U.S.: This Recovery Isn't Going to Stall Out
Business leaders and investors have a lot on their minds these days. Uncertainties over the Middle East, oil prices, and terrorism. Ongoing Enron Corp. and accounting fallout. And now, concerns over the liability of Wall Street brokerages stemming from the activities of their analysts. All this is casting a pall over how people value companies via the financial markets and how they feel about future investment decisions.
However, the latest data on the economy strongly argue that any gloomy view should not extend to assessments of the recovery. The economy grew at a robust 5.8% annual rate in the first quarter, suggesting a stunning productivity gain last quarter and an increase in profits. Moreover, inflation is a no-show, workers' buying power is up sharply, and the Federal Reserve is happy to keep monetary policy extremely stimulative.
More important, first-quarter growth in real gross domestic product was balanced between inventories and sales to consumers, businesses, government, and foreigners. A sharply slower rate of inventory liquidation created an $83 billion swing in inventories, which contributed 3.1 percentage points to GDP's 5.8% gain. Final sales added the other 2.7 points. This near-equal mix of inventories and demand is essential for a sustained upturn.
Equally critical for the outlook is that demand is spreading beyond consumers. Exports grew last quarter, tech outlays began to recover (chart), and businesses are spending on old-line machinery. In addition, the latest survey of companies by the National Association for Business Economics shows a steep increase in first-quarter demand, which was evident in almost all industry groups. That means this recovery will not have to depend on one sector to provide momentum.
TO BE SURE, second-quarter growth is slowing from the first-quarter's blistering pace, which was boosted by several special factors: Unusually good weather helped housing, military spending boosted government outlays, and the rapid shift in inventory positions won't be repeated this quarter. But all this is neither a revelation nor cause for worry. Keep in mind that growth was borrowed from the second quarter, not the second half.
The industrial sector began the second quarter in good shape. The nation's purchasing managers said that industrial activity continued to rise in April, although at a slower pace than in March, with broad gains in production, orders, and prices--all signs of improving demand (chart).
Already in the first quarter, sectors that had been drags on GDP growth are now contributing to demand. For example, real exports rose at a 7% pace last quarter, the first increase since the summer of 2000. The gain was all in services, but exports of goods dipped only 1%, after huge losses last year, which cut a half-point from 2001's GDP growth. As the global recovery gains strength, exports will pick up further.
Overall net exports, the tally of exports minus imports, subtracted 1.2 percentage points from the quarter's GDP gain. But, again, that's an indication of the strength of demand: Domestic spending pulled in a flood of foreign-made goods last quarter. Imports surged 15%, swamping the gain in exports. Adding spending on imports back to the mix, domestic demand grew 3.7%, about the same as the fourth quarter's 3.9% pace.
SOME OF THAT INCREASED DEMAND is coming from companies. Overall business outlays for equipment and software fell 0.5% last quarter, but that reflected a 24.5% plunge in transportation equipment, mainly cars and trucks, which had been boosted in the fourth quarter by special sales incentives.
Business spending on information-processing gear, about half of the total, rose 7.5% last quarter, the first rise in more than a year. And purchases of traditional industrial machinery jumped 16%, also the first increase in a year. Corroborating these gains, first-quarter industrial output of tech equipment jumped 17%, and imports of capital goods surged 27%. Both were the largest increases in more than a year and a half.
The capital-equipment sector is in the early stages of an upturn, which will gather speed when businesses come to appreciate that demand is firming and that profits are turning around. Indeed, many companies have projects with high expected returns sitting on the drawing board, just waiting for the go-ahead.
You can't blame businesses for being cautious after one of the worst collapses in profits in the postwar era. However, the profits outlook is rapidly improving. The GDP data suggest that productivity grew at an annual rate of about 7% last quarter, after a 5.2% surge in the fourth quarter. That would be the largest two-quarter gain in nearly 20 years--and unit labor costs will post the largest two-quarter drop since then.
The result: Despite weak pricing power, profit margins are widening, and economywide earnings, measured by the Commerce Dept., will post a solid advance when the data are released on May 24. Keep in mind that the earnings of the 500 companies in Standard & Poor's stock index are not added up the same way. And while the S&P earnings are important to stock prices, they do not represent the makeup of the overall economy.
A RETURN OF CAPITAL SPENDING and foreign demand will take the pressure off consumers, who have led this recovery with a 6.1% jump in spending in the fourth quarter and a 3.5% advance in the past quarter. Households cannot maintain that pace as they deal with higher fuel prices and waning stimuli from tax cuts and mortgage refinancings.
However, consumer spending still has plenty of support, and households remain optimistic despite all the uncertainties. The Conference Board's index of consumer confidence slipped to 108.8 in April, from 110.7 in March, but it held on to nearly all of its 15.7-point jump in March. Crucially, households' assessments of job-market conditions have stopped falling.
Confidence is holding up because, despite meager job growth, workers are generally seeing big increases in the buying power of their pay. The first-quarter employment-cost index, which covers pay and benefits, grew 3.9% from a year ago. Although that pace has slowed somewhat, it far exceeds that of inflation. In fact, real wages over the past year have grown 3%, twice as fast as the pace this time last year (chart). Even excluding the bonus from cheaper energy, real wages are still up 2.5%.
At some point, CEOs' decisions to delay capital spending plans and investors' desires to hoard cash and bonds will no longer make economic sense. Indeed, given that stocks and bonds appear to be priced based more on current worry than on current reality, some market surprises could be in store later this year, as evidence of a lasting recovery continues to mount.
By James C. Cooper & Kathleen Madigan