Consumers May Be Tightfisted, But Business Isn't

In past expansions, business spending was usually the economy's wallflower. Not this time. Outlays for new plants and equipment have been the life of the party. And with increasingly wary consumers likely to lift their spending only modestly, a strong capital-goods sector is a big reason why the second-quarter slowdown won't turn into a second-half rout.

The contribution of business spending to the economy is striking. Since the end of the recession in 1991, equipment outlays, just 11% of the economy, have accounted for a hefty 36.4% of the growth in real gross domestic product. And over the past year, outlays for business construction are up 11.6%. This capital-spending boom is the strongest of all postwar expansions.

By comparison, consumer outlays, even with last year's buying binge, have risen at their weakest pace. Consumers get most of the attention, though, because their spending drives two-thirds of the economy's output. And after all, discussing trends on cars and housing is a lot sexier than analyzing outlays for machine tools and computer peripherals.

THIS ROLE REVERSAL isn't hard to figure. With high-tech prices falling, capital is becoming increasingly cheap relative to labor. As businesses invest in more efficient machinery, they need fewer workers. Greater productivity generates healthier profits and allows businesses to buy even more equipment. That's why factory orders for durable goods remain at a high level.

In turn, though, the fortunes of Household America have paled beside those of Corporate America. Slack labor demand has held down wage growth, and thus consumer spending. The buying spurts of 1993 and 1994 had their roots in the wave of refinancings and greater use of credit, rather than in fat pay raises.

That's why the Federal Reserve's interest-rate hikes have hit consumers hard this year. And now, this consumer-led weakness has forced businesses to adjust their inventories, causing cutbacks in output and employment. Not surprisingly, consumer confidence wilted in June, but households, while down, are not out. The May gain in existing home sales and weekly reports on June retailing suggest that less optimism isn't killing spending.

Even amid consumer weakness, the increased spending by businesses will limit the production losses in manufacturing. Factory orders for big-ticket durable goods that are built to last three years or more managed to rebound 2.5% in May, after declines in March and April. The gain was widespread, but the 6.8% jump in nondefense capital goods emphasizes companies' commitment to productivity. Even excluding aircraft, whose hefty price tags can swing the data sharply, capital-goods demand rose 4.1%.

To be sure, capital spending will slow from last year's booming pace. But so far in the second quarter, shipments of capital goods are running 8.3% at an annual rate, above their first-quarter average, which was 22.8% above the fourth quarter. Although slower than in the winter, the spring increase suggests that equipment investment added to GDP growth last quarter, and further gains are likely.

That's because the backlog of unfilled capital-goods orders so far in the second quarter is also rising, for the third straight quarter. That means makers of business machinery, especially computer-related equipment, will continue to lift production in the second half.

FOR THE OVERALL ECONOMY, increased business spending has many implications. For one thing, a productivity jump at companies means that corporate profits may not slow that much, even if the economy overall grows at a modest 2%-to-3% pace in coming quarters. For another, U.S. companies are more competitive globally. That will help boost exports, the other sector expected to keep the economy dancing into 1996.

In fact, U.S. manufacturers are benefiting from the global efficiency push. Orders for U.S.-made machine tools rose 5% in May, or 20% above their year-ago pace. The big gain was in export demand, which has skyrocketed. In May, foreign orders jumped 81% from April. And so far in 1995, foreign orders have more than tripled from their 1994 pace.

The productivity crusade also means that inflation will continue to be well behaved in this upturn. The downside, of course, is that wage growth will stay anemic. And hiring, especially among goods producers, will be sluggish, with layoffs still making headlines.

LABOR-MARKET LETHARGY was surely a factor in the large drop in consumer confidence in June. The Conference Board's index fell to 92.8 from 102 in May, the largest decline in three years. Eight of the nine regions reported lower readings. But while the Board noted that the size of the drop was "disconcerting," it also said that confidence remains at a level historically associated with a strong economy. Indeed, the June reading is still above the average for all of 1994, when consumer spending was quite strong.

There is no evidence yet that the drop in confidence is translating into a retrenchment in spending. On the contrary, retail sales through the first four weeks in June rose a solid 1.5% from May, says the Johnson Redbook Report retailer survey. And May sales of existing homes rose a hefty 4.7%, to an annual rate of 3.55 million. All regions except the Northeast posted gains.

As has been true throughout this expansion, consumer confidence has proved to be more of a lagging indicator of households' reaction to newspaper headlines and less of a leading indicator of future spending.

The split between consumer and business spending is why the current problem with excess inventories is greater among consumer-related industries. The ratio of inventories to sales for capital-goods manufacturers, for instance, has been trending lower throughout this expansion, and in April stood near its record low. That's why the manufacturing inventory-sales ratio overall looks so slim.

Makers of consumer durables, however, saw their inventory-sales ratio touch bottom in May, 1994, and the ratio has been trending higher ever since. So, too, retailers have seen their merchandise stocks grow out of line with their sales. Hardest hit have been apparel stores, where the inventory-sales ratio has jumped to its highest reading in 10 years.

The rebound in existing home sales and the improvement in June retail buying suggest that the stockpile of consumer goods will become more manageable in coming months. That should help industrial output to recover in the second half.

Unquestionably, consumers have long been the main focus in the outlook. And given their size in the economy, consumers will not go unnoticed in the second half. But the expansion's tune of rising productivity and cheap capital is a bit different now, and the usually overlooked business-spending sector will enjoy more of the limelight this time around.

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