U.S.: The Soft Patch Is Giving Way to Solid Ground

Gains in corporate profits and real household income bode well for 2003

Has the soft spot run its course? It's starting to look that way. Layoffs are ebbing. Consumer confidence is turning up. The stock market rally is holding. And a few regional surveys show that industrial activity is firming up. What's more, the Commerce Dept. says that third-quarter growth was much stronger than its first estimate and that corporate profits were up from year-earlier levels.

It's beginning to look like the fourth quarter's weakness was front-loaded, with a generally poor October giving way to stronger activity in November. That pattern will not prevent the quarter's growth in real gross domestic product from looking anemic, but it means that momentum is building, a plus for the economy early next year.

The Commerce Dept.'s upward revision of last quarter's growth, to an annual rate of 4%, from 3.1%, helps explain why the fourth quarter's weakness won't last. In a nutshell, overall demand never collapsed the way many consumers, executives, and investors had feared. Economywide purchases of goods and services rose 3.5% last quarter, even as many businesses were hesitating on hiring and capital spending, and even as consumers said they were losing confidence.

Most significantly, the upward revision means that last quarter's advance in productivity was even stronger than the already handsome 4% annual rate originally reported by the Labor Dept. That helps explain why both corporate profits and real incomes of households have made solid demand-supporting gains over the past year. Those are the key fundamental forces that will continue to drive the economy forward.

THE TURNAROUND IN PROFITS is crucial, since earnings and cash flow are the fuel that will drive the rebound in capital spending, long the laggard in this recovery (chart). Commerce's accounting of corporate operating earnings shows that profits last quarter, while dipping 1.8% from the second-quarter level, posted a solid 12.2% increase from the year before.

Commerce's profits data may be of little use to investors, who need timely reports from individual companies and who see third-quarter earnings as old news. But investors, especially those skeptical of company reports, should take note that Commerce's accounting is consistent in its treatment of inventories and depreciation. It attempts to expense the cost of exercised stock options, and it is based on reports from thousands of companies large and small. It is thus representative of the entire economy and not skewed toward any industry, such as tech, media, or energy.

The 1.8% quarterly dip in profits reflects some loss of pricing power among corporations, but beyond that, the numbers need to be read carefully. The problem goes back to the fourth quarter of last year, when Commerce's measure of operating earnings soared 18.1% from the previous quarter. That jump reflected March legislation that gave corporations a generous, one-time, retroactive allowance for depreciation. Earnings this year have not been able to maintain that exaggerated level. They have, in fact, posted small quarter-to-quarter declines, ranging from 1.6% to 1.8% in each quarter. Making matters even more confusing, Commerce's measure of fourth-quarter earnings is bound to show a drop from the inflated level in the fourth quarter of 2001.

NEVERTHELESS, the 12.2% earnings increase from the year before, the second strongest yearly gain since 1997, indicates the profits upturn is real. In particular, the surge in productivity is cutting unit labor costs and lifting margins. Unit profits of nonfinancial companies are averaging 8.6 cents per dollar of real GDP so far this year, says Commerce, up from 7.9 cents in 2001.

The GDP revisions, moreover, show the profits improvement was not solely on the cost side. A steady increase in demand also is helping to lift earnings. Commerce's data show that overall sales to consumers, businesses, and government are up 2.5% from the previous year, the best annual pace in nearly two years (chart). While shoppers took a breather in September, they still seemed willing and able in October to continue playing a big role in propelling demand forward.

Plus, households' faith in the future took a turn for the better in November. The Conference Board's index of consumer confidence rose 4.5 points, to 84.1 (chart). Consumers are somewhat less jittery about future employment conditions, and the stock market rebound probably lifted the mood among households as well.

Consumers' brighter spirits are also reflected in their holiday shopping plans. In a separate report, the Conference Board said families expect to spend an average of $483 on gifts this holiday season, up 5% from last year's budget. A good yearend shopping season would mean real consumer spending will head into the first quarter at a high level.

ANOTHER IMPORTANT GUIDE to how consumers view the future is their home-buying attitudes, and their willingness to commit to a mortgage remains high. Not only did Commerce report that third-quarter residential construction was stronger than first estimated, but housing demand remained solid in October. Resales hit an annual rate of 5.8 million, a six-month high, with the median home price increasing 9.8% from the previous year. New home sales decreased 4.5% in October, but that was down from a record high in September.

Low mortgage rates, which remain near 6% for a 30-year fixed loan, have helped to keep demand strong, and rising home prices are adding wealth to household balance sheets. The capital gains from homeownership are helping to offset the downdraft from wealth losses in the stock market.

With the recent pace of new-home sales running faster than that of housing starts, new home construction may yet have some potential for further gains in coming months. In early November, builders said market conditions were still improving. The National Association of Homebuilders index, a measure of current and expected demand and buyer traffic through model homes, rose to 65, the highest level in two years.

Given housing's contribution to economic growth over the past two years, the sector is unlikely to add much in 2003. And construction's performance in the first quarter can be especially problematic, since a harsh winter could cut into building activity.

That leaves the other major sectors to carry the economy. Right now, the fundamentals for consumers and businesses, along with the expectations of some fiscal stimulus and a global turnaround, look favorable for demand in 2003. So while housing may not be a star performer next year, other sectors seem primed to move the economy past its current soft patch and onto firmer ground.

By James C. Cooper & Kathleen Madigan

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