For weeks, equity investors had looked at any bit of good news on the economy and sold shares, fearing that positive data would restrain the Federal Reserve from lowering interest rates. Now, after the upbeat Mar. 27 report on consumer confidence, the day's big rally suggests that investors are thinking straight again: That is, good news on the economy is good for future profits.
To be sure, the drop in the Dow Jones industrial average on Mar. 28 shows that market players are still very sensitive to bad news on earnings. However, that sell-off followed a 558-point rise in the Dow from Mar. 22 to Mar. 27. Investors may be realizing that their negative reaction to the size of the Mar. 20 rate cut, part three of the Greenspan Fed's most aggressive easing cycle, was overdone. Tough love by the Fed in not granting a bigger cut may have succeeded in breaking Wall Street's dependency on the Fed.
Despite the uptick in household confidence (chart), investors know that the economy remains fragile enough to warrant further rate cuts, possibly even before the Fed's next meeting on May 15. The plus here is that, if market psychology has indeed turned, further Fed action will be swimming with the market's current instead of against it.
While consumers are still optimistic enough to keep home and car sales at high levels, businesses are under intense pressure to bring inventories, capital spending, and other costs into line with the new reality of slower growth in demand. Indeed, based on the National Association of Business Economics' latest policy survey, an increasing percentage of the nation's business economists think Fed policy is too tight, even after the Mar. 20 rate cut.
GIVEN FED CHAIRMAN Alan Greenspan's past remarks about the growing glut of production capacity, it is clear that the Fed is as concerned about business confidence as it is about consumer confidence--maybe even more so. The Fed knows that a sharp retrenchment by businesses could fall back hard on the consumer sector, hammering household confidence and bringing down the economy.
Measures of business confidence are either unavailable on a timely basis, or they are anecdotal and subject to reporting biases. However, one good proxy for business sentiment, according to some at the Fed, is the monthly tracking of capital-goods orders, excluding commercial aircraft and defense due to their volatility. These data relate to sentiment because they indicate businesses' willingness to make future commitments.
The latest numbers are not encouraging. Bookings for nondefense, nonaircraft capital goods fell 4% in February, erasing all of their January gain. Orders have declined in four of the past five months at an annual rate of 14.7%, similar to the recession experience of 1990-91. That's a negative trend that the Fed will be eager to reverse. Until it turns, the Fed's inclination will be toward lower rates.
Previous cutbacks in capital-goods orders are already hitting economic growth. Outlays for business equipment in the real gross domestic product data fell at an annual rate of 3.5% in the fourth quarter, the first drop since the last recession, and first-quarter outlays may well have declined at a substantially faster rate. Based on data through February, and assuming March shipments are unchanged, first-quarter shipments of private nonaircraft capital goods fell at an annual rate of 13.4% vs. the fourth quarter (chart). In the fourth quarter, this measure fell only at a 2.4% pace.
SPENDING ON BUSINESS EQUIPMENT is hampered by increasingly stingy banks. The Fed's survey of senior loan officers taken in early March showed that "business lending conditions at banks had tightened further since early January, while demand for business loans waned." More than half of the respondents cited "a less favorable economic outlook" as the main reason for tightening their lending standards. Some respondents also commented on "the rapid deterioration in certain investment-grade credits."
These tighter loan standards run counter to the Fed's current desire to loosen up financial conditions in order to keep the expansion going. In fact, the survey was done earlier than usual, showing the Fed's concerns for the economy. Banks are raising the lending bar at the same time that profit shortfalls are cutting into the internally generated cash that businesses had been using to fund their capital budgets. This loss of two important financial sources may be contributing to a downbeat mood in the corner office.
IN AN INTERESTING TWIST, households appear to be shaking off their pessimism just as businesses are getting gloomier. The Conference Board's index of consumer confidence rose in March by eight points, to 117, the first increase in six months. More optimistic expectations for the future drove the index higher, while households' assessment of present conditions was essentially unchanged.
Households were apparently unshaken by the stock market's swoon in March, given that survey responses covered the days through Mar. 21. Possibly they drew faith from the increased certainty of tax cuts, or perhaps from lower interest rates or easing energy costs. For whatever reason, consumers showed increased confidence about the next six months in both the economic outlook and job prospects, said the Board. The job market will remain central to consumer attitudes, however, and any new signs of rising unemployment could darken the mood of households again.
Regardless of how consumers say they feel, what's important is that they clearly remain willing to make future commitments on big-budget items. In particular, housing remains firm (chart). Sales of new single-family homes dipped 2.4% in February, to an annual rate of 911,000, while demand for existing homes edged down by 0.4%, to an annual pace of 5.18 million. However, both levels are higher than their averages for all of 2000.
Also, mortgage applications for purchase, a good leading indicator of home sales, show no sign of any major erosion in demand through March. That squares with the March assessment from builders who noted improvement in both actual and expected sales. And keep in mind that the economy has never fallen into recession without the housing market toppling first.
Earlier in the year, good news about housing had sent jitters through the stock market. But now that investors realize that good means good, a solid outlook for housing indicates that consumer demand for related items will continue to increase this year.
Clearly, neither the stock market nor the economy are out of the woods yet, but healthy consumer demand is key to avoiding a recession. For now, consumers seem to be more upbeat about the future than businesses. And the Fed hopes that optimism is contagious.
By James C. Cooper & Kathleen Madigan