The Wild Card: Consumer Confidence

Despite the slowing economy and weak stock market, many consumer companies have escaped the profit decline--so far. Earnings at PepsiCo Inc., for example, soared 25% in the fourth quarter on the strength of rising food and beverage sales, while other consumer-driven companies, such as Nike Inc., showed decent gains as well.

If the slowdown turns into a recession, however, the earnings of consumer companies could be extraordinarily vulnerable. American households already have a negative savings rate and the highest debt-to-income ratio on record. A downturn that brings rising unemployment and a further decline in the financial markets could trigger a sharp retrenchment in consumer spending. And that would curtail the earnings of consumer companies.

MIXED SIGNALS. Ultimately, the near-term profit picture will depend on the intensity of the slowdown. History suggests that if the downturn is mild, profits at consumer-driven companies could hold up well. In the last recession, which started in July, 1990, and ended in March, 1991, nonauto retail sales actually rose as Americans kept spending on nondurable necessities. Profits rose in a wide variety of industries--including beverages, food, drugs, restaurants, and personal care products. Something similar could happen in 2001, especially if President George W. Bush and Congress quickly agree on a tax cut.

So far, surveys are showing mixed signals about the depth of worry among Americans. Consumer confidence is down sharply since September, reflecting the news of corporate layoffs, the troubles on Wall Street, and a growing pessimism about the future. But if the labor market stays strong and if the markets start to rise again, confidence could rebound just as quickly.

Yet even in a mild downturn there will be hard-hit sectors. Profits in the auto business and other consumer durables are already getting pounded, just as in the last downturn. And in the service sector, consumers may look for places to cut back--such as their telecom bills. That's what happened in late 1990 and early 1991, when household spending on phone service fell because of intense competition for customers in a slowing economy. The result was a sharp decline in the earnings of long-distance companies and a smaller drop for local outfits. A similar pattern today would compound telecoms' already troubled profit picture.

The earnings problems will get much worse for all consumer-driven industries if Americans get really nervous about their jobs and investments. That would force them to cut back on spending and boost their savings instead. If households go from today's -0.8% savings rate to a 6% rate, the 1990s average, that would chop more than $400 billion out of consumer spending--far more than any tax cut could counteract. In that case, watch out below.

By Michael J. Mandel in New York

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