The business sector led this economy into recession, and it will lead it into a full-fledged recovery. Until recently, though, businesses hadn't gotten much help from overall financial conditions. Faced with a depressed stock market, high borrowing costs, picky banks, and a prohibitively strong dollar, it's no wonder many CEOs have lost faith in the economy's ability to support growth.
But maybe it's time for Corporate America to take a new look at the financial landscape. In recent weeks, stock prices are up broadly. Corporate bond yields are falling, and banks are trying harder to attract business borrowers (charts). Plus, the dollar's depreciation is adding to pricing power at home and to profits abroad. This favorable mix has not been present in three years.
Improving financial conditions have always been a spark for stronger growth. They boost demand, provide working capital to raise production, and supply the means for businesses to expand. Stronger financial supports heighten the chances that improving profits, lower energy prices, strong productivity growth, and exceptionally stimulative policy from the Federal Reserve and Capitol Hill will lead to better economic growth in the second half.
WHAT'S NEW IN RECENT WEEKS is the change in expectations for both Fed policy and profits. Energized by upbeat first-quarter earnings, stock investors now believe that profit growth will improve over the course of 2003. Nearly two-thirds of reporting companies have beat expectations, according to Thomson First Call, and operating earnings for the companies in the Standard & Poor's 500-stock index are on track to rise 12% from the year before. So it's not surprising that the Dow Jones industrial average is up 5.9%, the S&P 500 is up 8.8%, and the tech-oriented NASDAQ is up 13.5% since earnings season began in early April.
But the interesting pattern in this recovery, which is different from past upturns, is that bond yields and the dollar are not following their traditional paths -- much to the economy's benefit. Typically, as the stock market begins to sniff out a recovery that will lead to tighter Federal Reserve policy, the bond market pushes bond prices down and long-term rates higher. Likewise, as stock prices pick up, the dollar has tended to strengthen. This time, over the past two months, yields on Moody's Investors Service (MCO ) BAA-rated corporate bonds, for example, have fallen 45 basis points, from 6.91% to 6.46%, and the dollar has plunged almost 9% vs. the euro.
What's causing this new pattern is changing expectations of Fed policy. There's no direct evidence that the Fed's goal is to push down long rates and the dollar. But its recent policy statement goes a long way toward achieving those results. The Fed has served notice that it is now concerned more about deflation than inflation. That comment has the impact of killing inflation expectations, which are a key component of long-term rates. Plus, the more unattractive bonds yields are in the U.S., the more investors will seek higher returns abroad, thus pushing down the dollar.
The net result is that the bond and currency markets don't expect the Fed to start lifting short-term interest rates until well into 2004, even as the recovery gains strength. That's especially true since the labor markets will be slow to heal amid strong productivity growth.
Because corporate borrowing rates are falling, companies are reliquefying their balance sheets by replacing expensive short-term loans with cheaper long-term debt. Many homeowners are doing the same. With mortgage rates back to record lows in mid-May, mortgage applications to buy a home are back up to a record high, and refi applications are rising again.
THE CREDIT MARKETS AND BANKS are warming up to the corporate sector again. Corporate bond yields are declining relative to riskless Treasury bonds, causing the spread between the two to narrow sharply this year. That means lenders' fear of corporate default is subsiding. Many such risk spreads have narrowed to gaps not seen in two years.
Banks, meanwhile, are more actively seeking out corporate borrowers, based on the Fed's latest survey of senior loan officers. Banks, on balance, continued to tighten their lending terms and conditions on commercial and industrial loans in April, but the net percentage of banks doing so "declined noticeably." Only 9% tightened standards. That's down from 22% in January, and it's the lowest rate since late 1999 (chart).
In addition, the net percentage of banks increasing their spreads between loan rates and their cost of funds fell from 27% in January to 15% in April, also a four-year low. Almost all banks noted that delinquency rates had stabilized because lower rates allowed business borrowers to cut their debt-servicing costs by refinancing loans and restructuring their balance sheets.
THE CURRENCY MARKETS are also adding a dollop of support to the business recovery. The dollar's value has always been a crucial adjunct to monetary policy. That's because an easing of Fed policy taken against a weakening dollar is a lot more potent than the same easing against a strengthening greenback, so the depreciating dollar is now working in tandem with the Fed's desires to lift economic growth and ward off deflation.
The weaker U.S. currency is having a positive impact by boosting pricing power and profits. Net receipts of foreign earnings in the fourth quarter rose 20% from the year before, and in April, prices of nonpetroleum imports were up 0.9% from the previous year. More expensive imports are giving U.S. producers some cover to raise their prices in U.S. markets. Later on, a cheaper dollar will help exports. But a full recovery in foreign sales needs stronger foreign demand, and a global turnaround will take a while, especially with SARS still hurting Asian economies.
Why is the dollar falling, despite the brighter prospects for economic growth in the U.S., compared with either Europe or Japan? Investors are simply seeking out the highest yields, and those are no longer found in the U.S., especially when U.S. rates are put against European yields. Moreover, given that the Fed is a long way from lifting short-term rates, U.S. yields will remain unattractive, implying that the dollar has room to decline further.
Although stock prices, bond yields, and exchange rates offer daily evidence of easier financial conditions, it's almost impossible right now to find concrete clues of improvement in business activity. It's important to keep in mind that better financial conditions lead any improvement in actual demand, production, and employment. After three years of disappointing growth, it's hard to muster more patience with this economy. But the very encouraging financial underpinnings now in place set the stage for a solid second-half pickup.
By James C. Cooper & Kathleen Madigan