Can the Consumer Go the Distance?
By David Shook
Think of the economic outlook as a high-endurance relay race. Look! Here comes the consumer, racing at full speed. All around him are the emerging signs of a recession -- but he ignores them, racing on. Meanwhile, companies are stuck in place, watching their profits wither. Capital spending has been cut drastically, and businesses are scaling back their workforce.
Does our hero, the consumer, have enough stamina to make to the finish line and hand off the baton to business as it regains its stride and confidence again? Or will the consumer collapse, leaving the economy to sink further?
While some indicators, the stock market chief among them, suggest that things may still get worse before they get better, investors have reason to put their faith in the notion that the consumer can save the day. Sure, we have entered what economists call a "corporate profits recession." But the consumer may well have enough stamina to last through the end of 2001 -- and in the process, save the U.S. economy from falling deep into a recessionary pit.
This year's third quarter and fourth quarter will be the most critical stages of the race. As long as consumers hold up their end in the second half of 2001, we should be able to avoid two consecutive quarters of negative growth, which is the shorthand definition of the start of a recession. Says Milton Ezrati, senior economist for Lord Abbett & Co.: "We think the consumer is capable of fostering a recovery by the end of the year."
The Federal Reserve is clearly doing its part to pace the consumer. At its Aug. 21 meeting, the Fed is expected to cut rates for the seventh time, probably by a quarter percentage point. Consumer confidence has stabilized after a sharp slide to a five-year low in April. The University of Michigan's preliminary August consumer-sentiment index, which is released directly to subscribers, rose to 93.5 from 92.4 in July, according to market sources. Economists had forecast the final index to be virtually unchanged at 92.5. Retail sales rose 0.6% in July, excluding vehicles and gasoline. And that trend should improve, as consumers cash their federal income-tax refunds, take advantage of lower energy prices, and refinance their homes.
The Mortgage Bankers Assn. says refinancing activity represented 47.9% of total mortgage applications during the week that ended Aug. 10, a slight increase over the previous week. Plus, U.S. housing starts advanced in July at the fastest monthly pace in nearly 18 months. "The demand for housing continues to be very strong," says Celia Chen, senior economist for Economy.com. Housing is a key driver of economic activity. When consumers buy a new house or refinance an existing mortgage, they tend to buy furniture, carpet, appliances, and other big-ticket items.
"Consumer spending makes up about two-thirds of gross domestic product [GDP], and the consumer is keeping the economy from sinking further," says Chen. But she emphasizes that the outlook still isn't bright. "The drivers [of the economy] have been weakening, job losses are mounting, the unemployment rate has risen slightly, and these factors could reduce consumers' willingness ability to spend. At this point, it's just too close to call a winner."
THE WALL STREET FACTOR.
No doubt, it will come down to the wire. Inflation-adjusted GDP increased at an annual rate of only 0.7% in the second quarter, according to preliminary estimates. In the first quarter, real GDP increased 1.3%. But the second-quarter number might be revised downward into negative territory when the Commerce Dept. releases a more comprehensive analysis on Aug. 29. "We see an increasing chance for a full-fledged recession," says Dr. Edward Yardeni, chief investment strategist for Deutsche Banc Alex. Brown. He cites the unemployment rate, which has edged up from 4.2% at the beginning of the year to 4.5%, as a primary reason why the economy may slip further.
It's unclear how much of the stock market will see improvement in the third quarter. While Cisco Systems (CSCO ), Oracle (ORCL ), and much of the tech sector is still reeling from the investment binge of the last several years, Microsoft (MSFT ) and IBM (IBM ) are doing fine.
Outside of tech, it's a mixed bag. Many energy producers are having record profit years, but some old-line manufacturers are suffering. Retailers -- the closest sector to the consumer -- appear to be holding up well. Home Depot (HD ) reported earnings Aug. 14 that beat analyst estimates, and Merrill Lynch's Peter Caruso raised his profit estimates slightly for the company next year and in 2003. On the same day, however, Wal-Mart (WMT ) met its second-quarter earnings and warned that third-quarter results would fall short of estimates by a hair.
"Consumer spending continues to proceed at a healthy pace, despite the miserly creation of new jobs," says Moody's Investors Service Chief Economist John Lonski. "What we're counting on are interest-rate cuts and tax cuts to compensate for this loss of jobs. With lower interest rates and lower taxes, people fairly secure in their jobs should step up spending, forcing companies to pump up orders and boost production." But that's no certainty, he says. "It comes down to the paradox of competition: With the layoffs we've seen this year so far, companies are, in effect, engaged in firing their customers."
WANTED: STRONG CEOs.
That's a real danger. And on the business side, several factors need to align to keep a crippling recession at bay. First, companies must continue to work off inventories that started accumulating last year, when the economy began to slow. Inventory-reduction plans are in full force across most industries now -- from chipmakers to auto manufacturers. Historically, low inventories spark the beginning of a recovery. But it will take more than that this time.
A real recovery will require CEOs to keep their nerve and retain as many employees as possible -- even when budgets become tighter than ever. Job cuts, companies have learned, have all too often resulted in a short-term fix -- and long-term problems. If the economy recovers, CEOs don't want to launch a costly recruiting effort just a year after firing thousands of workers.
Most important, though, companies need to start spending again -- not just on technology but also on advertising, acquisitions, and investment in new product lines. As long as the consumer remains willing to spend, there's reason for CEOs to assume that advertising and new products can spark revenue growth.
DOWN TO THE WIRE.
"Lower inventories alone cannot stimulate additional demand," says Moody's Lonski. "Sales growth will need to firm up to halt the downward slide in corporate profits and hiring activity." Adds Peter Cohan, an investment strategist in Marlborough, Mass.: "What we need is a comprehensive survey to find out what's going on in the minds of CEOs, to find out why they're not spending." As it stands, CEOs seem to be waiting for evidence from each other.
The race, then, may come down to whether CEOs can steel themselves to resist the pressure for further lay-offs and spending cuts. "Even with all the cuts so far, companies have been much more willing to slash capital spending than jobs," says Yardeni. If CEOs can maintain their faith that consumers will keep going and hand off that baton, the economy may yet leave recession in the dust.
Shook covers financial markets for BW Online in New York
Edited by Beth Belton