Please, Let Them Keep Spending

That's the Fed's fervent prayer for what it needs consumers to do -- at least until those rate cuts kick in

By Amey Stone

One of the mysteries of this economic downturn is that while stocks are tanking, earnings are slumping, and employees are being laid off, the overall economy continues to stay afloat, buoyed by healthy consumer spending.

So, if people are spending it and corporations aren't earning it, where's all the money going? This is an important question for investors, not only to understand why the Federal Reserve is widely expected to cut interest rates for the sixth time this year when it meets on June 26 and 27 but also to understand which sectors make the best investments now.

It's no wonder that execs are so gloomy these days. Corporate America is bearing the full brunt of the slowdown. As the second quarter comes to a close, analysts expect companies in the S&P 500 to earn an average of 17% less than they did in the same quarter last year, according to Thomson Financial/First Call. Profit margins are plunging, too -- from 6.7% of sales in the first nine months of 2000, to 5.8% in the last three months of that year, to 5.4% in the first quarter of this year, according to Moody's Investor Service.


  Some sectors are faring much worse than that. Tech earnings are expected to be down 63% from the second quarter of 2000. A glut of equipment and cutbacks in capital spending have decimated profits at telecom companies, where profit margins fell to 3.6% in the first quarter from 9.8% last year. Telecom equipment supplier Nortel Networks (NT ) reported in mid-June that it will lose a staggering $19.2 billion in the second quarter.

Yet gross domestic product (GDP) grew by an estimated 1.3% in the first quarter, with personal-consumption spending the largest contributor to the increase. And even though layoffs have picked up while the creation of new jobs has slowed, unemployment is only at 4.4%. "Five years ago, we would have thought we'd died and gone to heaven with a rate that low," says Jay Mueller, economist and portfolio manager at Strong Capital Management.

Consumer confidence, which slipped in April, bounced back in May. At the end of May, the number of people planning to purchase a home in the next six months rose, and the number planning to buy a car remained steady at 8.4%. Surveys of chain stores showed stronger retail sales in the second week of June. For more evidence, just look around: In most parts of the country, housing markets are robust, stores are busy, and restaurants full. Even with the high cost of gasoline, people are happily buying and driving gas-guzzling SUVs.


  Given that consumers are spending more than last year, how come companies are so worried? The most significant factor in this seeming contradiction is that most corporate planners had much higher expectations going into 2001. S&P predicts that consumer spending will be up 2.4% this year, a far slower rate than last year's 6.2% growth. Companies were stocking up, building stores, and adding staff in the expectation that strong growth would continue. Now capacity outstrips demand in many industries.

Result: "The spending that is going on is spread out across a wider base," says Sam Stovall, S&P's senior investment strategist. That has led to increasing competition and excess inventories, followed by price cuts, crimped profit margins, and a sharp decline in profitability. "Just a small decrease in consumer spending is enough to make earnings be negative," says Stovall.

Companies also face higher costs that they haven't been able to pass along in the form of price increases, says John Lonski, chief economist of Moody's. Energy costs are, of course, higher. But a bigger surprise is that labor costs have actually risen lately. The employment-cost index, which takes into account both wages and benefits, rose at a 4.4% annual rate in the first quarter.


  "You would think companies would quit paying such a big increase, but as of the first quarter, it hadn't happened yet," says Mueller. That's because labor markets remain tight, and also because the cost of labor typically lags behind a slowdown in business sales.

Another factor is that much of the money from consumer spending is going abroad. U.S. companies are increasingly losing sales to imports, while their exports are slumping. That's thanks in good measure to the strong U.S. dollar, which makes imports cheaper while American goods become more expensive abroad. Exports for the month of April were down 2%, and the trade deficit remains at an all-time high. "April's dismal performance by exports only adds to the case that earnings will fall more steeply in the second than in the first quarter," noted Moody's on June 21.

One more piece of the puzzle: Some sectors are getting the bulk of the spending that is going on. "A lot of the contraction is unevenly distributed," says Lonski. "It struck hard at high-technology companies, Internet companies, and has also been devastating to a number of manufacturers."


  Meantime, some sectors are enjoying strong earnings growth. Energy is the biggest beneficiary: Profits are expected to be up 14% in the second quarter. But rising costs of oil, gasoline, and home heating oil come directly out of household discretionary spending, leading in part to the slowing of consumer spending rate increases.

Health care is another sector that has managed to improve profits, thanks to a rise in the prices of prescription drugs and health-care services, says Moody's. Earnings should be up 12% in that sector. Other sectors expected to report rising year-over-year earnings are utilities (up 11%) and consumer staples (up 2%), according to Thompson Financial/First Call.

Lonski says some retailing sectors haven't fared too badly, while homebuilding has done well. Financial services, outside of brokerage houses, has also held up. He thinks home-furnishing and appliance makers could be particularly attractive sectors for investors now. That's because sales in these areas have slumped despite a brisk housing market and robust growth in home remodeling. That anomaly probably can't continue, he says. "There are a lot of people with reason to purchase new furniture and appliances," he says. "That will eventually lead to a rise in the year-over-year growth rate."

Perhaps. But investors looking to put money into the market should also take note that the more significant anomaly -- corporate profits are slumping while consumers continue to spend -- can't continue, either. That's the major reason why the Fed is expected to lower rates again at its upcoming meeting. It wants to stimulate growth before a mounting volume of corporate layoffs scares consumers into shutting off spending. Anyone investing in stocks today better hope Greenspan & Co. succeeds.

Stone is an associate editor of BusinessWeek Online and covers the markets in our daily Street Wise column.

Questions or comments? Join in the discussion at our Ask Amey Stone interactive forum

Edited by Douglas Harbrecht

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