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Little Bounce in This Rebound

Economic growth will be a slow 2.4%, but thanks in part to improved corporate earnings, the stock market should climb 13% to 15% in 2002. That's the BusinessWeek forecast, as expressed by Kathleen Madigan, BW's Business Outlook editor.

Madigan says an economy coming out of recession usually grows 5% to 6% -- but not this time. One of the culprits is the overhang in capital-equipment inventories, which will slow manufacturers' rebound. Furthermore, other economies are also slow, which puts a damper on exports. She does note, however, that biotech and other companies related to health care could show vigor.

The jobless rate will stay fairly high, peaking at 6.5%, Madigan says, partly because the productivity gains from high tech will enable companies to postpone adding to payrolls. And consumer spending in the first quarter will be cannibalized by the zero-interest-rate financing that stimulated fourth-quarter 2001 auto sales.

Madigan's remarks were made in a chat presented Dec. 27 by BusinessWeek Online on America Online, in response to questions from the audience and from Jack Dierdorff and Karyn McCormack of BW Online. Edited excerpts from this chat follow. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Kathleen, your yearend forecast article in the Where to Invest in 2002 issue of BusinessWeek is headlined "This Recovery Will Be a Slog." So what can we expect, broadly?

A: We surveyed 59 economists, and, on average, they expect the economy to grow only 2.4% for all of 2002. That's far below the 5% to 6% increase we see coming out of a recession usually.

Q: Can you tell us what indicators we should be looking at? And have we already seen signs of a recovery in certain areas of the economy?

A: Three that we think are very important are: The consumer confidence number, which tells us how consumers are feeling about the economy and their own financial prospects. Second is the employment report, which comes out the first Friday of every month. We're looking for back-to-back increases in the monthly payroll number to indicate to us that a recovery is coming. And then last is nondefense capital-goods orders, excluding aircraft.

Everyone should remember that it was an overhang of capital equipment that caused the economy to slow down in early 2001, so we need to see businesses ordering equipment again as a sign that business is picking up. Also, we know it's a number that the Federal Reserve watches very closely. So if capital-goods orders are still falling, the Fed is likely to continue cutting interest rates.

Q: What do you see for consumer spending -- especially with all the layoffs?

A: The consumer has surprised us by continuing to spend during this recession. But...we're worried that auto makers have induced so many people to buy cars in the fourth quarter through their zero-rate financing that car sales are going to suffer greatly in the first quarter, which will pull down overall consumer spending.

We're worried that in this high-productivity economy, even if output grows at, say, 2.5% in 2002, that won't be strong enough to stop the layoffs from coming. We see the jobless rate continuing to rise until the second half of 2002, peaking at about 6.5%.

Q: What do you see for interest rates? Someone in the audience wants to know where to put money from a CD that matured -- and considers CD rates too low now. Will Greenspan be any help to him?

A: [Rates are] likely to go even lower. We think the Federal Reserve will cut interest rates by a quarter point, probably at their January meeting. That will cause banks to lower what they pay on CDs. The analysts we talk to think the stock market is poised for a good year in 2002, with average gains of 13% to 15%. Another safer option might be the Treasury market.

Q: Did any economist make a correct forecast for this disappointing year?

A: No. None of the economists we surveyed in December, 2000, forecast a recession in 2001. The closest was James Paulsen of Wells Capital Management, who had the lowest forecast of real GDP of 1.7%. The actual growth has been almost flat -- about 0.6%.

Q: In your poll of 59 economists on their 2002 outlook, was there a wide range of opinion?

A: Well, the most optimistic expect the economy to grow nearly 4% in 2002. The most pessimistic expect the recession to last until the third quarter of 2002 and for real GDP to not grow at all for the year.

Q: Are we seeing any signs of a pickup in capital spending? It seems the tech sector is rallying on hopes of a recovery in spending.

A: Yes, certainly the stock prices of tech companies are rallying, but we haven't seen any concrete signs that demand for computers or semiconductors or telecom equipment is turning around. The only good sign we see is that tech-equipment makers have done a stellar job of drawing down their inventories, but those inventories are still excessive compared to how bad their sales are.

Q: Is there any hope for other countries to order U.S. goods and help our exports?

A: Probably the best hope is in the emerging markets -- say, Southeast Asia or Latin America. Japan shows no signs of coming out of another awful recession. Europe is following us into recession and is probably in one already. That leaves the smaller economies as a source of export growth for the U.S. The problem is that the U.S. dollar is so strong -- something that typically doesn't happen during a recession -- so our exports are too expensive for many countries to buy.

Q: Will the euro make any difference in our trade with Europe?

A: We think a bigger question is how the European Central Bank will conduct monetary policy. The ECB has been very reluctant to cut interest rates, even as the euro zone falls into recession. And until they begin to cut rates, growth in Europe isn't going to turn around.

Q: How big was the impact of September 11 on the way 2001 turned out -- and how much of that will spill over into 2002?

A: We feel that the economy would never have officially fallen into recession if the attacks of September 11 hadn't caused consumers to stop spending in September. That caused inventories to pile up for September and October, and we will see those spillover effects into the first quarter.

Q: Do you think the $300 tax rebate had any significant role in keeping consumers buying?

A: The studies done by the Fed say no. Most consumers saved the money or used it to pay off existing debts. Only about 18% of the money was actually spent. That, at least, was the case in October. We're not quite sure yet if households used the rebate to buy Christmas presents, and we may not know that until the consumer spending data come out in January.

An important point to bear in mind, though, is that if households used the money to pay down existing debts, that helps to repair their balance sheets so that they feel better about their financial condition -- and if they feel their finances are in better order, they're more likely to increase their spending from their current paychecks.

Q: Regarding energy, OPEC is likely to cut output for six months. Will that help the economy and markets? And how?

A: Generally, no. A cut in production would mean increased prices for oil. However, with demand so weak around the world, we're not so sure a cut in production is going to boost oil prices. I think OPEC is just trying to stabilize oil prices and prevent them from falling further. The recent drop in energy prices has been a boon to consumers because it has lowered the cost of gasoline, and it should lower the cost of heating oil as we enter the winter.

Q: Do you see any area where there might be dramatic growth? Or should we expect slow growth at best in most of the economy?

A: One area that people point to is health care, which includes biotechnology. There have been lots of advances, and there's a great demand for increased health care now that Americans are getting older, so there's a very ready market for new products that should come on stream this year. The big question is which companies have the resources to develop successful drugs or medical procedures. That's why the medical industry as a whole should do well in the stock market, but those gains may only accrue to a few medical companies.

Another possiblity is real estate investment trusts (REITs). REITs that specialize in business real estate should do well because when the economy recovers, they'll be able to attract more tenants for any vacant space, and they'll be able to charge higher rents.

Q: Stock prices often move with corporate earnings. What are the profit prospects in 2002?

A: We think profits will probably grow in the single digits, helped by lower labor costs and higher productivity. But...remember that one thing that will make profit growth look good in 2002 is that it's being compared to the really disastrous numbers of 2001.... However, in general, companies have done a really good job at holding down costs, and so when demand picks up, most of that increased revenue should go straight to the bottom line.

Q: What are the economic trouble spots abroad to watch for? Are Argentina and/or Japan a big threat to our recovery?

A: Actually, although Japan is the second-largest economy, Argentina is the bigger risk, not just because of what may happen inside Argentina, but because its problems may drag down the rest of Latin America. We saw the same thing happen in '97 and '98 when Thailand got in trouble and caused financial problems throughout Southeast Asia, which then went over the Pacific Ocean and hurt Latin America as well.

Q: Do you think the high-tech improvements in productivity will slow down the revival of employment?

A: Yes, definitely so. Because companies will be able to increase their output by using productivity in 2002, we don't see any real pickup in employment until the second half. The recovery is going to be very slow, with demand only rising 2% to 2.5%, and in this new economy, productivity is rising 2% to 2.5%. That means you don't need any extra labor to produce more goods or services. The U.S. economy has to grow above 3% before we see a significant increase in jobs next year. And we don't see us getting to 3% until late in 2002.

Q: Time for a summing up -- refresh us on the key points of BW's forecast for the economy in 2002.

A: The recession will end in the first quarter. But the recovery will be very mild -- real GDP will grow 2.4% in 2002, inflation will be extremely low, but the stock market will probably see a gain of between 13% and 15%.

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