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Shadows over the West

By Michael Wallace Investors, by shifting assets into stocks and out of long-dated bonds in April, appear to be pricing in an expected growth recovery for the U.S. economy by the September quarter. But judging from a regional report from the San Francisco Fed and recent economic data, for California and the West, the worst may be yet to come.

The San Francisco Fed's latest quarterly "Western Economic Developments" report for the first time reflected the full extent of the tech economy's crash into a bricks and mortar wall in the first quarter, painting a much more gruesome picture than before. Surveys of consumer confidence for the Pacific region showed a sharp drop in the expectations sub-index in February to the lowest levels since the recession in 1993.

The stock market plunge, dot-com implosion, job reductions, energy and regional hikes in consumer prices and the U.S. slowdown all took a toll on sentiment. Retail sales slowed sharply, especially big-ticket goods such as autos, and housing activity has slowed markedly.

NOT-SO-GOLDEN STATE. And California's budget is getting squeezed, via a dramatic fall in stock option and capital gains receipts (20% of revenue) and sizable outflows for overpriced electricity. Indeed, S&P's downgrade of the state's general obligation debt rating and maintenance of "credit watch" status will make its $10-14 bln energy bond issue more expensive.

At a national level, March durable goods orders ominously fell 1.8% ex-transportation, led by weakness in electrical equipment. New orders for electronic equipment collapsed from over an 25% peak in mid-2000 to near zero in January 2001. Semiconductor sales have followed, tumbling from near 50% growth globally to 15% over the same period. Semiconductor Industry Association reported global declines of 6.9% in February from January and a more worrisome 15.3% plunge on a 3-month moving average, due to an "inventory overhang and macroeconomic factors."

The San Francisco Fed noted particular weakness in internet infrastructure and communications equipment, which president Parry warned "may mean weakness in business spending for some time," a message he likely delivered to Greenspan.

FED ALERT. No coincidence then, that the centerpiece of the Fed's Apr. 18 statement read: "capital investment has continued to soften and the persistent erosion in current and expected profitability, in combination with rising uncertainty about the business outlook, seems poised to dampen capital spending going forward."

In combination with the reduction in equity wealth possibly affecting consumption and slowing global growth, the Fed deemed this a threat to keep the economy "unacceptably weak." This suggests another 50 to 100 basis points of easing is in the pipeline, pending a return of stability to the economy as a whole.

With more power and fuel price hikes and blackouts as sure as summer sunshine, Western business and consumer sentiment will likely decline further. This will negatively reinforce regional capital spending trends, earnings, consumer spending and housing. Fed "vigilance" will be needed to keep California's 12% share of U.S. GDP from dragging down the other 88%. Wallace is an economist for Standard & Poor's Global Markets

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