... especially for you J.T. ... <g> ... from Morgan Stanley yesterday ...
April 12, 2002 - Global: Listening to Business, Stephen Roach (New York)
The latest message from Corporate America is unmistakable. Statistical
recovery or not, the business operating environment remains
exceedingly difficult. IBM’s first earnings warning in a decade was one
thing. But now General Electric reports its first quarterly decline in net
income in more than seven years. If these icons of the business
community can’t turn the corner, how can the broader US economy be
expected to do the same?
By now, the earnings carnage of the past year has been well
documented: The nearly 20% plunge in S&P operating earnings in 2001
was the worst performance of the entire post-World War II era. Nor does
the picture look much better when measured in the earnings framework
of the national income accounts. Pre-tax profits for nonfinancial
corporations fell from 10.4% of GDP in 3Q00 to 7.5% a year later in
3Q01. That essentially brought the profits share all the way back to the
previous postwar low of 7.4% hit in 4Q82, in the depths of what is widely
recognized as America’s worst recession of the postwar period. Yes, this
broad proxy for profit margins rebounded to 8.5% in the final period of
2001, leading some to conclude that business earnings are now on the
mend. Let the record show, however, that this latest reading is still a
remarkable 4.3 percentage points below the cyclical peak of 12.8% hit
in 3Q97. What I find most astonishing is that this earnings collapse
occurred in the context of what could have been the shortest and
mildest recession of the post-World War II era. It’s hard to imagine how
businesses would have fared had there actually been a garden-variety
recession!
The hows and whys of this implosion in corporate profitability will long be
debated. There were several unique features of the current climate that
undoubtedly played a role. A lack of pricing power was pivotal, as a
synchronous global recession took a low-inflation economy closer to the
brink of deflation than at any point since the 1930s. The trade
liberalization of globalization was also key in reshaping the competitive
landscape. But, in my mind, the bubble was the crux of the problem.
The combination of Nasdaq and New-Economy hype redefined corporate
culture in America. Managers lost all sense of discipline over cost
control. IT spending went to excess, as did white-collar hiring. US
businesses became scaled for the seemingly open-ended growth path
of the late 1990s. The advent of e-commerce toward the end of the
decade was the icing on the cake. Suddenly, product and service lines
had duplicate distribution channels -- the old way and the "e-way."
Yet beneath the surface, an ominous transformation was occurring. A
new redundancy was creeping into corporate cost structures. That hardly
mattered when the economy was booming. That was especially the case
in America’s vast transactions-intensive services sector -- not just
financial services, but telecom, transportation services, and retailers.
Once quintessential variable-cost producers, service companies became
increasingly encumbered with the fixed costs of a massive IT
infrastructure -- hardware, software, and a huge support staff. All it took
was a modest slowing of top line growth and the squeeze by this new
layer of fixed costs was on with a vengeance. Sadly, the rest is now
history.
The message from IBM and General Electric, I believe, is that this is far
from ancient history. Still encumbered with cost excesses, Corporate
America is drawing little comfort from the statistical recovery of early
2002. Lacking confidence that there will be much in the way of final
demand growth on the other side of the inventory cycle, US businesses
have no choice other than to keep cutting their bloated cost structures.
So far, the bulk of the cuts have come in capital spending budgets,
especially the now dominant IT component. But there’s a limit to what
can be expected on that count. Capital spending has gone from 13.2%
of GDP to 11.6%; based on earlier secular shakeouts, this share could
go as low as 10% -- essentially equaling the drop that has already
occurred. But that will probably not be enough to restore profit margins
to acceptable levels.
That raises the distinct possibility that the onus of cost-cutting may well
have to shift to labor expenses -- by far, the largest chunk of business
operating expenses. With labor compensation accounting for about 50%
of national income in the United States -- more than four times the
share of capital spending -- this is where the rubber usually meets the
road insofar as a restoration of profit margins is concerned. To date,
there has been little progress in pruning such expenses. Labor
compensation remained at 49.9% of national income in 4Q01 -- down
only 0.2 percentage point from the cycle high set in the previous period
but still at a level that was last seen in the early 1970s. Moreover, the
compensation share remains well above the 47% readings that were
reached at the bottom of the last cycle in the early 1990s.
Nor is there any doubt in my mind that there is considerable scope for
cutting excess labor costs. That’s especially the case in America’s
increasingly bloated managerial ranks. Last year -- a recession year --
managerial employment actually surged by 2.9%. That was essentially
triple the increase recorded in 2000. By contrast, the non-managerial
portion of the US workforce declined by 0.5% -- pretty much in line with
what would be expected in an economic downturn (see my 8 March
Forum dispatch, "Unmanageable Bloat"). Nor is there any doubt in my
mind as to where the managerial excess is concentrated: Private
services employed fully 71% of all America’s managers in 2001. If
recent history is a guide, the managerial shakeout could be the last
shoe to fall in this business cycle. Indeed, there was a similar
development in the early 1990s -- a counter-cyclical increase in
managerial hiring during the recession year of 1991 followed by a 1%
decline in 1992. A replay of that same pattern is a distinct possibility in
2002, in my view.
For the broader macro economy, cost-cutting is a classic double-edged
sword. That’s especially the case if the pendulum of cost cutting now
swings from capital (IT) to labor (managers). After all, most workers are
consumers. As a consequence, any slashing of labor costs would most
assuredly take a real toll on consumer purchasing power. A pruning of
bloated managerial ranks could be especially problematic in that regard.
That’s because managers are the highest-paid segment of the US
workforce. US Bureau of Labor Statistics data put hourly compensation
for executive, administrative, and managerial occupations at nearly $41
per hour in 2001; that’s fully 44% above the white-collar average of
about $28 per hour. If I’m right and earnings-constrained Corporate
America now initiates a managerial shakeout, the heretofore-resilient
American consumer could finally have the rug pulled out from under him
or her.
But even if I’m wrong and another wave of cost-cutting is not at hand, I
am hard-pressed to believe that Corporate America is any mood to
loosen its purse-strings. To the extent that earnings constraints remain
an indelible feature of the macro landscape, companies should remain
reluctant to boost capital spending and/or hiring plans. At a minimum,
that will act to constrain the dynamic of any recovery. Moreover, to the
extent that lingering earnings pressures do, indeed, spark another
round of serious cost-cutting, a recovery could even be aborted. That’s
the real message from IBM ($84) and GE ($34). I, for one, think it pays
to listen to that message very carefully.
morganstanley.com |
