U.S.: The Hot-and-Cold Recovery Could Warm Up Soon

After a slow fourth quarter, the economy should gain momentum in 2003

When stock prices plunged 28% from mid-May to late July, the fear was that the stock market would derail the recovery because consumers would stop spending and businesses wouldn't make any money. Those fears helped to push stocks even lower by early October.

But a funny thing happened on the way to economic collapse: Consumers kept buying cars and homes, and many companies showed good gains in third-quarter profits. More fundamentally, the economy continued to enjoy some benefits that have been constants over the past year or more. Namely, robust productivity growth helped to lift both real household incomes and profit margins, and monetary policy remained quite accommodative. Consequently, when the Commerce Dept. reports the quarter's growth in real gross domestic product on Oct. 31, the numbers are likely to show a solid advance, probably in the 3%-to-4% range.

To be sure, the economy didn't weather the market's summer slump totally unscathed. Companies, especially those in manufacturing, appear to have taken a breather in late summer (chart). Industrial output fell in August and September, and many companies showed new hesitancy to lay in inventories or expand payrolls. In addition, consumers were less optimistic about the economy by the quarter's end than they were in July.

As a result, the economy began the third quarter strongly, but finished at a weaker pace. That sets up some difficult math for fourth-quarter GDP growth, since many sectors started this quarter at levels that were lower than their third-quarter averages. So the fourth-quarter GDP data will likely look disappointing.

BUT BEFORE INVESTORS, consumers, and executives resurrect their double-dip recession fears, they should remember that the monthly pattern of activity in this quarter will set the stage for 2003 growth. For instance, the wave of refinancing applications through mid-October means extra cash will be flowing to many homeowners throughout all of the fourth quarter. Plus, inventories probably ended the third quarter at a record low relative to sales. And since demand, especially by consumers, shows no sign of petering out, skimpy inventories will spur industrial orders and output. Add in the constant pluses of good productivity gains and low interest rates, and it is easy to see how the economy will end the fourth quarter on a stronger note, a positive trend for growth in early 2003.

Of course, the economy will still need to get through this quarter, and the news now is not all good. For instance, the Conference Board's index of leading indicators, designed to foreshadow economic trends, fell 0.2% in September, the fourth decline in a row. However, stock prices and two other related indicators accounted for most of the index' weakness since May. So the forecasting accuracy of the index in coming months will depend largely on how good the stock market is at predicting economic growth--and historically, its record has been spotty.

A BIGGER CONCERN for the fourth-quarter outlook is the increase in business caution. The summer's new uncertainties, especially about future demand trends, fell back most notably on manufacturers. Overall industrial production fell in September for the second month in a row, as did output in the factory sector alone, down 0.2% and 0.3% in August and September, respectively. Those declines followed solid growth over the previous seven months, and industrial surveys suggest that output dipped again in October.

The September industrial weakness was especially evident in business equipment. Production in this crucial sector had turned up from May to August after a long period of decline. Then, September equipment output dropped 1.7%, a sign that some businesses put their capital spending plans on hold this summer.

Some of those spending plans may now be moving forward again, given that the stock market has rallied and appears to be holding on to its gains amid many upbeat third-quarter profits reports.

Businesses should also begin to look more favorably on the future, as long as consumers keep spending. Consumers may say the market slump has rattled them, but they continue to have enough faith in the future to commit a sizable amount of future income to the purchase of a home. Record sales of new homes in August fueled a 13.3% surge in housing starts in September. The monthly increase was the largest in seven years and boosted housing starts to the highest level since 1986. Plus, increases in home buying always lift consumer spending for home-related goods.

With consumers still willing and able to buy, some businesses that were overly cautious in recent months may get caught short of merchandise in coming months. The August ratio of overall business inventories to sales was far below its long-run trend, suggesting that stockpiles are already too low. If retailers' dire concerns about the holiday shopping season turn out to be exaggerated, the need to build up inventories will set the manufacturing recovery back on track.

AN ONGOING PROBLEM for U.S. manufacturers, however, will be that a lot of that inventory rebuilding will come from foreign factories (chart). That was clear from the government's August report on foreign trade, which showed a huge widening in the trade deficit, from $35.1 billion in July to $38.5 billion in August. Imports jumped 2% from July, and so far this year, they are growing at an annual rate of 23.1%.

But companies that export may also feel some pressure in coming months. Exports plummeted 1.3% in August, and growing weakness in the euro zone will be a factor limiting growth this winter, particularly against the backdrop of continued strength in the dollar.

Manufacturers are also getting hit by a lack of pricing power, thanks to global competition and excess production capacity. Over the past year, consumer inflation has been running at 1.5%, with core inflation, excluding energy and food, at 2.2%. However, those numbers mask sharply divergent trends in goods and services (chart). Core service prices in September were up 3.6% from a year ago; core goods prices fell 1.1%.

Factory capacity utilization stood at 74.2% in September, well below its long-run average of about 81%, and import prices were still down from a year ago. With that in mind, it's little wonder why goods producers are so skittish, since their returns on investments in new equipment, inventories, and workers depend heavily on the revenues their goods generate.

However, businesses' worst fears from this past summer--that demand and the economy were falling off a cliff--have not materialized. A key feature of this recovery has been its jumpy growth pattern. And once the economy gets through the current soft period, this up-and-down recovery will head up again.

By James C. Cooper & Kathleen Madigan

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