Why the Optimists May Be Right
All year, investors and corporate chieftains have been at odds with economists. The former don't see a recovery and don't trust the future. The economists say the upturn is here, and the future looks good. Who's right? Federal Reserve Chairman Alan Greenspan has his money on the economists. He told bankers in Montreal on June 4 he felt that the dichotomy would be resolved by "the business community coming closer to the economists."
Let's hope he's right. Investors need some good news on the economy to offset a multitude of other worries. Corporate profits last year suffered one of their severest beatings in the postwar era. Now, terrorism and other geopolitical risks are also roiling the markets, not to mention CEO arrests and various government inquiries. "The post-Enron uncertainty surrounding corporate financial reporting and the tarnish on Corporate America have raised perceived risks in stocks," says economist Richard Berner at Morgan Stanley.
However, while investors may be pessimistic, Berner and others are sticking to their view of a lasting recovery and a profits rebound. Why? "Much of the uncertainty plaguing the financial markets is not associated with the underlying fundamentals of the economy," says Greg Mount of Bank One in Chicago. BusinessWeek's midyear survey of business economists shows that, on average, the forecasters expect real gross domestic product to grow at a healthy, if unspectacular, 3% annual rate during the second and third quarters, with the pace picking up to 3.5% in the first half of 2003 (table). Inflation will remain tame, they say, and the Fed will maintain its current, very stimulative policy into late summer or early autumn.
To be sure, economic growth will not repeat the first quarter's 5.6% gallop any time soon. Some of that gain resulted from a post-September 11 snapback as well as a sharp swing in inventories, and some was borrowed from the second quarter, reflecting stronger-than-usual demand during an exceptionally mild winter. Those factors could slow second-quarter real GDP growth to less than half the first quarter's pace.
But economic fundamentals point to healthier growth in the second half--a prospect investors appear to be overlooking. "The market has placed scant attention on compensating positive developments, such as renewed job growth, strong productivity gains, a weaker currency, fiscal stimulus, and firming export demand," says Richard DeKaser of National City Corp. in Cleveland. Moreover, the Fed's post-September 11 rate cuts, totaling 175 basis points, are only now beginning to work through the economy. These pluses will keep consumer demand growing and generate the profits needed to spur capital spending and inventory rebuilding.
Investors and economists are most sharply divided about the outlook for profits. Investors are taking their cues from dour CEOs, and in the current climate, corporate execs have every reason to be conservative. "The risk-reward trade-off is such that being wrong on the conservative side will pay major dividends to the stock price, while being wrong on the optimistic side will be greatly penalized," says Joel L. Naroff of Naroff Economic Advisors. Plus, as Greenspan noted in Montreal, the lack of pricing power means the recovery is not yet painting the buoyant profits picture that CEOs like to see.
The economists' optimism on profits stems from exceptional productivity and restraint on pay. Result: the steepest two-quarter drop in unit labor costs in two decades. That's why profit margins are widening though pricing power is constrained. So even in a mild recovery, any growth in top-line revenues will head straight to the bottom line.
Already, the trend can be seen in the data. The Commerce Dept.'s economywide measure of operating profits posted gains from the previous quarter in both the fourth and first quarters. And economists expect solid gains from a year ago by yearend (chart). Notes Bruce Steinberg at Merrill Lynch: "Operating earnings per share for the Standard and Poor's 500-stock index in the first quarter were up about 2% from a year ago, the first positive reading in a year and a half." He also points out that S&P profit margins widened sharply last quarter.
Economists are cautiously optimistic about future capital spending, as more profits are likely to spur it. Forward-looking indicators are already improving: First-quarter outlays for information-processing equipment posted their first rise in a year. April orders for nondefense capital goods, excluding aircraft, jumped sharply. And in May, output of both computers and semiconductors rose by double-digit rates compared with their year-ago levels.
But the capital-spending recovery will not have the vitality of the late-1990s boom because of current low factory operating rates, the capacity glut in telecom, and weak executive confidence. "If CEOs are benchmarking themselves against the profit levels of a few years back, then they may feel that business is still rather poor, and that could damp what would otherwise be a healthy pickup in capital spending," says Kevin Logan of Dresdner Kleinwort Wasserstein.
Financing problems won't hold back capital spending. By the first quarter, cash flow of nonfinancial corporations had recovered all of 2001's losses, with help from the government's new accelerated-depreciation allowances. Internally generated funds now cover nearly 90% of outlays for capital projects and inventories, up dramatically from last year. Also, sources of funds outside of the equity market are starting to open up. In contrast to stock investors, bond investors actually see less risk in lending to corporations, as shown by the smaller premium that corporations must pay on their bonds over riskless U.S. Treasuries. Even for the riskiest loans, "quality spreads in high-yield bonds, excluding telecom, have fallen, reflecting the improving economic outlook," says John E. Silvia of Wachovia Bank in Charlotte.
Financial conditions will continue to ease the longer the Fed refrains from lifting interest rates--and economists keep pushing that date further into the future. The Fed has never tightened before the jobless rate starts to fall, so "the primary trigger for a retightening of policy will be clear signs of a recovery in the labor markets," says Ethan Harris at Lehman Brothers. Given corporate efforts to lift productivity and cut costs, that will take a while.
But that doesn't mean consumers will bow out of the recovery. Job markets are already firming up, albeit gradually. And, while rapid productivity growth initially helps profits, especially at cutting-edge companies, consumers benefit in the long run. "History demonstrates that the big winners overall will be wage earners, and therein lies the most durable support for lasting expansion," says Robert V. DiClemente at Salomon Smith Barney/Citicorp. Why? Productivity keeps inflation tame, so even smaller gains in pay yield increased buying power.
Household income gains, an accommodative Fed, and signs of a profit recovery make it easy for economists to be optimistic about the outlook. Their hardest job now is to convince investors and CEOs that they're right.
|Corrections and Clarifications Because of a production error, the table ``BusinessWeek's Midyear Economic Forecast Survey for 2002-03'' (BusinessWeek Investor, July 1) was mislabeled. The eighth and ninth columns of numbers were projections for the federal funds rate at the end of the fourth quarter, 2002, and second quarter, 2003 respectively. The last column contained projections of the month for the first Fed rate hike.|
By James C. Cooper and Kathleen Madigan
With James Mehring in New York