U.S.: Forget the Double Dip--This Recovery Has Legs

Consumer--and business--spending figures bode well for the second half

At the end of 2001, when economists planned out their recovery forecasts, most were certain that the early stages of an inventory turnaround would boost economic growth in the first half. That scenario is playing out as expected. But analysts were less sure about how strong demand would be, fueling the worry that the rebound could peter out in the second half.

That's why data showing that spending by consumers and businesses is coming on peppier than expected are welcome news. The result: First-quarter growth will be the strongest in nearly two years. More important, healthy gains should be sustained into the second half.

It all starts with consumers. True, first-quarter car sales fell back from their incentive-inflated fourth-quarter level. But despite that, consumer spending last quarter not only held up but also posted a surprisingly solid advance. Inflation-adjusted outlays for goods and services rose a strong 0.5% in February, following a 0.3% increase in January. Those gains put consumer spending on track to grow at an annual rate in the neighborhood of 3.5% for the quarter (chart). That's a surprisingly good performance, coming after the fourth quarter's 6.1% surge, and it's enough to add more than two percentage points to the quarter's growth in real gross domestic product. Homebuilding should add at least another half-point.

HOUSEHOLDS HAVE BENEFITED from a number of special supports--including tax breaks, cheap energy, and money from mortgage refinancing. Those supports will wane in coming months, especially given the recent jump in oil prices, but real incomes should continue to rise at a pace that will sustain at least moderate growth in spending.

Households' real aftertax income got a big boost from the January cut in tax-withholding schedules. Real income jumped 1.7% from December, about four times greater than without the tax cut. Yet in February, incomes managed a solid 0.6% increase. During the past year, real household incomes have grown slightly less than 4%.

To be sure, that pace will cool off. Slack labor markets will result in smaller gains in take-home pay, and costlier gasoline will lift inflation. However, the squeeze on buying power will very likely be slight in coming months. And later on, as the job markets turn around, more people will be earning paychecks.

Households are not the only source of improving demand. Government, especially military outlays, will add to growth. And slowly but surely, businesses are starting to shell out more for new equipment. That shift is clear in the trend of factory orders. Bookings for capital equipment, excluding the volatile swings in aircraft, rose 0.9% in February, after a 0.7% gain in January. Capital-goods orders are set to post their first quarterly advance in nearly two years.

Moreover, first-quarter shipments of capital equipment are also above their fourth-quarter level, suggesting that equipment outlays in the gross domestic product data, due out on Apr. 26, will score a small gain as well. That would represent a major turning point. In the past five consecutive quarters, equipment investment has declined, causing a huge drag on GDP growth.

High tech, central to last year's slump in capital spending, is also showing signs of life. Orders for information technology gear are rising, and a March survey of chief information officers at 268 companies shows that they plan to lift their outlays for IT equipment by 7.7%, on average, over the next 12 months. That's the fastest planned gain since March, 2001, and it's up sharply from 3.2% in February and from only 1% in January. The survey was conducted by CIO Magazine in coordination with Deutsche Bank Alex. Brown Inc.

ONE KEY to the capital-spending turnaround is the improving outlook for profits and cash flow. Commerce Dept. data show that the profits recovery began in the fourth quarter. After adjustment for current replacement cost of inventories and capital equipment (instead of historical costs that companies report for tax purposes), profits jumped 17.9% from the third quarter, the first increase since the summer of 2000. Strong productivity gains and cost-cutting ensure another big increase in profits in the first quarter as well.

Corporate cash flow also posted a sizable gain, helped by the government's enhanced allowances for depreciation. Net cash flow jumped 8.5% from the third quarter, when it had risen 1.5% from the second quarter. Although Commerce's adjusted profits are 3% below a year ago, cash flow now stands 5.3% above year-ago levels. So companies headed into 2002 with a growing reserve of internal funds, which makes them less dependent on the financial markets for investment capital.

SOME OF THE EXTRA CASH will be used to rebuild inventories. Forecasters are counting on the upswing of the inventory cycle to add as much as two percentage points to the first half's annual rate of GDP growth.

Businesses are already easing up on their pace of inventory liquidation. Factory stockpiles shrank by 0.8% in January and then by just 0.4% in February (chart). That compares with an average of 1% in each month of the fourth quarter, when record inventory cuts subtracted more than two percentage points from real GDP growth. Some industries, such as pharmaceutical, home appliances, and construction equipment are beginning to build up their stock levels. More businesses should follow suit, as companies accept that demand has staying power.

The upswing in the inventory cycle is greatly improving the outlook for manufacturing. The March Purchasing Managers' Index, calculated by the Institute for Supply Management, indicated that the factory recovery picked up steam in March. That means manufacturing had some momentum heading into the second quarter. The March PMI rose from February's 54.7% to 55.6%, the best reading in just over two years. Production fell back a bit after jumping in February, but the index covering new orders rose further to 65.3%, a 14-year high (chart).

The ISM said that the average of the PMI in the past three months is consistent with real GDP growth of 3.9%. The survey also showed that inventory liquidation decelerated further in March, and it noted another increase in the percentage of purchasers who think their customers' stock levels are too low.

A few weeks ago, Federal Reserve officials and investors on Wall Street began to recognize that this recovery shot out of the gate at the start of 2002. Yet their worry remains that the economy might not make it past the first turn, let alone maintain momentum for a whole year. However, the most recent data showing increased tech orders, a manufacturing turnaround, and resilient consumers should dispel those fears. The recovery is here--and it's going to hang around a while.

By James C. Cooper & Kathleen Madigan

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