Industry Outlook

Strong productivity, willing consumers, and low inflation may again confound the doomsayers

The biggest question for industry in 1999 is a simple one: Can the U.S. economy beat the forecasts for a fourth year in a row? Going into 1996, 1997, and 1998, most economic forecasters expected modest growth of 2% or so. Each year, however, the actual number turned out to be much higher--hitting 3.5% or more.

In 1999, according to virtually every economic forecaster, the good news will definitely be coming to an end. The consensus once again is drab, calling for only 1.9% growth from the fourth quarter of 1998 to the fourth quarter of 1999. The reason, the forecasters say, is a combination of profound weakness overseas and a slowdown in capital spending at home. Americans will not be able to keep up the free-spending ways that helped power the economy in 1998. "The consumer is tapped out," says David Wyss, chief economist of Standard & Poor's DRI, who sees 1.8% growth over the next year. "It's difficult to understand how people can spend this much again."

If Wyss and the other forecasters are right, 1999 will be a year of weak profits and weak revenue growth across the broad spectrum of U.S. industries. Nobody will escape, and some sectors of the economy, such as steel and commodities, could be punished badly. Slow growth abroad will put the clamp on exports. Makers of construction equipment and other capital goods will have to retrench. And consumer-goods companies will face a more reluctant buying public.

Indeed, the latest BUSINESS WEEK/Harris poll of top executives at large companies shows a rising tide of worry about 1999. As of December, 27% of the polled executives were somewhat pessimistic about the coming year, while only 4% felt that way going into 1998. Roughly 35% of the executives expect to reduce, over the next year, the number of full-time workers they employ. And 22% expect to decrease their capital spending in 1999--a move that could help dampen growth.

But while the economy may not be able to duplicate the 3.5%-plus growth of recent years, the projections of a sharp 1999 slowdown should be taken with a grain of salt. Inflation has dropped to levels not seen since the 1960s, even in the service sector, suggesting that the economy has more room to grow without overheating. Productivity growth is still strong as companies intently focus on cutting costs and boosting profits. And perhaps most important, consumer spending--powered by rising wages and slow inflation--may turn out to be stronger than the forecasters expect.

"In the U.S., we still believe it's going to be a pretty good year," says Robert J. Eaton, co-chairman and CEO of DaimlerChrysler. "There isn't any reason that can't continue. I'm not saying it will--but there isn't any reason it can't."

"OFF THE CLIFF." Indeed, there is little evidence now that Americans are outspending their means. "It's the perpetual forecast, that the consumer will drop off the cliff," observes Rosanne M. Cahn, chief economist of the equities division at Credit Suisse First Boston. Cahn is predicting that the economy will grow by 3.4% in 1999. "I can't see why the consumer will punk out."

To be sure, there is certainly good reason to be cautious about 1999. For one thing, a repeat of last fall's global financial panic could occur, with Russia continuing to slide downhill and Brazil struggling to stay afloat. Many countries in East Asia, including Japan, still have fragile financial systems that could crash and burn. Weak corporate earnings could trigger a serious plunge in the U.S. stock market, halting consumer spending in its tracks. And a long trial of President Clinton in the Senate--if the Senate fails to reach a compromise ending the matter quickly--could create major uncertainty for investors and companies. All told, it's easy to construct a scenario in which the U.S. economy falls into recession in 1999.

Yet it's also easy to imagine how growth could come in stronger than the forecasters expect. Consider this: Over the past half-century, the main constraint on growth has been rising prices. Typically, too much growth would cause the economy to overheat, igniting inflation and leading the Federal Reserve to raise interest rates.

This time around, price increases have remained under control, despite the strong growth and the low unemployment rate. The core inflation rate is running at 2.4%, up only a bit over the past year. More important, the inflation rate in the service sector has actually been falling. Prices for consumer services have risen by only 2.5% over the past year, down from 2.8% the previous year, and the slowest rate since 1965. With inflation far lower than expected, there is no reason for the Fed to rein in economic growth. In addition, low inflation will help keep interest rates down, giving home sales and mortgage refinancings a boost.

The consensus economic forecast also assumes a sharp slowdown in productivity growth, from 2% in 1998 to only 1% or so in 1999--close to the trend of the 1980s. But that may be excessively pessimistic, since the near-record number of job-cut announcements in 1998 suggests that companies are doing everything they can to reduce costs and boost output per worker. Through November, U.S. companies had announced plans to cut 575,000 workers, about 50% ahead of the 1997 rate and close to the 1993 record pace.

BULLISH RETAILERS. The ongoing merger explosion is pushing companies to find new efficiencies. Aetna Inc. expects its acquisition of Prudential HealthCare to save $130 million to $150 million per year after taxes. The Exxon-Mobil merger will lead to the elimination of 9,000 jobs, while on Dec. 11, MCI WorldCom announced plans to cut 2,000 positions in the U.S. "This is what business has to do to preserve profit margins," says Cahn.

At the same time, many industries are continuing to spend heavily to boost productivity and expand their markets. Railroads are expected to continue their heavy capital investments, which independent analyst Anthony B. Hatch figures will increase to more than $7 billion in 1999 from about $6.5 billion in 1998. Says Craig F. Rockey, senior assistant vice-pResident at the Association of American Railroads: "The onlY way the railroads are going to hold their huge productivity gains is to continue to keep the investment flowing into the in-ground and above-ground assets".

Certain retailers are also bullish. Wal-Mart Stores Inc. has aggressive growth and capital-spending plans this year. Capital expenditures are expected to approach $5 billion, the company's highest ever. As part of its growth plan, Wal-Mart will open about 150 supercenters, selling food and general merchandise, and 80 new stores abroad. "We're going to be very aggressive with our international growth," says David D. Glass, CEO of Wal-Mart.

At home, Americans could still keep spending in 1999--not necessarily at the same powerful rate of growth as in 1998, but faster than the consensus forecast predicts. Adds David R. Goode, CEO of Norfolk Southern Corp., which acquired part of Conrail Inc. and will be merging the two systems in the first quarter of '99: "We're seeing mixed signals in the economy, but there are some indications that the consumer economy is still strong."

Where will the consumer strength this year come from? One source could be wages, which, adjusted for inflation, have been rising at an annual rate of 2.5%, the fastest rate in a generation. As long as corporate productivity continues to rise and unemployment stays low, such wage gains will continue to drive spending.

Plus, there is simply no evidence that consumers are overdrawn, despite the spending surge in 1998. Over the past year, total wage and salary payments, before adjusting for inflation, have risen by 6.7%, outpacing the 5.5% increase in consumer spending. By contrast, in the 1980s, consumers were left strapped as their spending growth exceeded the gains in wage income. And consumer installment debt totals just under 18% of income, about the same level as a year earlier.

"A HORRIBLE MARKET." True, the personal savings rate in the third quarter was close to zero. But that omits capital gains and the benefits of refinancing, both of which were important for improving the financial position of households in 1998. And the Commerce Dept. typically revises income and the savings rate in an upward direction as new data come in. "Every time we do the forecast, we think people don't have the money to spend, and they do," admits DRI's Wyss.

If consumer spending is going to stagnate, that shift is not yet showing up in auto production. Despite forecasts of flat auto sales in 1999, General Motors Corp. is planning to boost first-quarter production of cars and light trucks by 7% compared with a year earlier, while Ford Motor Corp. is planning a 12% increase.

Of course, even a stronger-than-expected economy won't help everyone. With a global economy that is likely to still be weak, 1999 will continue to be tough for some industries. According to forecasts by DRI, the world economy outside of the U.S. will grow by only 0.8% in 1999, a near-recession rate. As a result, there are tremendous amounts of excess capacity globally. A flood of imported steel, for example, has lowered prices by 30%, pushing two steel companies into bankruptcy. "It is a horrible market," says Paul J. Wilhelm, president of USX-U.S. Steel Group, which has laid off more than 500 workers and shut down blast furnaces at Lorain, Ohio, and Gary, Ind..

At the same time, the global slowdown could put a damper on capital spending. As of November, 1998, the capital utilization rate in manufacturing had fallen to 79.8%, the lowest level since 1992, so that companies are under far less pressure to expand capacity. Kellogg Co., for example, announced that it would cut capital spending to $270 million in 1999, down from $400 million this year. And with crude prices very low, oil companies are cutting capital-spending budgets sharply.

TECH HOPE. The slowdown in capital spending is showing signs of extending into the high-tech sector as well. According to a survey of senior IT executives by Morgan Stanley Dean Witter, information technology spending by corporations in 1999 will grow at a rate of between 4% and 6%, compared with growth of 7% to 9% in previous years. And BT Alex. Brown is projecting that growth in capital spending by U.S. telecom carriers is likely to slow down to a 4% increase in 1999, compared with 13% growth in 1998.

But even in telecom there are bright spots. Despite the fact that many of the Latin American economies are slowing, BellSouth Corp. has been very aggressive there, bidding $1 billion for a wireless license in Sao Paulo and investing another $500 million in capital expenditures to get the system running. "We've seen a little drop-off in demand, but nothing to give us pause," says F. Duane Ackerman, CEO of BellSouth.

Every year, the forecasters say that it doesn't get any better than this, as they predict a slowdown for the next year. Maybe they are right this time--but the economy has the momentum and the fundamental strength to surprise them again.

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