The Recovery Is Proceeding By Fits And Starts

The shape of nearly all past recoveries has been tied to the strength of the rebound in the goods-producing sector. As manufacturing and construction go, so goes the upturn. By that rule of thumb, this recovery will not pack the usual punch. However, after three years of recession and stagnation, the economy does appear to be moving to a higher plane of growth that consumers and businesses can finally feel.

Goods producers will not supply the same thrust as in most previous upturns because heavy debt burdens and high long-term interest rates will weigh on the demand for credit-sensitive items, such as cars and homes. Also, the rebound in income growth will not match that of past recoveries because of widespread corporate restructuring aimed at cutting costs and boosting productivity.

The latest data show that manufacturers and builders are looking at better times, but they also point to problems. Despite rising factory orders and lean inventories, the nation's purchasing managers say that industrial activity slowed in April (chart). Sales of domestically made cars picked up a bit in late April, but sales for the month held at the March annual rate of 6 million. Moreover, the rebound in construction is not as broad as it usually has been in past recoveries.

The spotty nature of the recovery shows up in the Federal Reserve Board's latest survey of business conditions. The May 6 report says that economic activity increased further since the March report, but that "conditions remain uneven across regions and sectors."

The government's index of leading indicators, its main forecasting gauge, also suggests a subpar recovery. The index rose only 0.2% in March, following gains of 0.8% in February and 1% in January. But in the early months of past recoveries, the leading index has averaged monthly increases of more than 1.5%, with advances often exceeding 2%. The index appears to be capturing some of the special forces that are restraining the current upturn.


To be sure, the recovery appears to be proceeding along traditional lines. A combination of strong sales and weak output last quarter left business inventories exceptionally lean heading into the second quarter. Replenishing those stockpiles will lift production and employment this quarter.

That pattern shows up in the recent manufacturing data. Factory orders for durable and nondurable goods rose 1.6% in March, the largest increase in five months. The monthly advance was also the third in a row, something that hasn't happened in nearly four years. Producers of both durable and nondurable goods posted healthy gains, although a big jump in bookings for new aircraft accounted for nearly half of the overall rise.

The recent rise in orders and shipments caught many manufacturers just at the time when they were cutting output in an effort to eliminate the excessive inventories that had built up at the end of 1991. As a result, factory stockpiles are extremely low relative to demand as manufacturers head into the second quarter.

The ratio of inventories to shipments fell sharply in both February and March (chart). In fact, the March reading was the lowest in 13 years, and the ratio for durable goods was the lowest on record. The data go back to 1958. A ratio that low suggests that inventories and shipments are out of balance and that manufacturers will have to lift output in order to meet demand.

However, not all signals are flashing green in manufacturing. Orders are still coming in slower than goods are being shipped out. That means the backlog of unfilled orders is declining. It fell 0.6% in March, the seventh consecutive drop. That shrinkage does not reassure manufacturers that there will be enough business in the pipeline this summer to justify big additions to output--or costly additions to payrolls.

That could explain why the National Association of Purchasing Management reported that the manufacturing recovery slowed down in April. The NAPM's index of industrial activity fell to 51.3% last month from 54.1% in March. Still, a reading above 50% indicates that the factory sector is expanding, but at a slower rate in April.


The second largest segment of the goods side of the economy, the construction industry, continues to climb out of its own slump. But as in the factory sector, the recovery is uneven. Homebuilding has been sailing along for a little more than a year, while commercial and office construction remains under water.

Total outlays for building projects increased by 1.6% in March, with large advances in government projects and residential construction. For the first quarter, spending grew at a healthy 9.7% annual rate after adjusting for inflation. And the F. W. Dodge Div. of McGraw-Hill Inc. reports that new contracts for all construction rose at a strong 28.7% annual rate last quarter.

These impressive gains, however, mask the problems in commercial building. Nonresidential construction has fallen 15.1% from its pace of a year ago--which was 14.3% below spending of March, 1990 (chart). And the Dodge survey shows that contracts for such building projects dropped by 8.9% in the first quarter.

Commercial real estate clearly is not contributing to the overall economy's recovery as it has in past upturns. The overbuilding of the 1980s and the reluctance of banks to make real estate loans have hampered industrial and office projects.

More important, demand just isn't there. White-collar layoffs have added to the glut of available office space. Until payrolls expand again, businesses are unlikely to need more space. So, too, the troubles in retailing have reduced demand for new stores. And low operating rates in the factory sector suggest that manufacturers will not need to increase their capacity by much this year.


Housing is a totally different story. Homebuilding climbed 1.8% in March, the eighth gain in 11 months. Spurred on by the drop in mortgage rates since mid-1990, spending on residential construction is up by 13.9% from a year ago.

All of the gain has been in single-family homes, which account for 90% of new-home construction. The oversupply of apartments in many regions will keep multiunit construction from staging much of a recovery this year.

How long will homebuilding's momentum last? One key factor will be mortgage rates. The average rate on a 30-year fixed mortgage stood at 8.92% for the week ended May 1. And with short-term rates at 20-year lows, adjustable-rate mortgages are extremely attractive. One-year adjustables averaged 6% on May 1. Mortgage rates are low enough to keep the housing recovery going. That means that the upturn in consumer spending on home-related goods will also continue.

But mortgage rates alone cannot sustain the housing rebound. Since rates seem unlikely to fall much further, faster growth in jobs and incomes must now provide the financial foundation for further gains. Already, mortgage applications for home purchase have dropped some 30% since early February, partly reflecting the leveling off of rates.

One new problem: A spike in lumber prices is eroding affordability. The cost of lumber jumped by 50% from December to March because of increased demand, import restrictions, and environmental concerns (chart). Prices have come down a bit since then, but the National Association of Home Builders calculates that the higher cost of wood will add $2,000 to $3,000 to the $120,000 median price of a new home.

The increase in construction costs, although worrisome for some buyers, isn't large enough to derail the housing recovery. That's important because a continued upturn in homebuilding is crucial to getting the economy moving. And no recovery has ever gotten off the ground without a rebound in manufacturing. Since there aren't a lot of players in this upturn just yet, the economy cannot afford to lose two of its star performers.

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