Welcome to the Growth Recession
Is the worst over?
After the economy stumbled badly at the end of 2000, fears of recession clouded the outlook. But thanks to some well-timed policy moves from Washington, the most difficult time for this economy may well be behind us. Although risks remain, forecasters are generally confident that a full-fledged recession is not in the outlook and that the economic landscape will begin to brighten in the second half of 2001. However, if you are expecting a rapid return to those sunny days of 4% to 5% growth, you will be disappointed.
Business and consumers are adjusting to the New Economy's new reality. The limit to noninflationary growth, while much higher than it was a decade ago, is not as high as many investors had come to believe back in the go-go days from 1998 to early 2000, when real gross domestic product soared at a 4.8% annual rate. Now, companies are adjusting to lower expectations of growth in demand and profits. And consumers are learning to spend within their income limits now that their stock portfolios have taken a hit. The result: The recovery from this slowdown will be only modest, but the unusually rapid and aggressive policy actions on interest rates and taxes assure that growth will improve in coming quarters.
That's the word from BusinessWeek's midyear update of economic forecasts. The economy's look and feel are decidedly different from what they were when we took our yearend 2000 survey--when the consensus view called for 2001 growth of 3.1%. The main reason: "A pronounced erosion of profitability has sparked corporate belt-tightening, including cutbacks in capital spending and hiring," says John Lonski of Moody's Investors Service. The forecasters believe that the economy is in a "growth recession"--that is, a period of positive but weak growth in which unemployment rises.
FAIRLY UPBEAT. On average, forecasters expect real GDP to grow at an annual rate of less than 1% in the first half, followed by growth in the 2%-to-3% range in the second half. That pace would be below the 3.5% or so that economists believe to be sustainable without arousing inflation. Only two of the 25 forecasters see an outright recession--and an extremely mild one at that. By early 2002, growth should pick up to a modest 3% pace (table). The economists think the Federal Reserve will be done cutting interest rates by the third quarter, and they expect inflation, measured by the consumer price index, to fall from its current 3% to 2.3% this time next year, mainly reflecting lower energy prices.
Business cycles have always been about booms that go bust and the adjustments that are required when reality sets in. Part of the economy's problem is that the current episode contained two booms: First, businesses, especially technology companies, overinvested, as New Economy mania swelled expectations of future profits beyond justification. And second, wealthy consumers went on a buying binge as stock-market gains supported spending growth far beyond the pace of incomes.
The near-doubling of business investment in tech equipment from early 1997 to early 2000 implies excess capital spending in the range of $70 billion to $140 billion, estimates Constantine G. Soras of Andrew, Alexander, Wise & Co. That's some 10% to 20% of the current level of real tech investment. "Even a gradual adjustment is likely to wreak havoc on growth in the tech sector this year and next," says Soras.
Overcapacity in technology also means that the Fed is fighting an uphill battle against this slowdown. "No amount of cheap money will spur additional investment until that excess capacity is reduced," says Joel Naroff of Naroff Economic Advisors in Holland, Pa.
In addition, the financial markets aren't cooperating with the Federal Reserve to the same extent they usually do. Despite the Fed's superaggressive rate cuts totaling 2 1/2 percentage points since January, stock prices are still down this year, long-term interest rates are up, and the dollar has appreciated. "Financial conditions as measured by our Goldman Sachs Financial Conditions Index have not changed much since the beginning of the year," says Bill Dudley of Goldman Sachs.
There are other reasons not to expect the classic V-shaped recovery. For one, highly cyclical Old Economy industries, such as housing and autos, were not severely depressed when the Fed began easing. As a result, consumer outlays in these traditional interest-sensitive areas will not bounce back as sharply as they typically do after an economic slump. For another, weaker global growth and a steady rise in the dollar are hammering U.S. exports. European growth is slowing, led by steep second-quarter weakness in Germany that is expected to drop growth in the 12-nation euro zone to less than 2%. Japan appears to be sliding into another recession, increasing the vulnerability of the rest of Asia.
The key question in the outlook is this: Who will control the economy, Corporate America or Household America? Consumer spending has slowed from its red-hot pace of a year ago, but it remains supportive of overall growth. And so far at least, corporate cutbacks in capital spending and jobs, especially in the technology sector, have not been severe enough to drag down the rest of the economy. But therein may lie the rub. "The principal risk now is that falling employment could trigger a second wave of cuts in demand--this time, in the consumer sector," says David Resler of Nomura Securities International.
ENERGY RELIEF. Through the second quarter, at least, consumers remain up to the task. Despite shrinking payrolls and rising unemployment, labor markets remain relatively tight. Indeed, workers' pay is growing faster than inflation, and consumer confidence has stabilized at levels well above those typically associated with recessions. Another plus for consumers is that inflation is set to drift lower. "It appears that--California electricity notwithstanding--we are nearing the end of this energy shock and there should be some downward pressure on energy prices," says Ralph Monaco of IERF in College Park, Md.
The resilience of consumers makes a key point about the outlook. That is, while technology is a crucial player in the economy, a tech recession may not necessarily mean an economywide recession. Moreover, the tech adjustment is temporary. "We believe that the wave of innovation of the past decade still promises a substantial source of strong productivity and overall growth in the long run," says Robert V. DiClemente of Salomon Smith Barney.
In the short run, the biggest plus in the outlook is that policymakers at the Fed and in the White House have reacted in record time to put stimulus in place. That will provide added support under consumer spending and foster the business conditions necessary for companies to adjust to the new realities of the New Economy.
By James Cooper, with Kathleen Madigan and James Mehring