The new era of uncertainty and heightened security in the wake of the September 11 attacks and the ongoing anthrax scare continue to dim economic prospects. That's especially true for the bottom line of Corporate America, where the profits recession is sure to be longer and more severe than previously expected.
Profits were already in trouble before September 11. BusinessWeek's own preliminary tally shows that earnings plunged 54% from a year ago with no growth in revenues. Now, companies face a new layer of costs and distribution problems on top of a greater-than-expected drop-off in demand. Profit margins are under the most intense pressure since the 1990-91 recession, says a recent survey by the National Association for Business Economics (chart). Many businesses are warning that profits may not start heading higher until the third quarter of 2002.
A prolonged profits recession will be a significant impediment to the economy's recovery. Companies will not generate the funds needed to increase capital spending. The labor markets will not turn around quickly, creating a risk for the consumer sector. Moreover, the longer the profits slump lasts, the more vulnerable the stock market will be--a danger for both consumer and capital spending. And it won't be only domestic profits that sag. The global recession means that overseas earnings will get hit, too.
CERTAINLY, REVENUES WILL SUFFER because the slump in demand will last longer than expected. The Commerce Dept.'s first look at third-quarter real gross domestic product, on Oct. 31, will show that consumer demand posted little if any growth, while capital spending continued to shrink at a double-digit pace.
Overall domestic demand is set to fall sharply in the fourth quarter. Given the weakness in orders, the drop in capital spending is likely to last well into 2002. While weekly retail reports suggest that consumers are heading back to shopping malls and car lots, they won't be buying with the same gusto of a year ago. That means spending during retailers' crucial holiday season could prove dismal for both sales and profits.
Amid weak demand, most companies can't mark up prices. For the year ended in September, consumer inflation stood at a 10-month low of 2.6%. Goods prices are virtually flat, while service inflation has slowed from its recent high of midyear (chart).
If anything, companies are cutting prices, not raising them. It's the only way to generate business. Vehicle sales are holding up because Detroit is offering generous incentives, likely at the expense of future sales. Hotels and resorts are filling rooms by cutting rates. Deals like that help the inflation outlook, but they are a disaster for profits.
The Federal Reserve took note of the economic effects of the attacks in its Oct. 24 Beige Book. That report contains anecdotal soundings on economic activity from around the nation since September 11. The Fed said, "Business activity recovered quickly from some aspects of the shock,...but longer-run effects are more difficult to assess." In particular, the bank noted retail sales and manufacturing were weakers in early October than they had been in August. Both sectors are more pessimistic about future sales and orders.
GOOD MANAGERS, HOWEVER, have long understood how to deal with sagging demand. A more uncertain part of the profit equation is on the cost side. Prior to September 11, companies were ready to enjoy a pared-down cost structure thanks to lower commodity and energy prices, cheaper borrowing costs, and slower wage growth. Those prospects haven't changed.
What is different is the rash of unexpected expenses companies now face because of the threat of terrorism. The Fed's report also noted that supply disruptions had temporarily affected output in certain industries. Likewise, the NABE survey shows that a significant portion of its members are concerned about how September 11 will affect their companies' daily business activities. Two-thirds of those surveyed expected no disruptions or that they would be short-lived. But a large 37% expected the effects to last until the end of 2001.
The survey was taken before the discovery of anthrax in Washington and Trenton, N.J., which now threatens to disrupt or delay mail service. The NABE survey said the main effects would be costlier security measures, travel disruptions, increased insurance costs, and personnel-related productivity losses.
Safety precautions mean getting goods and people from point A to point B will cost more and take longer. Already, the threat of anthrax is slowing some mail deliveries. Security checkpoints at airports and inspections of trucks crossing borders, bridges, and tunnels also hamper the easy movement of passengers and supplies.
Those delays may impel companies to build up precautionary inventories as a safeguard against distribution disruptions. In the very short run, this could help real GDP growth, since the drawdown of inventories was a large drag on economic growth in the first half. Increased stockpiling in the fourth quarter may help cushion the weakness in output, but carrying those extra goods will add to the cost of doing business.
Finally, extra security and rising insurance premiums will lift expenses further. Of course, businesses shell out money all the time. But what makes these post-September 11 costs different is that they do not generate any additional revenue for the companies incurring them, nor do they have the potential to lift productivity as would, say, a new computer system.
IN ADDITION, CORPORATE AMERICA is unlikely to get any relief from overseas operations. Weak global demand will hurt exports, and a still-strong dollar means that money made by foreign subsidiaries will lose value when translated into dollar figures. The trade-weighted dollar has actually risen a bit since September 11, and it is 2.4% ahead of its year-ago level.
Because of new security precautions, however, foreign trade may wind up being a positive for the economy in the very near term. A sharp narrowing in the August trade deficit suggests that net exports were a big plus for third-quarter real GDP growth. In the fourth quarter, imports may be facing a tougher time entering the U.S. than exports face going out.
However, exports are already falling faster than imports (chart). By early 2002, weaker global growth will hit exports even harder, likely reversing any near-term narrowing in the trade gap, adding further downward pressure to economic growth and profits.
In just six weeks' time, it has become a cliche to say so, but this truly is a new world. U.S. companies are reacting on the fly as best they can, but added costs are clearly a burden on earnings. While dollar losses may pale next to the human tragedy, the severity of the profits recession will play a key role in the strength and shape of the U.S. economic recovery in 2002.
By James C. Cooper & Kathleen Madigan