Postwar Euphoria Will Help But It May Not Be Enough

If you want to know why American consumers and businesses are in such a funk these days, don't look toward the Mideast. Look at consumer incomes and corporate profits here in the U. S. The sad state of both may be saying volumes about the outlook. If consumers don't have the cash to put down on a new car, or if a business can't afford that new piece of machinery, then you can kiss off the economy's peace rebound.

Pocketbook issues have been the driving force in all previous recessions and recoveries. Now that peace in the gulf is finally a tangible commodity, these fundamentals will quickly resume their proper place in the analysis of this downturn.

On that front, consider the following: Consumer income--at least what's left after inflation and taxes--is well on its way toward a third consecutive quarterly decline. And not only did corporate profits fall in the fourth quarter of last year but also business' efficiency at generating earnings continued to deteriorate, signaled by further erosion of profit margins.

The recession will keep the squeeze on corporate earnings in the first half of 1991, and until the labor market begins to firm up, consumers can expect little in the way of income gains. Those are poor underpinnings for consumer and capital spending, which generate more than three-fourths of the economy's overall demand.


Consumers are heading into spring with little more than faith--and not much of it--that things will get better. Consumer confidence rose slightly in February but hardly enough to signal a shift toward optimism (chart). The Conference Board's index gained 2.6 points to 57.7, but it had dropped sharply in January to a 10-year low.

The index is likely to rise further in March, since the gulf war played a big role in the January decline, but there are issues other than war and higher fuel bills. The Conference Board said that consumers continued to express considerable concern about jobs. More than a third of those surveyed complained that jobs were "hard to get." That figure has risen steadily during the past year.

Worry over jobs and incomes is an important reason why car buying remains so weak. Sales of domestically made automobiles in mid-February came in at an annual rate of only 6 million, little changed from 6.2 million early in the month and from 5.9 million during January.Moreover, the recent drop in energy prices will provide only a small boost to purchasing power, because the surge in energy prices last year did less damage to incomes after taxes and inflation than one might think. BUSINESS WEEK calculates that higher prices for gasoline and fuels accounted for slightly less than a third of the drop in real disposable income since last July. Higher taxes, inflation for other goods and services, and the recession caused the rest of the deterioration.

That suggests that a decline in energy prices back to their prewar levels of July, 1990, taken by itself, would give real income a boost of about 2.3 percentage points, measured at an annual rate from December to June. But offsetting that modest gain will be the erosion of real income by higher taxes, stubborn nonenergy inflation, and the slowdown in overall income growth because of layoffs and smaller pay gains.

In the 44-year history of the data, real aftertax income has never declined for three consecutive quarters. But after losses in the third and fourth quarters, such an event seems likely, given the poor showing of incomes in January. Happening when consumers are heavily in debt and savings are unusually low, that would virtually preclude a consumer-led economic rebound this spring.


Corporate America's bottom line doesn't look any better. The Commerce Dept.'s revisions to fourth-quarter gross national product showed a 2% drop in real GNP, barely changed from the first reported decline of 2.1%. The numbers suggest that operating profits fell below their year-ago levels for the eighth consecutive quarter.

Based on BUSINESS WEEK estimates from Commerce's data, book profits fell 1% from the third quarter to the fourth quarter, to an annual rate of $315 billion. Washington will release its profits report on Mar. 27. Last quarter's earnings would have been lower had it not been for price-related gains in inventory profits racked up by the oil companies. After adjusting for inventories and depreciation allowances, operating profits appear to have dropped an even steeper 3%, to $291 billion.

Shrinking profits are bad enough, but deteriorating margins are compounding the problem (chart). Profits of nonfinancial businesses on each unit of output fell last quarter to an estimated 7%, the lowest margin in nearly seven years. The drop reflects not only weakening prices and volume but rising costs as well.

In particular, unit labor costs in many service industries are rising faster than prices. That could mean further layoffs in services in coming months as companies try to cope--and more downward pressure on incomes.

The story in manufacturing is a little different. Although the recession has hammered factory profits, manufacturing companies have maintained healthy margins. They have been trimming payrolls for two years in an effort to cut labor costs. So despite the lack of pricing power for goods generally, unit labor costs are growing slower than prices. When the recovery finally does get under way, factories are poised to reap better earnings.


The slump in profits is cutting into corporate cash flow at a time when banks are increasingly unwilling to make loans. The lack of funds is a big reason why capital spending won't pull this economy out of the recession.

Business capital budgets are expected to rise by 2.4% in 1991--or almost no gain after price adjustments. And most of the increase was planned for this quarter. Second-half spending was slated to fall.

Those plans may end up even more downbeat. Consumer demand remains weak, and an increasing amount of existing capacity stands idle. So, companies have little reason to invest in new plants and equipment right now. Plus, some businesses undoubtedly delayed new projects amid the economic uncertainty surrounding the war.

That means capital spending is likely to be weaker than expected this quarter, but the downward trend in durable-goods manufacturing suggests that any rebound will be slight. New orders for durable goods fell by 0.7% in January, to $118.5 billion--the fourth decline in six months. Orders since November are running 7% below the average of the previous three months.

Bookings for nondefense capital goods--a signal of future plant and equipment spending--plunged 8.4% in January. And shipments of nondefense capital goods--an indicator of current capital outlays--are also lackluster. They fell 0.8% in January, and began the first quarter at an annual rate of 3.2% below their fourth-quarter average, before price adjustments. That suggests that equipment investment could decline this quarter.

The sag in new demand is cutting the backlog of orders. Unfilled orders slipped by 0.1% in January, despite a gain in aircraft. In fact, transportation equipment has kept the backlog above its year-ago levels. But excluding those industries, unfilled orders have been drifting lower since 1989 (chart). Without a pickup in demand, manufacturers will continue to cut output and jobs.

The weakness in hardgoods dims the outlook for equipment spending. And the other part of capital investment, construction, is in serious trouble. The glut in office and retail space and falling operating rates for factories mean that companies have little interest in new buildings.

Contracts for new construction fell 0.8% in January, according to F. W. Dodge Group, a unit of McGraw-Hill Inc. Public works advanced by 17%, but private spending was weak. Homebuilding sank by 7%, and nonresidential building was off by 1%. February and March are unlikely to bring better news on the construction front. The building sector will remain one of the most intractable drags on this economy.

With the fundamentals of consumer and capital spending so downbeat, peace in the gulf seems unlikely to provide anything more than a fleeting fillip for a sagging economy. In fact, it will probably refocus attention on just how bad the economy's problems really are.

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