For about a year prior to September 11, U.S. businesses were adjusting to a new reality of slower demand at home and abroad, after the unsustainable boom in 1999 and early 2000. The September shock only made matters worse. However, there are now indications that companies' two biggest problems--excessive inventories and the hangover from too much capital spending--are beginning to work themselves out.
"Beginning" is the key word here, but a few encouraging signs for the outlook have cropped up. Orders for durable goods rebounded in October, and the November purchasing managers' index of industrial activity rose, lifted by a big bounce in new orders (chart). The nonmanufacturing PMI also jumped last month. In addition, revised data by the Federal Reserve show that producers of high-tech equipment may be dealing with less excess capacity than initially thought.
Bear in mind, though, that progress will be slow because of the enormity of each problem and because businesses will not build up their stockpiles or fatten their capital budgets until they see stronger demand for their own products. Right now the outlook for demand in 2002 is good but not great. Spending by U.S. consumers, while surprisingly resilient in the fourth quarter, will not bounce back next year to the 5%-plus pace seen during the economy's boom period. And foreign demand won't be providing any help because the rest of the world is either in or close to recession.
Even so, these nascent signs of improvement on the inventory and capital-spending front are important to the outlook for the industrial sector, the economy's first area to crumble more than a year ago. And they are crucial to the overall economy's future because a healthier industrial sector is a key component of a true U.S. recovery.
PERHAPS THE MOST HEARTENING NEWS for the industrial sector is the speed with which excess inventories are being brought into line. Based on the revised data for third-quarter gross domestic product, businesses liquidated inventories last quarter at the fastest rate in any quarter since World War II.
This faster liquidation played a big role in the downward revision in overall GDP growth from a dip of just 0.4% to a 1.1% decline. The inventory runoff, which began in the first quarter, is now the largest in any three-quarter period. So far this year, final demand for goods has declined at an annual rate of 0.2%, while business inventories have fallen at a 2.8% clip. Eventually this disparity will fuel gains in goods production.
Another hopeful sign is that the steepest cutbacks in capital spending, a major source of the inventory adjustment, may be over. The financial fundamentals that will support a pickup in spending are coming together. First, the rally in the bond market, along with past Fed rate cuts, have lowered borrowing costs.
Second, despite weak third-quarter profits, corporate cash flow is now rising. Profits in the third quarter, based on the Commerce Dept.'s economywide roundup, fell 8.3% from the second quarter and 22.2% from a year ago. Even excluding financial companies and the hit to insurers from the September 11 disasters, earnings at nonfinancial companies plunged 26.5%. But cash flow, which adds back depreciation, managed to rise by $12 billion, the first increase in a year. This is a sign that improving financial conditions are helping corporations to repair their balance sheets.
EVEN THE TECH SECTOR, which is hardwired into the capital-spending outlook, is showing a few signs of working through its problems. Although overall industrial production dropped a steep 1.1% in October, output losses in the tech sector are getting smaller. In the past three months, production losses in the tech industry--including computers, office equipment, communications equipment, and semiconductors--have averaged 0.9% per month, compared with declines averaging 2.8% per month in the spring and summer.
Moreover, new Fed data suggest that the excess capacity in the tech sector is a bit less than the original data had implied (chart). The Fed's annual revision of industrial production and capacity shows that tech output capacity did not grow as rapidly last year as first thought, and that the slowdown in capacity growth this year has been much steeper. The new data show that growth in tech capacity fell from a peak of 43% last year to 15% in October, much greater than the slowdown from nearly 50% to 24% in the old data.
Clearly, there is still a problem. Tech output is shrinking 17% per year through October, and data for overall capital goods shipments imply another sharp drop in equipment outlays in this quarter. However, tech orders, which had been falling like a stone for a year, rebounded in October to the highest level since June. And the ratio of tech inventories to sales, while still high, fell in October for the second month in a row.
THE BIGGEST REASON FOR OPTIMISM that excesses in production capacity and inventories will be brought under better control in coming months is the surprising resilience of consumers in the face of the September 11 shocks. That's one source of demand that remains stalwart.
Led by a surge in car sales, real consumer spending in October soared 2.2% from September, when it plunged 1.1% (chart). It was the largest monthly increase in 15 years, fueled by a 27.9% jump in sales of cars and parts, the biggest gain on record.
October buying assures that consumer spending will make a significant positive contribution to fourth-quarter economic growth. For example, even if outlays fall back by 1.5% in November and don't grow at all in December--assumptions that are highly conservative--real consumer spending will rise at an annual rate of 2% for this quarter. That gain may be large enough to keep overall GDP from declining.
November car buying did decline from October's record annual rate of 21.3 million, but only to a still-strong 18 million pace, as many companies left their generous incentive programs in place. Car sales have been higher during this recession than they were prior to the downturn. Plus, November retail sales outside of car buying look healthy, based on weekly reports. The holiday buying season may not be as bad as many analysts had feared, although the heavy discounting needed to lift sales will likely hammer retailers' profits.
Undoubtedly, increasingly weak labor markets will limit consumers' contribution to growth next year. But even a modest pace of consumer spending will help to offset the ongoing drags from business and foreign demand. Given the progress that businesses have already made and the improving fundamentals for growth, the industrial sector--and the overall economy--may not be too far from righting itself.
By James C. Cooper & Kathleen Madigan