Introduction

A recovery is likely, but one with a small r. Even with productivity up and interest rates at historic lows, anemic demand will make patience a virtue for company and investor alike

As economists and corporate executives assess the prospects for a U.S. recovery this year, they are starting to sound like President Bill Clinton testifying in front of a grand jury. "It depends on what you mean by recovery," observes Maury Harris, chief economist at UBS Warburg. "If you mean a complete recovery to 2000 levels of growth, that's not going to happen."

That said, there's little doubt the U.S. economy will rebound from the recession in the next 12 months--at least to the extent that it hits bottom and starts growing before the second quarter ends. The combination of deep interest-rate cuts by the Federal Reserve and last year's tax-rate reductions should have the intended effect of warding off a precipitous downturn, even if the Republicans and Democrats can't manage to agree on a fiscal stimulus package.

As recoveries go, however, this one won't be very impressive. The growth rate, measured from the fourth quarter of 2001 to the fourth quarter of 2002, will be about 2%, according to West Chester (Pa.)-based Economy.com Inc. Moreover, things could get still worse before they get better. "I think the economic recovery is likely to be later in the year," says Thomas W. Horton, CFO at American Airlines Inc. (AMR ) "The strength of that recovery is anybody's guess."

The uncertainty is because the situation now is more complicated than at the end of the last downturn. For starters, although the tech sector should stop hemorrhaging, it's unlikely that businesses will buy a lot more computer equipment or software until the fourth quarter at the earliest. Hard-pressed managers expect to continue to hold down capital budgets--along with inventories, wages, and any other reducible expenses--as they cut costs and try to boost productivity.

Increased efficiency is surely a plus, but the push to get leaner could have a nasty side effect. There will be precious little job growth even after the economy starts to recover. Indeed, unemployment could continue to climb as companies push fewer workers to do more. Sustained unemployment means that consumer spending--which has held up through the start of the recession surprisingly well--will start to sag. And the looming recession abroad will keep foreign buyers from taking up the slack. "The soft landing everyone was predicting a year ago has been anything but," says John Perriss, CEO of media buying firm Zenith Optimedia Group.

Still, rising productivity, together with tight controls on labor costs, could lift profits of companies in Standard & Poor's 500-stock index by 10% from the fourth quarter of 2001 to the fourth quarter of 2002, according to Economy.com. Some forecasters are more optimistic. "There will be a significant earnings turn in the fourth quarter," insists Bruce Steinberg, chief economist at Merrill Lynch & Co. He expects a 30% surge in S&P 500 profits in the same period. After squeezing costs out of the supply chain, food companies such as Campbell Soup (CPB ), Kellogg (K ), and ConAgra (CAG ) expect to see earnings growth of 8% to 10%. And drug companies will still turn a profit, helped by a raft of new products. "In the last three years we've doubled the productivity of R&D," says Eli Lilly & Co. (LLY )chairman and CEO Sidney Taurel.

Productivity gains aren't the only plus. Banks will continue to benefit from low interest rates that reduce their borrowing costs and improve lending margins. In the wake of September 11, insurers plan to raise their premiums aggressively, and the defense and security sectors will mushroom as the "War on Terrorism" develops. Among retailers, discounters will continue to excel. Wal-Mart Stores Inc. (WMT ) CEO H. Lee Scott Jr. plans to increase his capital spending by 11%, to $10 billion, and to hire 75,000 employees in 2002.

Low interest rates will also keep the construction sector buoyant, even though there won't be a big uptick in building. "When the Fed cuts interest rates, the hope is that the economy will get an upsurge in building," says Lynn Michaelis, chief economist for the building materials and pulp and paper giant, Weyerhaeuser Co. (WY ). In the last recession, for example, single-family housing starts fell sharply and then rebounded when the recovery began, giving the economy a big lift. This time, housing starts aren't declining much, so there probably won't be a big rebound. "The residential sector will be neutral at best, and it could be a slight drag," says Michaelis.

Capital intensive industries, on the other hand, will struggle. "As near as anybody can forecast, in the first half, companies will still be reducing spending," warns J. Thomas Madden, Federated Investors Inc.'s chief investment officer. Manufacturers, for example, which are operating at 72% of capacity, have neither a strong reason nor the capital to spend on new machines. It's a similar story for tech buyers, who seem more interested in getting their existing mix of computers and software working right than in adding more. "Info-tech people are saying, `We've had this drunken technology spree, we need to sober up,"' says Vernon Turner, an analyst at International Data Corp. "They're starting to become uncomfortable over buying more infrastructure than they need."

As a result, tech equipment and software sales may drop at an annual rate of 5% to 10% through June, projects Neal Soss, chief economist at Credit Suisse First Boston. "We're seeing little bright lights in certain areas, but not enough to say we have comfort in a significant improvement [for tech spending]," says Michael Winkler, executive vice-president of Compaq Computer Corp. (CPQ ).

The drought in business spending has hurt the travel industry, too. Construction starts of additional hotel rooms will drop to 33,200, vs. their peak of 158,000 in 1998, according to data from PricewaterhouseCoopers, as lodging companies try to come to grips with lower demand. And airlines, which cut 20% of their capacity following September 11, may permanently retire upwards of 6% of these seats. "The high-end business traffic is not where it needs to be," says Gordon M. Bethune, CEO of Continental Airlines Inc. (CAL ).

Media will suffer as well, because advertisers will continue to stick with austere budgets. Ad spending fell 4% in the U.S. in 2001 and 1.7% worldwide--the first global drop since World War II. For 2002, ad-giant Universal McCann is projecting a modest 2.2% increase, to $466 billion, most of it coming in the second half.

The outlook isn't much rosier for consumer-products companies. Having shown remarkable staying power throughout the downturn of 2001, consumers may finally have been knocked down in the fourth quarter. The Commerce Dept.'s Dec. 3 report on aggregate personal after-tax income showed that it fell by 2.4% in October. That number will continue to deteriorate as unemployment climbs to as high as 6.5% or 7% by midyear.

Already there is evidence that rising unemployment is dampening overall wage gains. By the third quarter of last year, the wage and salaries component of the employment cost index had slowed from 1.1% growth in July to 0.7% growth in September. As unemployment creeps higher, wage gains will slow further.

It's not just weak incomes, however, that will hurt consumer spending. Part of the problem is that low interest rates convinced many consumers to accelerate big purchases ahead of 2002. That's true in the auto industry, where aggressive financing and promotions induced so many car buyers to purchase ahead of schedule that 2002 sales could drop by more than 10%, to as little as 14.8 million units. That spells trouble for Detroit's profitability. "None of the North American operations is making money at 16 million units [sold]," observes Federated's Madden.

Unfortunately, U.S. companies can't look abroad to make up for shaky domestic demand. In the 1990s the U.S. consistently set the pace for the global economy. Most economists--especially those based overseas--expected that Europe and Asia would be the main engines of growth in the coming decade. While that may eventually turn out to be true, the numbers for 2002 won't be worth bragging about.

Indeed, world growth is expected to crawl along at 1.1% this year. Europe's economy is still in slow motion, and--once again--Japan's will be in reverse. What's worse, there's no sign yet of a non-U.S. productivity pickup that would produce a global New Economy-style boom. In Europe, for example, the latest data show productivity growth averaging a resounding 0%.

So, with all this bad news, why expect a recovery at all? In part because many companies have already chopped inventories so much that even the slightest blip up in demand will require some spending to meet it. And that will benefit even hard-hit industries such as steel. "Many of our customers have shrunk down their safety stocks [of steel]," says Robert S. "Steve" Miller Jr., chairman and CEO of No. 3 U.S. steelmaker, Bethlehem Steel Corp. (BS ) "I am cautiously optimistic about this."

Moreover, consumers are still benefiting from low interest rates, falling energy costs, and the income tax cuts passed last June. Taken together, these could mean a 3% boost to personal income, says Bruce Steinberg of Merrill Lynch. That should keep consumer spending afloat even as unemployment rises.

During the boom of the 1990s, companies bet on fast growth and sky-high goals. But this year, patience and moderate expectations are going to turn out to be virtues. The economy is going to grow, but slowly--and that will feel better than the dreariness of 2001.

By Margaret Popper, with Tom Lowry in New York, Michael Arndt and Julie Forster in Chicago, Andrew Park and Wendy Zellner in Dallas, and Amy Barret in Philadelphia

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