The Economy: Half-Speed Ahead!

Despite signs that growth is picking up, a glut in manufacturing capacity will slow recovery

As recessions go, the downturn of '01 has been unprecedented. The housing market has stayed strong, and consumer spending has held up. Two other forces, however, have really done serious damage: a deep dive in production as manufacturers worked off bloated inventories, and the sharp collapse of capital investment. After a buying binge in the late 1990s, U.S. companies suddenly found themselves with too many goods and too much manufacturing capacity. Their response: savage reductions in capital spending and inventories. Together with the fallout from the September 11 terrorist attacks, those factors drove the economy into its first recession in a decade.

Now, though, there are signs that some of the business bloodletting may be easing, especially on the inventory side. The fall in inventories has been nothing short of breathtaking, with manufacturers, wholesalers, and retailers getting rid of stocks at a record clip. Manufacturers alone have slashed stocks by $30 billion over the past year. Indeed, they have been cut so extensively that many companies are now finding their cupboards nearly bare.

For the hard-pressed U.S. economy, that's mighty fine news. After a year of cutting production, companies from auto giant General Motors Corp. (GM ) to optical-fiber maker Corning Inc. (GLW ) are finally starting to rev it up to ensure they have enough inventories on hand to meet current and future demand.

Just getting back into gear, though, won't bring about a full-fledged recovery. For that to happen, companies must start to boost capital spending once again. But with manufacturers operating at just 75% of capacity, the lowest level in 18 years, a strong upturn in capital spending remains a long ways off. Still, the need to rebuild inventories is a necessary first step on the road to recovery, and a sign that the economy may well have bottomed out. "Companies have done a lot of housecleaning," says Morgan Stanley economist Richard Berner. "The recession appears to be ending."

Nowhere is that more true than in manufacturing, the sector which has borne the brunt of the downturn. On Jan. 8, the Commerce Dept. reported that factory orders outside of the defense sector rose 0.8% in November after jumping 2.9% in October. The first back-to-back increase in nondefense orders in nearly a year, those numbers signaled that the beleaguered manufacturing sector may finally be on the mend. "Our order book has ticked up in the last month significantly," says United States Steel Corp. (X ) Chairman and CEO Thomas J. Usher. Even better: Some manufacturers, including steelmakers and chip and chemical companies, have seen enough of a revival in demand to raise prices.

News like that has Federal Reserve Chairman Alan Greenspan and his colleagues growing more hopeful that the economy may have weathered the worst, even if they're not yet ready to declare that a full-fledged recovery is underway. "The economy is at or near bottom," New York Federal Reserve Bank President William J. McDonough told reporters on Jan. 8 in Frankfurt. Such hedged optimism may signal the willingness of central bankers to forgo cutting interest rates again when they next meet on Jan. 29-30.

Even in the most battered of industries, there are clear signs that the wholesale slashing of inventories is coming to an end and that production is starting to turn up. Take Corning, the world's biggest maker of optical fiber, a market that has been decimated by the collapse of the telecommunications industry. The company announced on Jan. 4 that it was restarting production at four plants after it succeeded in bringing inventories in line with sluggish sales. "It's not like we are going from zero to a hundred miles an hour in one day," cautions Corning Chief Financial Officer James B. Flaws. "This will be a slow ramp-up." But it is a ramp-up nonetheless.

Another sign of emerging need to rebuild inventories: renewed pricing power in the semiconductor industry. Companies are raising chip prices as customers, particularly PC makers, are restocking after a better-than-expected Christmas season. South Korea's Samsung Electronics Co. (SSNLF ), the world's No. 1 memory chip maker, has raised prices three times since the start of December, by more than 50%.

Much of the recent progress on the inventory front has come from Detroit. The fall's 0% financing offers allowed the Big Three and their dealers to clear out huge amounts of swollen stock. At yearend, the Big Three's auto stocks totaled 2 million vehicles, a 26% drop from the end of 2000. "Our inventory levels are in a nice position," says General Motors Vice-Chairman and Chief Financial Officer John M. Devine. As a result, the company, which launched an across-the-board $2,002 cash rebate on all its vehicles in early January, is stepping up production 7% in the first quarter, to 1.3 million vehicles.

Detroit's other two auto giants, however, are playing it safe. DaimlerChrysler's Chrysler Group (DCX ) is holding production steady in the first quarter. Ford Motor Co. planned to slash output by 9% but is likely soon to revise first-quarter production plans upward. Shrinking market share made both companies cautious about their winter sales prospects, especially after the 0% financing deals pulled sales of one million autos, industrywide, into the fourth quarter of 2001 from the first quarter of '02. They worry, too, about the global glut of capacity that is hanging over the entire industry and acting as a deadweight on prices and profits. North America alone can produce three million vehicles more than are sold here in a good year.

Retailers are in much the same position as the auto makers. Like Detroit's Big Three, they pulled forward quite a bit of demand into the Christmas selling season through massive and widespread discounting. And they're stuck with too much capacity after a 1990s' store-building boom. That's got retailers and their suppliers vigilant on costs. "Whether it's inventory or personnel decisions or capital expenditures, it's a time to be conservative, not aggressive," says Frank D. Bracken, president of apparel maker Haggar Corp. "That's the way we're playing the game."

Indeed, even if the economy is bottoming out, few executives have forgotten that a surfeit of capacity remains through much of the economy. That excess capacity is likely to keep a lid on capital-spending plans for many months to come. In fact, a December survey by the Institute for Supply Management found that manufacturing companies expect to slash capital spending by nearly 15% this year. Says Daniel R. DiMicco, CEO of Nucor Corp. (NUE ), the nation's largest steelmaker. "Companies are going to have to start making money before they loosen their purse strings on capital spending."

Most recessions end with a bang as depressed consumer spending springs back and companies feverishly restock their shelves with inventory. But with businesses still reeling from the bust of '01, this recovery is more likely to start with a whimper.

By Rich Miller in Washington, with William C. Symonds in Boston, Robert Berner in Chicago, Wendy Zellner in Dallas, Jim Kerstetter in San Mateo, and bureau reports

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