Why the Bounceback Won't Be Quick

On Jan. 30, the Federal Reserve left interest rates unchanged after 11 rate cuts, and investors cheered. The Fed's hands-off approach to monetary policy this time around signaled to many that the economy had bottomed out. And that perception was significantly reinforced by shrinking inventories, which in late 2001 were 4.1% below their high point a year earlier, according to Commerce Dept. statistics. With inventories fast declining, Corporate America would soon begin ramping up production, with higher profits sure to follow.

Not quite. Despite the impressive falloff in inventories, business profits aren't likely to come charging back. Why? Inventories may well fall even further. Many companies are afraid that history will repeat itself. They got burned once when they began restocking at a rapid clip in late 1999 in anticipation of disruptions from the Y2K computer virus--which never came. Last year's economic slowdown dampened demand. Then, after the September 11 attacks, businesses turned gun-shy about rebuilding inventories, fearing the economy-deadening aftereffects of terrorism. So now, cautious managers are likely to let their inventory levels fall at least through the summer, and maybe longer, say economists. "Firms don't see demand turning up quickly," says David Huether, chief economist at the National Association of Manufacturers. "Growth in profits will be gradual."

Working off excess capacity in the hard-hit telecom sector, where many companies wildly overestimated demand last year, could delay a profit rebound for years at such companies as JDS Uniphase (JDSU ), Ciena (CIEN ), or Corning (GLW ). But worries about demand also exist in healthier sectors of the economy. Heavy equipment maker Deere & Co. (DE ), for instance, says it will rebuild inventories only as orders come in. In fiscal 2001, the company cut stocks by $400 million, or 7%. This year, the goal is to lower inventory by an additional $400 million. "As things turn up, we may not turn up our production as much as generally thought," says Chief Financial Officer Nathan J. Jones.

Not everyone is cutting. General Motors Corp. (GM ) says it will increase first-quarter production by 20,000 vehicles, to 1.32 million, an 8.7% increase year to year. And Fortune Brands Inc. (FO ), a maker of office supplies such as Swingline Staplers, expects inventories to pick up soon. Fortune Brands CEO Norman H. Wesley notes that buyers have been emptying stockrooms for over a year now. "We should be at a point where, particularly when the economy turns, we should see the reverse effect and see some positive growth," Wesley says.

Overall, Diane C. Swonk, chief economist at Bank One, expects inventory investment to stay negative until the third quarter, when she forecasts a reversal--and corporate profits rising 4.8% year to year. In other words, Corporate America will eventually restock its shelves and recover. Just don't look for it until late in the year.

By Laura Cohn in Washington, with Michael Arndt in Chicago

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