The best analysis I've seen on the current state of the American economy. I encourage everyone to read it.
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The TSC Streetside Chat: Richard Berner, Chief U.S. Economist at Morgan Stanley
By Lee Barney
Staff Reporter
09/08/2001 10:54 AM EDT
The Fed has lowered the interest rates, but that doesn't mean banks are playing ball.
Richard Berner, chief U.S. economist at Morgan Stanley, says the willingness of banks to grant loans is more important than lower interest rates. Now that banks are finally easing their credit policies, he says, more businesses will be able to take out loans for capital spending, which he sees as an essential ingredient for an economic recovery.
Berner maintains that we are in a global recession and doesn't foresee the economy improving until early next year. He says U.S. corporations won't return to significant capital spending until the first quarter, corporate earnings won't pick up until the second quarter and inventory liquidations won't be over until sometime during that period. In anticipation of these improvements, the market may move slightly higher by the end of the year, to end the year flat. But not until the first or second quarter, Berner says, will we really, finally, be out of the woods.
For the economist's thoughts on the economy, the stock market, capital spending and "the bottom," read on. (This interview has been edited for length and clarity.)
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TheStreet.com: Most other economists have been harping on the Fed rate cuts as cause for optimism about a pending economic recovery. But you say you look at interest rates in combination with three other factors: the value of the dollar in foreign markets, asset prices and credit availability. Can you tell us what these factors, combined, are telling you?
Richard Berner: I add up those four factors, and they are telling me that we're starting to see an easing in financial conditions. But there's a lag between the time you start to see an improvement in financial conditions and the time the economy starts to recover.
It's not enough to have an easing monetary policy, although that's important. Having those other things follow is also important. Some central banks look at interest rates and the dollar in what they call a monetary conditions index. There are people who certainly try to add in the role of stock prices in thinking about financial factors affecting the economy or financial conditions.
The one that I focus on more than other people is credit availability and credit spreads. It's hard to quantify that, but I think there's some work that shows the Fed senior loan officers' survey is a reasonable proxy for credit availability. And when you take that into account, you see that over the past six months, credit availability has improved, but from a fairly restrictive level. So it's going to be a while before that starts to show up in improved market activity.
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"If people are turned down for loans, then it doesn't matter what the interest rates are."
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TheStreet.com: Do you have any sense of when that might occur?
Richard Berner: I think we'll start to see more vigorous growth in the first quarter of next year. I think we'll have a return to positive growth from declines in the economy in the fourth quarter because I anticipate the third quarter will show a decline.
TheStreet.com: Why do you believe that credit easing is so important?
Richard Berner: It's not just interest rates that affect whether people can borrow. If people are turned down for loans, then it doesn't matter what the interest rates are. So the availability of credit is very important, whether you're looking at people or businesses.
TheStreet.com: Why, given the economic conditions right now, would banks be willing to make loans? Has creditworthiness declined?
Richard Berner: They are always willing to lend to what they feel are creditworthy borrowers who, they believe, have good prospects of paying the loan back. But there's no mistaking the fact that banks have become more cautious, reflecting the economic backdrop and its implications for corporate and household credit quality.
Creditworthiness has declined, compared to two years ago. Compared to six months ago, corporate credit quality has begun to stabilize or improve, but that's defined by the way that bond investors have begun to look at it. That's because companies have begun to cut back severely on capital spending and have cut costs elsewhere, laid people off. They've done things that will enable them to preserve the cash flow to service the debt. That's the way bond investors look at it.
TheStreet.com: How does corporate debt refinancing factor into creditworthiness?
Richard Berner: There's been an enormous amount of refinancing, particularly locking in longer-term, low-rate financing and paying down short-term debt. And that's been very helpful to corporations because it eliminates the interest-rate risk that arises from holding short-term liabilities if the rate on those liabilities is going to go down. I don't think it's going to go up anytime soon, but if you eliminate that risk, then you can sleep easier at night as a chief financial officer. That's also helped households, by the way. Households have been refinancing their mortgages. Some of them have been able to reduce their debt service as a result.
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"I think that between the second quarter and the third quarter, we will see the economy getting slightly worse, but not a lot."
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TheStreet.com: What about the inventory liquidation process? Do you think we are nearing the end?
Richard Berner: I think we're in the middle of it. I think we've got a couple more quarters of inventory liquidation ahead of us. The debate is over how long it will last, and my view is that it will last longer because inventory-to-sales ratios are higher than most people are willing to concede. The second, subtler part of the debate is how intense it will be. I think that in the third quarter it could be every bit as intense as it was in the second quarter. But I think there's more work to do.
As to when we will be through with it, I would argue that we won't see a return to inventory accumulation until next year. The fourth quarter should be a transition period. Companies will still be liquidating their inventories, but that's because they will be hesitant to have production catch up to demand, and inventories will finish being liquidated as demand slowly improves.
TheStreet.com: Where are we with capital spending?
Richard Berner: Right now they are mostly negative. The fundamentals include the prospects for growth, the returns on investment that companies can earn (and therefore what their profits and profitability look like), cash flow and the cost of capital.
I don't expect capital spending to improve until sometime next year. My guess is that we shouldn't start to see capital spending turn around until the first quarter of next year. But that's still a forecast.
TheStreet.com: In recent weeks, some economists -- citing a smattering of mildly positive data -- have said they think we may be at a turning point that could poise us for a recovery by year-end. They've cited increases in the Conference Board's leading economic indicators over the past four months, new housing activity hitting an 18-month high and factory output stabilizing after nine monthly declines. How do these factor into your outlook?
Richard Berner: I am pessimistic near term, optimistic longer term.
All those data that you just described are part of a bottoming process, which we are working our way through. I look to see if the economy is getting worse, and I think that between the second quarter and the third quarter, we will see the economy getting slightly worse, but not a lot.
I think we'll see signs of stability ahead, but some of those things the optimists have cited might turn down again -- factory output, for example, after seeing some signs of stability in July. So, yes, we have set the foundation for healthy growth, but it's not going to appear until next year.
What that means for the market, I think, is that there are going to be all kinds of questions about a rebound in corporate profits. I don't see the year-over-year comparisons in corporate profits turning positive until the second quarter, when the comparisons get a lot easier. The biggest decline in corporate profits will probably occur in the third quarter of this year.
The stock market will eventually begin to anticipate some improvement, but every piece of negative news we hear has a negative effect on perceptions about profits. This implies a market that might be moving somewhat higher sometime between now and the end of the year. We've said all along we thought this year would be a flat year. We are currently down 10%, so we certainly could move up 10% between now and the end of the year and validate that forecast.
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"The difference between this eventual recovery and previous ones is there are still big parts of the equity market, particularly technology, that are still expensive."
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TheStreet.com: Is there a chance that the recovery could be delayed beyond the first quarter or second quarter of next year?
Richard Berner: Sure, there's a chance. How big is that chance? At this point, I'd say it's one in five. But the difference between this eventual recovery and previous ones is there are still big parts of the equity market, particularly technology, that are still expensive. The way we describe it is valuation risk in technology and earnings risk in the old economy.
But despite those risks, it seems to me that this market has been way oversold. When we finally start hearing some good news, I think that will be a catalyst for the market to start to improve.
TheStreet.com: What are the chances that a global recession could further hammer our economy?
Richard Berner: We're in a global recession. The way we define it, calibrated by the way the IMF [International Monetary Fund] defines global growth, anything below 2.5% is a global recession. And we figure we are growing perhaps as slowly as 2% this year. So we're in it, and I think it is having an impact on our economy and the markets are starting to price that in.
But it's the U.S. that will lead the world out of this world recession, and it will be lower interest rates, tax cuts, lower energy prices and an end to some of the things that have been holding the economy back that will make that happen.
TheStreet.com: What about consumer spending? Do you expect it to continue to hold up?
Richard Berner: I believe declines in consumer spending have bottomed, and I don't look for retrenchment at this point. Obviously, there are some downside risks if companies lay off people more aggressively. That would change the consumer-spending picture. But there are some positives out there that are likely to sustain consumer spending growth in the 2% to 2.5% range between now and the end of the year, and they include the factors I have discussed. |
