U.S.: In with the New Year, Back to the Old Rules

Time-tested fundamentals will drive growth, but slowly

It looks like the beginning of a mood swing. Consumers are more optimistic. Their assessment about the future soared in December to the highest level since before September 11. And orders for capital goods--a good proxy for business sentiment--are up strongly two months in a row. While emotions are ephemeral, rising confidence is the most concrete evidence yet that the weakness in the economy is starting to ease up.

But even though the economy may be hitting bottom, there is nothing to suggest a return to the go-go days of the late 1990s when consumer spending grew at a hefty 5% or 6% annual rate and business executives felt compelled to buy the hottest new equipment. Instead, 2002 will see the return of the back-to-basics economy.

Growth this year will be driven by time-tested fundamentals, not unsustainable fads. First, forget the wealth effect from stock-price bubbles. Consumer spending in 2002 will grow more in line with gains in take-home pay. Second, companies will take a more prudent approach to new technology as more realistic expectations about sales and profits will dictate capital budgets. Last, despite the promise of just-in-time delivery systems, businesses have learned that the inventory cycle is not dead. Thankfully, though, inventory rebuilding will supply an important boost to growth this year.

The latest data on consumer confidence, durable goods orders, and industrial activity show that these traditional forces were influencing the economy at the end of 2001 (charts). Signs of improvement, especially in manufacturing, suggest that the recession may soon be over. But because there is no strong catalyst for growth, the recovery will be far more sober than the typical upturn.

EVEN SO, consumers are upbeat about the future. The Conference Board's index of consumer confidence jumped to 93.7 in December from November's 84.9. Almost all of the gain came from a surge in expectations about the economy six months from now. The expectations index jumped more than 14 points, to 91.5, its highest reading since August. Household assessment about the current situation edged up slightly.

The board said consumers' moods might have reached a plateau in part because of "a stabilizing employment scenario." The recent drop-off in new claims for unemployment benefits supports that notion. Progress in the war in Afghanistan, the fourth-quarter stock-market rally, and lower energy prices probably boosted sentiment as well.

Moreover, consumer actions underscore their feelings. Retailers were disappointed by Christmas sales, partly because of consumer wariness over the current economy and partly because deep price cuts robbed profits. But because the future looks brighter, consumers are willing to make the long-term commitment to a mortgage. In November, new home sales rose 6.4%, to an annual rate of 934,000, and sales of existing homes gained 0.6%, to a 5.2 million pace.

Unseasonably warm weather lifted the November data, but housing remains one of the U.S.'s most resilient sectors. In the eight months since the recession began, new-home sales have averaged 887,000 per month, down only 4% from their pace of the eight months before the economy's peak. In the 1990-91 recession, homebuying collapsed by 16.1%.

But because housing hasn't suffered much, it is unlikely to add significantly to real gross domestic product in 2002. That's a big reason why the recovery will be mild. For the first quarter, a return to more normal weather and the recent uptick in mortgage rates could knock the housing data for a loop. But the 2001 rise of new homeowners sets the stage for continued spending gains on home goods such as appliances and electronics.

DEMAND FOR HOMEGOODS and other consumer items, however, will depend on how fast incomes grow in 2002, a trend that was evident in the fourth quarter. In October and November, real aftertax income was up 2.1% from a year ago and real consumer spending increased 2.9%. Back in 1999, when households used their stock-market gains or credit-card reserves to finance many of their purchases, real income rose 2.4%, but consumer spending soared by 5.6%.

This shift in behavior isn't hard to figure. Stock portfolios got hammered over the past two years, so investors aren't touching their holdings. And the recession has made many households think twice about taking on more debt. The new attitude means consumer spending will increase at a subdued rate in 2002, closer to 2% or 3% rather than 5%. It also suggests that the factory rebound, when it comes, won't be very strong.

THE BEST NEWS FOR MANUFACTURERS, therefore, is that excessive inventories will be much less of a drag on production in 2002. When demand soured in 2001, companies had to pare their stock levels by a record amount. This old-fashioned inventory cycle cut more than one percentage point from growth in real GDP last year. Business inventories likely shrank by the largest amount on record in the fourth quarter.

The December data from the Institute for Supply Management, formerly the National Association of Purchasing Management, suggest that inventories have finally shrunk so much that companies are increasing orders and production. The purchasing managers' index rose to 48.2% in December, from 44.5% in November. Inventories were drawn down for the 23rd month in a row. And the indexes covering new orders and production both rose above 50%, a sign that demand and output of manufactured goods increased last month for the first time since the autumn of 2000.

The extended drawdown of inventories has been led by nondefense capital goods, including high-tech equipment. The ratio of tech inventories to sales has slipped for three consecutive months and is now at its lowest since April, 2001. But now, with inventories in better shape, companies feel more confident and are ordering supplies and equipment again. November durable goods orders fell 4.8% after a defense aircraft-related jump of 12.5% in October. But nonmilitary capital goods rose 4.8% in November on top of a 5.9% advance in October (chart). That was the strongest two-month gain since January, 2000, and it was led by increased bookings for motor vehicles, computers, and electrical machinery.

The gain in capital-goods orders is a sign that executives think demand will rise enough over the next year to justify expanding capacity. To be sure, the factory sector isn't out of the woods yet. The latest data suggest only that, after 16 months of decline, manufacturing is finding a bottom.

Indeed, consumers and businesses seem to sense that the worst is over for the economy. But even as the business cycle takes a turn for the better, the old rules concerning spending and income and investment and profits will apply ever more importantly in 2002.

By James C. Cooper & Kathleen Madigan

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