Why Profits Are Improving, But The Recovery Is Still Sick

Recoveries aren't supposed to hurt. The economy has grown steadily since the second quarter of 1991, but try to convince consumers and businesses. What they will tell you is that a 1.6% annual rate of growth during the past five quarters is painful. Such a woeful pace cannot generate the jobs and incomes that debt-strapped households desperately need, and it squeezes the bottom lines of even well-run companies.

So far, people are coping. The trouble is, Corporate America is surviving at the expense of Household America. Pressure to cut costs to make money in a lethargic economy where pricing power is weak is the reason why jobs and incomes are registering subpar gains (chart). The resulting inability of consumers to supply their usual post-recession punch lies at the core of this historically dolorous recovery.

Clearly, past overleveraging in both the public and private sectorsand the Federal Reserves unwavering efforts to achieve price stability via tight moneyare the fundamental factors that set this recovery apart. But what's becoming equally clear is that unloading the heaviest debt burden in half a century, while tightening the screws on inflation, creates an impossible climate for healthy economic growth.


That much was evident from the Commerce Dept.'s report that real gross domestic product grew at a disappointing 1.4% annual rate last quarter, following a 2.9% pace in the first quarter. The two-quarter gain was the peppiest in three years, but the failure of growth to maintain even its moderate first-quarter gait indicates that the recovery is still struggling.

Commerce also released its annual benchmark revisions to GDP. The new numbers upgrade the severity of the recession, shifting it from one of the mildest to one more in line with the average postwar downturn. More sobering, the data show that the economy has grown at an annual rate of only 0.7% since the end of 1988. Except for the period spanning two recessions in the early 1980s, which included one of the worst postwar slumps, that's the poorest 3 1/2-year performance since the 1930s.

Growth like that will obviously take the starch out of inflationsomething that investors, unlike consumers, are finally beginning to recognize. The GDP fixed-weight price index, the broadest measure of inflation, rose a mere 1.6%, at an annual rate, in the second quarter. That's the smallest quarterly increase in 25 years.

But the really interesting footnote to the second quarter is that, despite weak prices and anemic growth, many corporations managed surprisingly strong earnings gains. Aftertax profits were up some 20% from a year ago, according to Business Week's latest roundup. And Standard & Poor's Corp. reports that dividend payouts are recovering strongly. Through July, they are up 21.3% from a year ago, says S&P.

What this suggests is that businesses are fattening their profit margins by cutting costs, in large part by keeping the growth of wages and payrolls in check. But that's the catch. Because corporate cost-cutting hits consumers right in the wallet, the steady drone of slow growth seems likely to continue in the second half.

Weak income growth explains why real consumer spending, adjusted for inflation, declined last quarter at an annual rate of 0.3%. Personal income was flat in June, and real aftertax earnings fell 0.2%. Real income is down notably from its March level. The three-month drop is the steepest since the recovery hit rough going last summer.

Slow growth seems to be the forecast from the index of leading indicators. It posted a broad 0.2% decline in June (chart). Six of the 11 indicators gave negative readings, especially money growth. The drop was the first since December.

The index of coincident indicators, which plots the economy's current path, looks particularly disheartening. It fell 0.6% in June, and it has risen only twice in the past year. In fact, the index hit a cyclical low point in June. Taken by itself, that's evidence that a recovery isn't even under way.


Mild growth in consumer demand suggests that the industrial sector will continue along its start-and-stall trend in the second half. In general, the headway of good months will outpace the backsliding of bad periods, but this zigzag pattern is another reason why this recovery still feels more like a recession.

July seems to have been one of the good months. The National Association of Purchasing Management's index of business activity rose to 54.2% in July, from Junes 52.8% (chart). New orders, especially for exports, and production led last month's increase. The NAPM also said that inventories were up sharply in July.

Some producers intentionally built up stockpiles in anticipation of their suppliers shutting down for vacation and maintenance. The shutdowns will affect other data as well. For example, the two-week closings at General Motors Corp. will cause a temporary surge in initial claims for unemployment insurance beginning in late July.

For some industries, the inventory buildup may reflect a need to restock empty shelves. The government's report on factory activity, which is much broader than the NAPM survey, shows that shipments surged 2.4% in June, helping to shrink inventories by 0.1%. As a result, the ratio of inventories to sales dropped sharply, from 1.59 in May, to 1.55 in Junethe lowest ratio in 33 years of record-keeping.


Companies' tight rein on inventories is a big reason why output should respond quickly to even a modest pickup in consumer spending. And with the housing rebound showing new signs of life, thanks to an infusion of lower mortgage rates, demand for home-related items will help to revive consumer outlays by late summer.

Sales of single-family homes jumped by 7.9% in June, to an annual rate of 572,000, and May's data were revised sharply higher, to show a sales rate of 530,000, instead of just 501,000. In addition, the latest news on mortgage applications indicates that home buying should continue this strong performance into the fourth quarter.

The Mortgage Bankers Assn. reports that loan applications for home purchase hit an all-time high in the week ended July 24, surpassing the previous record set in January. These applications suggest big gains in the home-sales data for August and September.

Continued healthy demand for homes will be the major prop under the construction industry. The nonresidential sectorplagued by overbuilding in the 1980s and lack of financingcontinues to be a dead weight on the industry (chart). As a result, the recovery in construction remains quite sluggish by historical standards.

Outlays for all construction projects fell 1.5% in June and pushed spending back to its lowest level since February. But the unexpected drop, though unnerving, probably overstated the trouble that builders are in.

That's because government spending on building projectsanother support for buildersfell 5.7% in June. That's the last month of the fiscal year for most states, though, and the decline likely reflected states putting projects on hold until new budgets kicked in on July 1. If so, spending on public works probably bounced back in July.

Private construction spending was virtually flat in June, as a 1.1% rise in homebuilding offset a 0.9% fall in industrial and commercial projects. These divergent trends should continue. The home-buying rebound will clear out some of the supply of unsold houses, unlike the seemingly endless glut of commercial properties.

Low mortgage rates will keep the housing reboundand the economymoving ahead. Low rates also enable households to clean up their balance sheets. However, this recovery will have to generate a lot more jobs than it did in the first half before more consumers start reaching for their wallets instead of a bottle of aspirin.

Before it's here, it's on the Bloomberg Terminal.