The Corporate Forecast: Serious Scrimping

Capital investment helps drive earnings, but with executives still hitting the brakes on spending, don't expect profits to take off any time soon. Capital spending fell in the past two quarters, and the Federal Reserve's aggressive interest-rate cuts won't reverse that trend before next year, economists say.

"It was the investment boom that made the late 1990s a special period for the economy and corporate earnings, and the investment bust suggests the next year is going to be very tough for the economy and earnings," says Mark M. Zandi, chief economist at Inc.

Business spending on capital equipment grew on average by 15% a year from 1997 to mid-2000, then it contracted in last year's fourth quarter (chart). That's hurting companies in two ways: It cuts profits at outfits supplying capital equipment and retards earnings at companies that forgo the productivity gains resulting from capital investment. Spending on info-tech equipment and software has seen the sharpest drop--it fell 6.4% in the first quarter from the previous quarter. That's slamming tech suppliers, such as Lucent (LU ), Texas Instruments (TXN ), and JDS Uniphase (JDSU ). Verizon Communications (VZ ), for one, will cut its planned capital spending for this year by $1 billion, to $17.5 billion. "We feel that this is a prudent action to take right now, to tap on the brakes in terms of capital," says Chief Financial Officer Fred Salerno.

DOWNDRAFT. The same belt-tightening is happening elsewhere in Corporate America. The Commerce Dept. says orders for nondefense capital goods, excluding the volatile aircraft category, fell about 2% in March, vs. February. And a survey of purchasing executives at nonmanufacturing industries by the National Association of Purchasing Management showed that business activity and new orders fell in April, the first contraction registered by the monthly survey since it began in 1997.

Don't count on sharply lower interest rates to boost investment, at least in the short term. Executives respond first to business demand and the need to expand capacity. "Interest rates are last in terms of importance," says Jan Hatzius, senior economist at Goldman, Sachs & Co. With demand slowing--especially as rising unemployment saps consumer confidence--there's plenty of unused equipment in most industries, so cheaper money to buy equipment misses the point. "Investment will stay negative through this year and show a slight rebound in 2002," predicts Hatzius.

Investment eventually will pick up. But real capital spending at a level seen in the late 1990s won't soon be repeated. "That was a speculative bubble, juiced up by extraordinary expectations in the stock market," says Zandi. Given the current earnings doldrums, though, even a modest gain would be welcome.

By Charles J. Whalen, with Peter Elstrom in New York

— With assistance by Peter Elstrom

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