance. Over the years, central banks around the world have increasingly proven that they are sensitive to inflation risks.

Productivity. Productivity growth slowed briefly during the recession a couple of years ago, but it has generally been quite high and is currently near all-time highs. If it continues, high productivity growth will be an important force reining in inflation because it reduces labor costs per unit of output.

Capacity utilization. Capacity utilization has increased recently, but it is still well below historical averages. Low levels of utilization allow companies to increase output without having to purchase new plants and equipment.

As always, we must remind investors that there are risks out there, and as new information is absorbed by the markets, volatility is likely to continue.

INTEREST RATES
Now, clear evidence that the economy is strengthening and inflation is moving higher is being interpreted negatively because it increases the probability of continuing interest rate increases by the Fed. The fear of rate hikes is not unwarranted, since rising interest rates raise the cost of debt for both companies and individuals, and increase the attractiveness of other interest-oriented investments, both of which tend to put downward pressure on stock and bond prices. A student of history might wonder why investors are so fearful of rising rates. Looking at the five Fed increases since 1983, the market has generally risen in the year after the first rate increase because the increases are recognition that the economy is doing well.

As usual please feel free to call us. We are here to answer your questions, respond to your concerns, and help you make smart decisions about your money.

Very truly yours,

ZRC Financial Services, LLC
A Registered Investment Advisor

By:
         Richard P. Clarke

RPC/ih