Tough Times: How Long?

Fiscal and monetary stimulus may spark a sharp upturn by next spring or summer

No matter how much things change, human nature stays the same. When business is booming, people assume the good times will never stop. But that works in reverse, too. When the economy is going down, many find it hard to see what will make things turn around again.

That's the position the U.S. is in today. Even before September 11, the economy was trapped in a long, slow slide. Growth had slowed to a crawl. The Standard & Poor's 500 had fallen 13% since the start of the summer. Manufacturing was contracting, unemployment was rising, and orders for tech gear were falling at a 28% annual rate.

Now, after the attacks, the immediate future has gone from gray to black. From retail sales to advertising to technology, there's little cheery news. "The short-term outlook is not good," says R. Glenn Hubbard, head of the Council of Economic Advisers. He thinks the "probability" is that the U.S. fell into recession in the second half of 2001. His predecessor at the CEA, Martin N. Baily, now a senior fellow at the Institute for International Economics, says "it's possible" that the economy could contract as fast as it did during the second quarter of 1980, when gross domestic product fell at an annual rate of almost 10%.

"CAPITAL V." Now the question is simple: How long will tough times last? As companies announce layoffs and shutdowns, many fear that unemployment could undercut consumer spending, forcing more layoffs and sending the U.S. economy into a long downward spiral.

But unless there's another major terrorist attack at home or a series of military defeats overseas, that's not the most likely scenario. Instead, the combination of enormous fiscal and monetary stimulus, plus a stable financial system, could produce a sharp recovery starting sometime in the spring or summer of 2002. "We were in an L [-shaped recession] before this," says Charles L. Hill, director of research at Thomson Financial/First Call. "Now, we are back to a V, except that it is a capital V." By that he means the economy will probably suffer a rapid downturn, followed by an equally rapid upturn.

This positive view is shared by some in business. That even includes some executives in the beleaguered auto industry, which saw sales fall by almost 9% in September, according to Autodata Corp., a Woodcliff Lake (N.J.) researcher. "I think we can expect two very difficult quarters," says Tom Purves, CEO of BMW (U.S.) Holding Corp. But, he adds, "my crystal ball is fairly optimistic for spring and late summer next year."

Why such optimism? First, the latest Federal Reserve rate cut, announced on Oct. 2, drops the federal funds rate on overnight lending to banks to 2.5%. That's below the core rate of inflation, now running at 2.6%. As a result, short-term borrowing is effectively free, lowering the cost of funds for lenders and stimulating borrowing. The last time this happened was in early 1992--precisely when growth really started to accelerate after the last recession.

At the same time, a combination of higher defense spending and recovery aid is reversing a decade of a falling government share of the economy. The fiscal stimulus--which could exceed $100 billion--will boost demand, add jobs, and partially offset the drag from layoffs and cutbacks in business investment. "We are about to apply more stimulus than I can ever remember being pumped into the economy," says Bruce Steinberg, chief economist of Merrill Lynch & Co. He's forecasting 4.7% growth for the last three quarters of 2002.

One problem that might upset this rosy scenario would be a distressed financial system, which would make interest-rate cuts less effective. The danger is that banks and other lenders could be paralyzed by the combination of a depressed stock market, rising defaults, and increased uncertainty--causing a sharp contraction in lending and borrowing, even if interest rates fell. In many ways, that's what happened in Japan in the 1990s.

But the U.S. is not Japan. There, the banks have been weighed down by an enormous overhang of bad loans, leaving them unwilling and unable to lend no matter how low rates got. Indeed, the U.S. financial system seems to be surprisingly healthy. Banks are well-capitalized, with the top 30 institutions having $40 billion in excess capital as of the middle of 2001, according to Andrew Collins, an analyst at U.S. Bancorp Piper Jaffray. Moreover, the Fed, by starting to pump money into the economy early in 2001, enabled the financial system to absorb the tech crash without much ill effect. Although initial public offerings and venture capital fell, corporate borrowing was still going strong before the attacks.

DEEP VALLEY. Unlike the Japanese, U.S. consumers still appear responsive to lower interest rates, especially when they have the chance to turn the equity in their homes into cash or reduce monthly loan payments. Since the beginning of September, refinancing applications have risen by 51%, as 30-year mortgage rates fell by 20 basis points, to an average of 6.5%, their lowest levels since October, 1998. "The worst economic contractions have always been associated with major financial instability," says Frederic Mishkin, a professor at the Columbia University School of Business and a former research director at the New York Federal Reserve. "There's no evidence that I've seen of any stress on the financial system."

None of this, however, will stop a deep downturn in the fourth quarter. Forecasters willingly admit that they have no idea just how bad it will be. "We're going into a valley," says Merrill Lynch's Steinberg, "and we don't know how deep the valley will be." His best guess is that the economy will contract at a 1% rate in the third and fourth quarters.

Every part of the economy will be hit. Consumer spending, exempt so far from the general malaise, will fall at a 2.2% rate in the fourth quarter as confidence stays low, says David Wyss, chief economist at Standard & Poor's. And new-home sales are also expected to fall--from a seasonally-adjusted rate of about 900,000 in August to as low as 790,000 in December--says David F. Seiders, chief economist at the National Association of Home Builders. He estimates housing's overall portion of GDP will contract 3% in the third quarter and 5% in the fourth quarter. "We will no longer be a support to the economy," he concedes. The same is true for commercial real estate, notes Sam Zell, chairman of Equity Office Properties Trust, the nation's largest publicly traded real estate investment trust: "Right now, there is almost nothing happening."

And there's certainly no immediate sign of a revival in technology spending. In a post-attack poll of 198 senior executives, CIO magazine found that they expect info-tech budgets to rise by only 3.7% in the next 12 months, down from a 7.2% prediction in August. And when it comes to venture capital, "we were in a big chill before 9/11," says C. Richard Kramlich, a founding partner at New Enterprise Associates, one of the country's largest venture funds. "Now, we're in a deep freeze."

Moreover, another big terrorist attack would almost certainly poison the midterm economic outlook. It would destroy any tentative revival of confidence and spending. Such an attack, "would slow things down dramatically," says Jed Connelly, senior vice-president at Nissan North America Inc. "We'd go right back to square one, right where we were after the first one."

Some business leaders, to be sure, are more downbeat about prospects for a quick recovery even if there's no new attack. "I don't know whether it will be another quarter or another three quarters, but we have to be ready for at least another year [of tough times]," says W. James McNerney Jr., chairman and chief executive of 3M Corp, which is facing a continued drag from its unit that supplies telecom companies.

PLENTY OF MAGIC. And certainly there's a danger that a recovery could be stalled by a sharper-than-expected rise in unemployment. That could drag down the housing market and consumer spending. Already, credit-card delinquencies are at record levels. If unemployment hits 7%, bankruptcy rates could rise by 20% in 2001 and by an additional 20% to 30% in 2002, to $1.7 million, estimates Kenneth A. Posner, an analyst at Morgan Stanley Dean Witter & Co. "The thing to worry about most is consumer defaults," says David O. Beim, a finance professor at Columbia University. "That's the thing most likely to accelerate us from a modest to a more significant recession."

Still, there may be enough monetary and fiscal stimulus in the pipeline to keep that from happening. Moreover, there's plenty of evidence that lower rates can work their magic. For example, potential car buyers clearly responded when General Motors (GM ), Ford (F ), and DaimlerChrysler (DCX ) introduced 0% financing deals at the end of September. GM sales, which had declined about 20% after the attacks, rose 22% in the final week of the month--after the company introduced its low-rate promotions to jolt people back into spending. Even though auto sales are still expected to fall by 5% to 10% in 2002 as the economy slows, the Fed's latest rate cut will lower the cost of auto loans and leases. It also will make it less expensive for carmakers to offer such sweet financing deals again in the future, if needed.

Surprisingly, the sagging technology sector may also be more responsive to interest-rate cuts than people realize. Tech growth started to slow only in mid-2000--about a year after the Fed began raising rates. The link works in the other direction, too, notes G. Dan Hutcheson, an analyst at VLSI Research Inc., a market researcher in San Jose, Calif. "Historically, there's a year lag between interest-rate cuts and their effect on the chip industry." He's predicting an upturn in the semiconductor industry in the second half of 2002. Another favorable sign: On Oct. 3, IBM announced lower-financing rates on some servers and products.

Some analysts believe that, in the long term, the events of September 11 could stimulate demand for some kinds of tech spending, as companies focus on boosting the reliability of their networks. "We've raised the priority [for enterprise computing] level once again," says Laura Conigliaro, an analyst at Goldman, Sachs & Co.

In addition, many venture capitalists expect the venture market to hit bottom in the fourth quarter and stabilize early in 2002 as inventory backlogs get worked off. Says Tracy T. Lefteroff, global managing partner for private equity and venture capital at Price- waterhouseCoopers: "People in the venture industry just want to get this year behind them. Then, I think they'll start getting back in."

Homebuilding may follow the same pattern, with a slowdown followed by recovery during the second quarter. "Historical evidence points to the fact that there are always aftershocks in the wake of tragedy, but that these effects are typically temporary," explains KB Home CEO Bruce Karatz. He adds that business has returned to near-normal levels at KB Home as consumers try to get back to normal.

That's a claim that a lot of other businesses would like to make. Economic forecasting is never a science, and the uncertainty at times like these is even greater than ever. But there's a good chance that the middle of 2002 will be far brighter than today.

By Michael J. Mandel, with Heather Timmons, in New York; Stephanie Anderson Forest in Dallas; Michael Arndt in Chicago; Joann Muller in Detroit; Linda Himelstein in San Mateo; and bureau reports

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