Prior to September 11, 2001, businesses were making progress toward adjusting to the new world of diminished expectations and increased risk ushered in by the crash in tech stocks that began in early 2000. Then came something worse: paralyzing uncertainty, first from the terrorist attacks and then from corporate scandals. And this anxiety continues to weigh heavily on the recovery even as summer begins to wind down.
That's because the uncertainty of the past year has fallen disproportionately on businesses, where planning, decision-making, and financing require at least an educated guess about the future. But with little faith in the future, companies have kept the recoveries in capital spending and job growth lackluster. Those key areas must accelerate in order to assure a solid and lasting upturn, and that's why the recovery remains so vulnerable.
The effects of the past year's events can also be seen in monetary policy. After September 11, the Federal Reserve cut interest rates a generous 175 basis points to reassure businesses and the financial markets. But since Corporate America is still rattled, the Fed has not reversed that stimulus.
In fact, some recent weak reports have made policymakers more concerned about slowing business activity. The economy heads toward autumn still firing on only one cylinder: consumer demand, especially for new homes and cars. Consumers continued to lead the recovery with a powerful showing in July. The economy's 3% average growth rate since the third quarter of last year, while respectable, is not enough to convince many companies to buy new computer systems, build warehouses, or beef up their payrolls.
DESPITE RECENT EVIDENCE of steadfast consumers and improving profits, based on the latest Commerce Dept. numbers, businesses and investors still have the willies. Outlays for new capital equipment in July rose, but the trend remains a slow upward crawl. And business construction continues to be dragged down by soaring office and industrial vacancy rates (chart).
Moreover, the nation's purchasing managers said that the sudden slowdown in manufacturing activity in July continued in August. The Institute for Supply Management's purchasing managers' index, a composite of production, orders, and other measures, held at 50.5% in August, the same as in July, when the index plunged from 56.2%. Readings above 50% mean that factory activity is expanding. But the ISM pointed out that at the economy's current growth rate "many manufacturers find themselves anxious about second-half sales."
That anxiety is evident in the forward-looking components of new and unfilled orders. The index for new orders dipped slightly below 50%, indicating that the level of bookings fell for the first time since last November (chart). The unfilled-order index, which dipped below 50% in July, remained down in August, implying the order backlog is shrinking. Those trends could be signaling a coming slowdown in factory production.
That's hardly conducive to new capital spending. Businesses do appear to be lifting their outlays for new equipment. Such spending rose in the second quarter for the first time in a year and a half, and outlays for tech gear and software increased for the second straight quarter.
Still, overall capital spending continues to fall, eroded by a steep slide in new business construction. Inflation-adjusted outlays for offices, industrial plants, and warehouses fell 2.1% in July, on top of the 26% plunge since early 2001. The drop-off so far rivals the construction slump of 1990-91, following the late 1980s savings-and-loan meltdown.
This time, the dot-com bust and widespread white-collar layoffs are causing office vacancy rates to soar, while the jump in industrial vacancies follows the spate of overbuilding in the late 1990s. In the past 18 months, the vacancy rate for offices has nearly doubled in downtown areas, from 6.2% to 12.1%, and in suburban locations from 8.6% to 15.9%. The vacancy rate for industrial space has risen to 11.2%, from 7.6%.
AGAINST THE CURRENT UNCERTAINTY, it will take more than just a fledgling pickup in profits and cash flow to convince businesses to invest in new equipment and to expand their capacity. Nevertheless, profits are clearly headed in the right direction. The Commerce Dept.'s latest earnings data, which is based on thousands of companies large and small using consistent accounting methods, show that corporate operating profits rose 8.7% from a year ago, and earnings for nonfinancial corporations were up 15.2%.
Aftertax profits from domestic operations posted especially strong increases from a year earlier in each of the past three quarters, while net earnings overseas fell. Profits of U.S. operations abroad rose, reflecting the weaker dollar, but foreigners took away even more earnings from their operations here in the U.S.
Corporate cash flow received a kick from the government's new generous write-offs for depreciation enacted in March. Second-quarter net cash flow of nonfinancial corporations increased by 15.1% from a year ago, or by about $95 billion, to $725.1 billion, well above the peak reached in the late 1990s (chart). Companies are amassing sizable war chests to pour into new investments later on, when confidence rebounds and the outlook becomes clearer.
UNTIL CORPORATE SENTIMENT recovers, consumers are ready to keep the recovery moving forward. Inflation-adjusted consumer outlays in July jumped 0.8%, posting their largest increase since the October surge following September 11. As back then, consumers this summer responded to zero-rate financing offers on new autos. But households bought more than just cars. Real purchases of nondurable goods, such as clothing and food, rose 0.5%, and outlays for services, such as movies and medical care, increased a solid 0.3%.
The July spending performance hardly argues for a double dip back into recession. August retail buying has weakened, but even assuming no growth in both August and September, third-quarter consumer spending is on a path to increase at a 4.5%annual rate from the second quarter. That expected gain makes it likely that third-quarter gross domestic product will grow by at least 3%.
Consumers who have jobs are benefiting from tax breaks and low inflation, which have resulted in real aftertax incomes rising 5%in the past year, way faster than the 3% pace of spending. Low interest rates, rising home prices, and record refinancing activity are boosting consumer finances as well.
From here on, any acceleration in household spending will require stronger job markets. Until businesses lose their fear of the future, however, hiring and capital spending--the two things the recovery needs most--will continue to languish.
By James C. Cooper & Kathleen Madigan