... with apologies ...
... to Business Week ... the new issue published yesterday, has a cover story called "The Surprise Economy" (which is very bullish) and also includes a commentary "Why the Bears Aren't Backing Down" (fairly bearish) ... a well articulated view from both sides ... here they are ...
Ken Wilson
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Business Week - March 18, 2002 - The Surprise Economy, First-half growth could be three or four times recent expectations
The U.S. economy truly has changed. If there is any doubt about that, look at the surprisingly mild 2001 recession--if that's what it really was. Last year's economic resilience defied expectations, even in the wake of the worst shock to the U.S. psyche since World War II. Now, a new and more exciting possibility is shaping up: The New Economy forces that helped to mitigate the recession may well generate a stronger-than-expected recovery.
Don't expect a reprise of the late-1990s boom. But compared with forecasts of less than 1% growth for the first half that were common as recently as a month ago, economists are increasingly convinced that the U.S. could turn in a 3%-to-4% growth spurt. "Everything that could be going right for the recovery is going right," says Ian C. Shepherdson of High Frequency Economics. Indeed, from manufacturing and consumer spending to construction, almost every report for January and February has beaten expectations. Not only, in the words of one Federal Reserve insider, could the first half "be gangbusters," the momentum may well be sustainable. The rise in demand is triggering hikes in industrial output that should lead to gains in jobs and income that can be spent later on.
Perhaps the biggest surprise is that the momentum even points to faster-than-expected recoveries in profits and capital spending, which were by far the hardest hit in the recession. Upturns there will provide the crucial fuel needed to carry the rebound into the second half, and the new structural influences of technology, productivity, and global markets will help to supply the thrust. More rapid growth will also limit this year's rise in unemployment. And the benefits are also starting to show up abroad as stronger U.S. growth helps to rekindle activity in Europe and Southeast Asia.
For now, though, this rosy view is mostly held by economists. Many CEOs have yet to break out the champagne. "While the technical indicators may suggest a recovery, the practical signals we live with don't validate that notion," says Barry W. Perry, chairman and chief executive officer of materials company Engelhard Corp. But that doesn't surprise economist James E. Glassman of J.P. Morgan Chase & Co. "This is a situation that hasn't quite shown up on the front line," he says. "It's just that we economists are looking at a situation that tells us to fasten your seat belts."
Of course, CEO caution is hardly unwarranted. Risks to this blue-sky scenario remain, and chief among them is the danger that the first-half growth spurt is stealing business from the second. If demand is too weak and profits don't come in robust enough to persuade businesses to bump up their capital-spending plans, the inventory-led acceleration in the first half will peter out as soon as companies have restocked their shelves. With profits weak, that's still a major concern of Fed Chairman Alan Greenspan. Other risks, such as high debt loads or an unexpected financial market shock, could send optimistic expectations tanking rapidly as well.
But even investors jaded by the tech bust and 18 months of sliding stock prices are finally believing in better times. Stocks posted their largest and broadest two-day advance since late 2000 on Mar. 1 and Mar. 4, with the Dow Jones industrial average surging 480 points. Expectations of a healthier economy and higher profits seem to have finally trumped accounting questions and loan worries.
Moreover, the good news from the U.S. economy is starting to be felt around the world. The U.S. led the global slowdown, and it will lead the upturn. For starters, Canada and Mexico, which account for 30% of the volume of U.S. trade, will benefit enormously. So will Europe. With the exception of Germany, Europe escaped sliding into a recession. Now, says Kevin Gaynor, chief European economist for UBS Warburg, the weight of evidence supporting recovery continues to build, from increased business confidence to improved export performance. The current expectation is that a stronger-than-expected U.S. upswing will prompt greater growth in Europe, though with a three- to four-month delay.
Asia is already profiting from America's rebound. Even before the latest upbeat data, stock markets from Taiwan to Singapore to Korea had been gaining momentum as investors bid up companies, especially in electronics, in anticipation of a U.S. upturn. It's not just financial market speculation. Prices for dynamic random-access memory chips have shot up in recent months, and production in certain lines is starting to pick up. "The first quarter is pretty strong," says Charles Kau, executive vice-president for Nanya Technology, Taiwan's biggest producer of DRAM chips. Moreover, the tech bust washed out some excess global capacity. "Supply has actually dropped," says Lau. Capacity utilization at CMC Magnetics Corp., a Taiwan-based producer of recordable CDs with factories spread across the globe, has risen to 100% from 40% a year ago.
Why the surprisingly brighter outlook? The story is both cyclical and structural. The cyclical part starts with inventories, which will provide the biggest bang in the first half. Businesses slashed their stock levels in 2001, a move that subtracted more than a percentage point from growth in real gross domestic product. Although the liquidation was broad, tech stockpiles were hit especially hard. Inventories at Cisco Systems Inc. (CSCO ), the networking kingpin, are at their lowest level in seven quarters, a 60% drop from a year ago. It's the same story at 3Com Corp. (COMS ), where stockpiles are down 57%. "If anything, inventories may have come down too far," says Merrill Lynch & Co. senior analyst Sam Wilson.
Indeed, inventories economywide are so low that companies now have to ramp up production to meet demand. In February, manufacturing showed signs of rebounding from a contraction that began in late 2000. Since inventories are unsold output, a slower pace of liquidation means that production is accelerating. If the liquidation comes to a halt by midyear, as widely expected, the extra output will add, on average, about 2.5 percentage points to economic growth in each of the first and second quarters. And by the second half, companies should begin to rebuild their inventories outright if they see a steady growth in demand. The critical question is whether demand will rise sharply enough to keep the orders coming in the second half once inventories have been replenished.
So far, at least, consumers seem up to doing their part to keep things going. "The biggest surprise is the strength in consumer spending and housing," says economist William C. Dudley of Goldman, Sachs & Co. Just look at demand for cars. Sales averaged an annual rate of 16.1 million in January and February and have stayed strong even though generous buyer incentives ended last year. Solid sales are boosting production, a direct result of last year's sharp reduction in inventories. Ford Motor Co. (F ) announced on Mar. 1 that it plans to raise second-quarter North American production by 4%, to 1.18 million vehicles. Overall, auto makers expect to build 4.4 million vehicles in 2002, 2.2% ahead of year-ago figures.
Consumers aren't just parking something new in the driveway. They're also splurging on home goods. Appliance maker Whirlpool Corp. (WHR ) is seeing its best growth in high-end appliances, such as washer-dryer sets that retail for $2,500. The Benton Harbor (Mich.) company says sales are running 10% above 2001 levels and that earnings in the first quarter could be as much as 20% above last year's $88.3 million. At Pier 1 Imports Inc. (PIR ), profit projections have also been pushed higher. The retailer of home furnishings and knickknacks raised its earnings target for the fourth quarter, which ended Mar. 2, three times in the past two months. For 2002, sales are expected to be up 10%. Says Chairman and CEO Marvin J. Girouard: "I'm so positive, it's scary. I see nothing but upside."
Americans can shop because they still have plenty of money to spend. Although the weakness in the labor markets means that pay gains will slow in 2002, inflation is expected to decline as well. As a result, workers' real pay will continue to grow at a healthy clip. That boost to purchasing power should keep consumer spending rising at a moderate pace throughout 2002. Household finances are also gaining from lower interest rates, mortgage refinancings, and tax rebates. True, overall consumer credit-card debt rose considerably in recent years, but the asset side of household balance sheets posted handsome gains as well. Increases in home values are offsetting stock-market losses, which are concentrated among higher-income individuals.
As encouraging as the cyclical upturn is for future growth, the more important story for the near term will be the structural changes stemming from technological advances, new efficiencies, and more interconnected global markets.
Indeed, the New Economy is debunking the old truism that mild recessions generate weak recoveries. According to this argument, steep recessions purge the economy of imbalances, such as excess inventories and heavy debt. They also create pent-up demand by consumers that is released when the economy begins to improve. Absent these forces, the theory goes, an upturn has no initial burst of speed.
For now, at least, the old thinking isn't holding up, largely thanks to astonishing gains in U.S. productivity despite the recession. The Commerce Dept. has revised fourth-quarter 2001 economic growth upward, from 0.2% to 1.4%. This means that productivity last quarter grew at an annual rate of about 5%--much faster than the already stellar 3.5% rise that was originally reported. And with output rising, productivity is set to post another healthy advance in the first quarter. Since the recession officially began in March, 2001, productivity has grown at an annual rate of 2.7%. That's a remarkable performance during a recession, especially since the average showing during all downturns of the past 50 years has been -0.6%.
High productivity will also be a leading force in sustaining the recovery. In economics, accelerating productivity growth is about as close to a free lunch as you can get. Businesses don't need to put through sharp price hikes to lift profit margins, and at the same time workers can get pay raises that are in line with the increase in their productivity. Moreover, the Federal Reserve can keep interest rates lower longer without fear that a solid recovery will boost inflation.
Just as important, the current growth in productivity--when combined with a flexible labor force--could translate quickly into fatter profit margins. For now, businesses are holding the line on labor costs by slowing the growth of variable pay, such as stock options and bonuses, or by laying off temporary workers. Although temps make up only 2% of payrolls, they have accounted for 30% of all jobs lost since last March, a phenomenon new to this business cycle.
As a result, total compensation has lagged behind the growth in productivity. That allowed companies to slash unit labor costs in the fourth quarter, and they will fall again in the first quarter. For the rest of 2002, productivity gains will keep unit costs so subdued that even small advances in prices and revenues will go straight to the bottom line. "It's a dynamo for profits," says Morgan's Glassman.
Indeed, the evolution of American labor markets has been one of the most significant structural changes the U.S. economy has undergone. A growing pool of part-time workers and increased use of variable pay have made the U.S. workforce the most flexible ever. That allows businesses to adjust quickly to changes in demand while helping to save permanent jobs and keep household income growing.
These new dynamics are challenging old business-cycle dogma. Last year's record collapse in business outlays for equipment and unprecedented inventory liquidation should have triggered massive layoffs, falling incomes, and a serious recession. But they didn't. True, companies slashed payrolls, but the unemployment-rate high of 5.8% that was hit in December is well below past recession highs, such as the 10.8% jobless rate of the 1981-82 downturn. Moreover, in a high-productivity economy, output and real income of households can rise even as employment falls. The evidence: Last year--a recession year--the economy grew 0.4%, real compensation increased 2.5%, and consumer spending rose 3.1%.
Another new trait of the business cycle is that businesses and policymakers have sharpened their reflexes. Technology has given businesses real-time information, such as computerized order-tracking and inventory-control systems that allow managers to revise with one keystroke their production schedules, work shifts, or capital budgets to changes in demand. That helped the U.S. economy respond rapidly on the downswing--and it will help build momentum on the upturn.
To be sure, even with the fanciest technology, businesses will never be able to eliminate inventory swings. But real-time information can help them react faster and more aggressively. And that's exactly what happened. Businesses managed to liquidate stockpiles at a rapid rate in 2001, including a record $120 billion shrinkage in the fourth quarter alone. Those quick reflexes will help on the upside, too. Elio Levy, senior vice-president for Tech Data Corp. (TECD ), a Clearwater (Fla.) distributor of computer hardware, notes that retailers and manufacturers are staying in close contact concerning inventories and sales. As a result, he says, "everybody's better able to match demand with supply and turn inventory faster."
Business executives aren't the only ones with quick trigger fingers. Economist Stephen Gallagher at Société Générale believes that much of the credit for the economy's resilience should go to the rapid reaction of policymakers at the Fed. For the first time--maybe in the history of monetary policy--the Fed began cutting interest rates before the recession officially began. "There's only one central bank in the world that has been willing to react as fast to the untested theories and data that are available," says Gallagher.
But not everyone's response times are now measured in Internet time. In fact, the most dilatory reactions to the recovery may be in the tech sector. That's where the biggest worry for recovery lies. Capacity excesses, both in the U.S. and abroad, will shrink slowly. That will result in only a gradual recovery in capital spending, and many believe that without a strong return in capital expenditures, the second half will be much weaker than the first. But even here, recent signs suggest that the capacity glut may be less restraining than once feared. In January, tech manufacturers' orders for computers, peripherals, communications equipment, and semiconductors rose for the fourth consecutive month. Shipments turned up strongly in January as well, and the realignment of tech inventories with sales is progressing rapidly.
The growing importance of technology means that this is no ordinary capital-spending cycle. Typically, business outlays lag behind the upturn in the economy as companies wait for firm evidence that future demand will justify additions to production capacity. But this time, businesses are buying new tech gear not so much to add to capacity but to enhance productivity in an effort to cut costs and restore profit margins. A recent survey of capital-spending plans by the National Association of Manufacturers shows "the first concrete evidence that our members are actually planning to increase capital spending." The NAM says the outlook for the second half is upbeat: 54% of companies plan to raise spending by up to 5%, with 25% planning new outlays of 5% or greater.
Plus, tech gear, which now accounts for nearly $1 of every $2 spent on new equipment, has a dramatically shorter asset life and requires more frequent replacement than old-line items such as injection molding machines, turbines, or heavy-duty trucks. "Only 5% of currently installed technology is leading-edge," says James C. Morgan, chairman and CEO of Applied Materials Inc. (AMAT ), an industry bellwether that supplies equipment to microchip makers. "That means there is a major upgrade cycle coming due." With the right mix of economic and financial conditions, that new wave of investment is ready to come onstream in the second half.
After getting burned by pie-in-the-sky forecasts of the late-1990s tech boom, CEOs and some investors remain exceptionally skittish about betting on the future. But if there is anything we have learned in recent years, it is that the U.S. economy's improved efficiency, flexibility, and quick reflexes have given it a surprising resiliency. The New Economy has shown time and again that it can deliver on its promises. This year may well be another one of those times.
By James C. Cooper and Kathleen Madigan, with James Mehring, in New York, Michael Arndt in Chicago, Cliff Edwards and Ben Elgin in San Mateo, Bruce Einhorn in Hong Kong, David Fairlamb in Frankfurt, and bureau reports.
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Business Week - March 18, 2002 - Why the Bears Aren't Backing Down, Will consumers stop spending just as businesses regain confidence?
By Peter Coy
By late 1981, economists were sure that the recession that had begun in July was over. Forecasters surveyed by BusinessWeek thought the economy would grow nearly 3% in 1982. Wrong. The economy actually shrank more than 1% that year.
Could the conventional wisdom be wrong again? Sure. Despite a spate of favorable data, pessimists argue that the U.S. faces a long period of slow growth--or even a "double-dip" recession. They worry that the mild 2001 downturn left in place the imbalances built up during the late 1990s. "The recession was too shallow to create the efficiencies that a longer, deeper recession would have," says Donald H. Straszheim, president of Straszheim Global Advisors in Westwood, Calif.
Many economists believe consumers are getting tapped out even as the stock market and housing remain overvalued. And they worry that households and companies have overborrowed, while the U.S. is getting too deep in debt to the rest of the world. Says Morgan Stanley Dean Witter & Co. Chief Economist Stephen Roach, dean of the double-dippers: "The case for a double dip is just as compelling--if not more compelling--than a couple of months ago."
Certainly, history is on the side of the doubters. Five of the seven recessions since 1957 have been double dips. In each, the economy grew for awhile only to relapse. The severe recessions of 1973-75 and 1981-82 were actually triple dips, with three distinct periods of shrinking output. Says Roach: "The reason you get a double dip is that businesses start getting confident just in the face of what turns out to be a relapse in consumer demand." Seeing consumers falter, businesses cut investment and the economy slumps. If it happened in five of the last seven recessions, who's to say it can't happen in this one?
In the pessimists' view, vigorous consumer spending now is hardly cause for celebration. To the contrary, it may simply rob from future growth. Personal consumption rose at a 6% annual rate in the fourth quarter of 2001, and spending on durable goods rose at an unsustainable 39% rate. The binge was fueled by zero-percent financing on cars and aggressive discounting by retailers, as well as by warm weather that kept people shopping. People moved up purchases they would have spread throughout 2002.
Moreover, both free-spending consumers and businesses are reaching the limit of their ability to carry debt. Srinivas Thiruvadanthai, research director of Jerome Levy Forecasting Center in Mount Kisco, N.Y., points out that at various points last year, delinquency rates reached all-time highs for credit cards, consumer direct auto loans, and government-guaranteed mortgages. Default rates on junk bonds reached 11%, tying the post-Depression high set in 1991. And write-downs of commercial and industrial loans last year were the highest since 1991-92. Debt loads will eventually inhibit consumers from spending and businesses from investing, dampening growth. And low inflation makes debt more onerous, because debts can't be paid off with cheap, inflated dollars.
Overleveraged consumers can't expect much help from the markets. The stock market got so high that even the past two painful years haven't brought price-earnings ratios down to earth. The p-e ratio of the Standard & Poor's 500-stock index is 22 based on projected earnings--and 61 based on last year's earnings. Prices are also high from a historical perspective, according to Minneapolis-based Leuthold Group. It calculates a p-e that averages four years of past earnings and one year of projected earnings, and splits the difference between net and operating profits. Its p-e was 24 at the end of February. That's 19% higher than the median p-e since 1957 for periods in which inflation was 3% or less.
Nor will the housing market continue to bolster consumers. As stocks sagged the last two years, speculation shifted to housing, an unintended consequence of Federal Reserve easing. House prices rose 9% last year despite higher unemployment. Homeowners raised about $80 billion through cash-out refinancings, and spent about $50 billion of it. But that source of money is tapped out unless rates fall even further, which looks unlikely. And the housing bubble could burst if the economy stays weak. That would make it harder for consumers to qualify for new loans. Says James Grant, editor of Grant's Interest Rate Observer, quoting an economic truism: "Asset values are contingent, but debt is forever."
The mildness of the recession is the Achilles' heel of the recovery. A severe recession forces weak companies to liquidate. Their employees and assets are then redeployed more productively. But the recession that began last March was so shallow that many weak companies have clung to life. The problem is worst in sectors that have been buoyed by consumer spending, such as retailing and food. Says Straszheim: "If the heat is not on, it just doesn't get their attention."
The 2001 recession also failed to correct the trade imbalance. Ordinarily the trade deficit shrinks in a recession because imports fall. Not this time. Consumers' demand for imports, fueled by the strong dollar, remained robust. And exports fell because the rest of the world also slumped. As a net debtor to the rest of the world, the U.S. is living beyond its means. So far, foreign investors have been happy to finance U.S. spending. But as the U.S. debt-to-GDP ratio rises, they're bound to get nervous. A slowing of the capital inflow--let alone an outflow--could trigger a severe recession. Says Standard & Poor's Chief Economist David A. Wyss: "You can't continue to borrow $350 billion a year and rising."
Double-dip recession or chilly recovery--which will it be? Maybe neither. But don't say the bears didn't warn you.
Coy is Economics Editor. |
