U.S.: The Past Won't Be Prologue in This Recovery

The risks lie with Corporate America and the market--not consumers

For forecasters, the differences in business cycles are always more illuminating than the similarities. That's especially true right now, as the economy shows nascent signs of turning around.

In past downturns, sectors toppled like dominoes. First, housing collapsed, then consumers stopped spending. Later on, companies cut capital spending. And inflation fears made the Federal Reserve a bit tardy in cutting interest rates.

This time, however, the weakness hit at roughly the same time, the result of sharply diminished expectations among both investors and companies. The loss of double-digit stock gains slowed consumer spending from its boom times of the late 1990s, leading to excess inventories and cutbacks in factory output. At the same time, corporations, overloaded with tech gear bought during the boom, slashed capital spending as a means to lift earnings. Now, with no recovery in profits, companies are quickly laying off workers (chart). Fortunately, with no inflation to worry about, the Fed has been equally quick to cut rates, so consumer spending and housing have not been hit so hard as to sink the economy.

The upshot: If last year saw a new type of slowdown, then this second-half recovery may not resemble any of its predecessors. For one thing, housing and autos won't provide their typical lift because they didn't go bust. More importantly, the risks to this recovery will be concentrated in the business sector. Household America may be the linchpin to overall growth, but Corporate America and the stock market will constitute the greatest uncertainty. In particular, if expectations about second-half revenues and future profits don't match reality, then businesses will be under pressure to keep cutting costs, which could topple the economy.

WHAT'S BEHIND THIS NEW ORDER? For the most part, technology, with its rapid information flow, has compressed reaction times among executives, investors, and policymakers. Companies get ordering and inventory data at the click of a mouse, so they can rapidly adjust production schedules. Likewise, Wall Street information is available on TV or the Internet. News about profit expectations moves equity prices in nanoseconds at a time when more people than ever have a stake in the stock market.

Even the Fed has felt compelled to compress its reaction time. It described its first five interest-rate cuts of 2001 as "a rapid and forceful" response to economic conditions. Only at its last meeting, on June 27, did the Fed decide to dial back the pace of easing.

One implication of all this is that various economic data have shifted in importance. For example, minor numbers, like new orders for nondefense capital goods, have become significant as business demand becomes a proxy for corporate confidence. And the inventory reports, usually a snoozer on Wall Street, may grab more attention until tech manufacturers have whittled down their stock levels.

Conversely, the employment report, usually the trendsetter of economic news, may be more of a lagging indicator this time around. Payrolls may not show any healthy gains in the second half, even if real gross domestic product growth bounces back to around 2 1/2%. Just like after the 1990-91 recession, businesses will be keen to extract all possible productivity gains from their slimmed-down payrolls before adding new workers. But unlike a decade ago, productivity growth now is quite high and can account for almost all of the growth expected in the second half.

THAT'S ONE REASON WHY the jobless rate, which hit 4.5% in June, will continue to inch higher, possibly into 2002 as the recovery gathers momentum. Unemployment will stop rising only when real GDP growth picks up to its sustainable, noninflationary rate, generally put at about 3 1/2%.

In addition, the rise in unemployment has been limited by another oddity in this business cycle: Many people who were sucked into the labor force are now simply dropping out (chart). The twin booms in consumer spending and business investment created so many new jobs that the unemployment rate fell to a thin 3.9% in late 2000. Lured by easy job opportunities, many people entered the labor force who would not normally have done so, such as retirees, students, and those with few skills.

Now, as these workers are being laid off, they are not looking for new work, meaning the Labor Dept. counts them as "not in the labor force," instead of "unemployed." As a result, the percentage of the adult population not in the labor force has spiked up recently to the highest level in five years. If all of those workers had remained in the labor force unsuccessfully seeking another job, the jobless rate would now be 5.3%.

Clearly, labor-market conditions are easing, as the June job report shows, but the numbers say more about second-quarter weakness than about prospects for the second half. Total nonfarm payrolls fell by 114,000 last month, after a tiny gain in May and a 165,000-job loss in April. As has been true in past months, the declines were concentrated in manufacturing, where layoffs totalled 113,000. But growth in service payrolls has slowed as well, led by steep declines in temp jobs.

DESPITE THE LAYOFFS, factory activity may be turning the corner. Based on a survey of its members, the National Association of Manufacturers says that factory weakness is "bottoming out" and "poised for a modest recovery" by yearend. Some 80% of those surveyed foresee no inventory problems after August, and they expect orders to increase in the third quarter.

A key factor helping businesses to make their required adjustments in inventories and equipment outlays is that, even amid layoffs, the labor market is still relatively tight. That means healthy pay raises are providing a key support for consumer spending. Hourly pay of production workers grew 4.2% in June compared with a year ago (chart), much faster than inflation. With fuel prices coming down, lower overall inflation will allow household incomes to stretch further.

If consumers seem to be on firmer ground, the same can't be said for the stock market, which is the most critical unknown in this new-era recovery. Investors have built expectations of better demand and profits into stock prices. If those expectations are unfulfilled, another downshift in the market would crack consumer and business confidence. That would cause more cutbacks in capital spending and jobs, knocking the props out from under consumer demand. This is a recipe for a classic recession that would make the 2001 slowdown look like a walk in the park.

Make no mistake, the economy is still at risk. But for now, it looks like a modest recovery is slowly taking shape. And after almost no growth in the first half, even a slight upturn will feel a whole lot better.

By James C. Cooper & Kathleen Madigan

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