U.S.: When Will Corporate America Pry Open Its Wallet?
A key theme resonating among business economists is the belief that 2003 will bring broader and more consistent economic growth--in short, a recovery that feels like one. But no matter how compelling the argument, the year begins with a nagging question: How do we get from here to there?
A true recovery depends on the willingness of businesses and investors to take risks. Without it, investors won't invest, financiers won't finance, and businesses won't make commitments to future growth in the form of new capital spending and new hires.
But risk-taking has been rare for two years now, with predictable results. Even as household spending rose 3.8% in the year after September 11, businesses cut their investment in equipment and buildings by 5% and slashed payrolls by 1.2 million workers. As a result, the economy's 3% growth rate, while a solid pace, felt unsatisfying.
The problem at the start of 2003 is that new uncertainties are reinforcing this risk-averse behavior. While hostilities with Iraq loom ever more imminent, worries over an oil-price spike have grown because of the strike in Venezuela, which supplies more than 10% of U.S. crude. At yearend, oil was nearly $33 per barrel, a two-year high. Fresh concerns over North Korea's nuclear weapons program are casting another shadow. Simply put, until these unknowns are cleared away, don't expect Corporate America to contribute much to the recovery. And without it chipping in, the economy cannot attain a higher, more fulfilling growth rate.
HOW WILL WE KNOW when this risk-related gridlock is easing? Several key indicators will point the way, including orders for capital equipment, the credit spread between corporate and government bond yields, stock prices, and bank lending.
Taking these in order: Capital-goods orders reflect business sentiment and the willingness of companies to spend on future growth. In November, core equipment orders, which exclude commercial aircraft and military hardware, fell 2.2% from October, and the trend is flat (chart). Falling prices for tech items mean the actual volume is crawling higher, but businesses are mostly buying to replace old gear, not to expand capacity.
In addition, shipments of core capital goods weakened last quarter, suggesting that capital spending will add little, if anything, to fourth-quarter growth in real gross domestic product. In today's risky climate, that trend is unlikely to change in the first quarter.
Another measure to watch is the difference between what corporations pay to borrow in the credit markets and the rate paid by the government, whose bonds are seen as riskless. In late December, the rate for BBB-rated, 10-year corporate bonds was 7%, vs. 4% on 10-year Treasuries, for a gaping credit spread of three percentage points. The gap has narrowed recently, but it remains unusually wide, a sign of investors' aversion to risk. The spread is wider than in 2000, after the NASDAQ's collapse, and as wide as it was after the September 11 attacks (chart).
The stock market also captures risk attitudes, which is why it often foreshadows economic growth. Despite its rally since October, the Standard & Poor's 500-stock index was off about 23% in 2002, the third consecutive year of losses. True, questions about the profits recovery still dog stock prices, but Iraq and other anxieties are also distorting the earnings equation.
Finally, keep an eye on bank lending, especially commercial and industrial loans. These loans, which are used primarily to finance inventories and materials, are a key indicator of businesses' desire to beef up inventories to support future sales. For nearly two years, C&I loans have been headed straight down, and in recent months, banks have become stricter in their lending to small businesses. However, note that surveys by the Federal Reserve show that banks have been reporting declining demand for C&I loans since 2000. Falling loans are not a sign of a credit crunch; they are evidence of little willingness to expand output.
BUT WHILE EXECUTIVES concentrate on avoiding risk, they seem to be giving short shrift to the strengthening of economic fundamentals, which typically drive future earnings. Profits in 2003 will benefit from current stimulative policy, strong productivity, and rising consumer spending. So far, those aspects of the brightening profits outlook have been largely ignored.
One encouraging report: The Conference Board's composite index of leading indicators jumped 0.7% in November. The broad gain erased all of the four losses incurred in the summer. Compared with its May level, the index is flat, far from the Board's rule-of-thumb that a 2% decline over six months means recession.
Another reason for optimism is the continued resilience of consumers. Of course, the downbeat reports about holiday shopping would seem to indicate that consumers are tired of spending. But those results may be deceiving, especially since the reports have come mainly from retailers. Many stores had to discount merchandise heavily to make sales. That strategy means many retailers will be reporting dismal profits for their fourth quarter, which ends in January, unless after-Christmas sales pick up sharply.
BUT FROM THE CONSUMER'S SIDE, price-cutting meant shoppers got much more merchandise without shelling out more bucks. Bear in mind that, for GDP purposes, consumer spending is adjusted for price changes and includes services. So while profit-hungry retailers were disappointed by the holiday season, real consumer spending probably grew at least modestly in December, after rising a strong 0.5% in November.
Grinchy Christmas stats aside, two other recent reports show that consumers may remain committed to the recovery. Real aftertax income is on track to grow at a healthy annual rate of about 2.4% in the fourth quarter, despite the sluggish job market. With incomes rising, consumers have little reason to cut back.
Home sales are on a tear. In November, purchases of new homes rose 5.7%, to a record annual rate of 1.07 million (chart). Existing homes sold at a 5.56-million pace. Thanks mainly to low mortgage rates, sales of both new and existing homes in 2002 will post their best year ever.
Home sales are a good indicator of future consumer spending for two reasons. First, they show how confident consumers are about the future, because taking on a mortgage is a long-term commitment. Second, homeowners have to furnish their new digs. So the wave of home sales in 2002 means more purchases of furniture, textiles, and other home-related goods in 2003.
Even so, the lesson of 2002 is that the economy needs more than stalwart households. But getting businesses and investors to shoulder more of the recovery burden will depend on how non-economic factors play out in coming months.
By James C. Cooper & Kathleen Madigan