The Economy Is Still in Limbo

War fears, weak profits, and slow growth are pushing hopes of recovery back to the second half of 2003

As President George W. Bush strode jauntily into the packed House of Representatives chamber on Jan. 28 to deliver his State of the Union speech, the Salesman-in-Chief faced two daunting and distinctly different tasks: He had to press his case against Saddam Hussein and convince an increasingly skeptical American and world public that Iraq's leader poses a clear and present danger to the U.S. He also had to dispel worries about the economy now spreading among consumers, companies, and investors that threaten to turn a soft growth patch into something far worse.

Going by instant opinion polls, Bush succeeded in mustering support for his bellicose stance toward Iraq. But when it came to calming fears about the economic outlook, he looks to have fallen short. Only about one in three of those surveyed by ABC News after Bush's big speech said they felt more confident about his handling of the economy.

Part of the problem, of course, is that Bush's twin goals are contradictory, at least in the short run. The threat of war with Iraq is hanging like a cloud over the economy. It's eroding consumer confidence. And it's dampening the animal spirits of business leaders and other risk takers who are the soul of a capitalist economy. Faced with the possibility--however slim--that a war with Iraq could go horribly wrong and that oil prices could skyrocket, Corporate America is conserving cash and delaying plans to take on more workers, rebuild inventories, and step up capital investment. "The uncertainty of such an extraordinary event like war paralyzes planning," says Gary C. Kelly, CFO of Southwest Airlines.

But growing uneasiness about the economic outlook isn't just a case of war jitters. The sudden burst of optimism with which the stock market greeted the new year wilted in late January in the face of a string of squishy economic statistics and a clutch of cautious, if not downright pessimistic, business forecasts. As one CEO after another ratcheted down earnings expectations for the upcoming year, investors suddenly had to face the fact that the profits revival that was hoped for early in 2003 won't come until the second half--if then. The big fear: that the post-bubble U.S. economy will remain stuck in a twilight zone between full-fledged recovery and outright recession for yet another year. "Iraq is a scapegoat," says strategist Laszlo Birinyi Jr. of Birinyi Associates in Greenwich, Conn. "The news coming out of major companies is bad."

The sudden spate of grim news hit Wall Street hard. In just 10 days, the Dow Jones industrial average lost 10%. By Jan. 27, it had given up all of its gains since the first of the year and finished below 8000 for the first time in three months, though it later recovered somewhat. Foreign investors, too, are increasingly dumping U.S. stocks--as well as the dollar--adding a sliding greenback to the economic woes. On Jan. 27, it touched $1.09 to the euro, a 39-month low against the suddenly muscular currency.

For now, the potential for war is arguably the biggest drag on the economy. While companies have been holding back on capital spending since the boom collapsed in 2000, the increasing uncertainty over Iraq has further hobbled corporate decision-making. War jitters are clearly showing up in the numbers. Orders for nondefense capital goods (excluding aircraft) fell 0.1% in December after dropping 3.1% in November. "Because of the fear and uncertainty, everyone is being cautious about spending," says DuPont CFO Gary M. Pfeiffer. "It's only prudent to defer anything that is deferrable." That's why he plans to spend just 40% of his $1.6 billion capital spending budget in the first half.

Consumers, too, seem to be getting the jitters. After powering last year's recovery, free-spending Americans may finally be pulling back. Retail sales, excluding autos, were flat in December, compared with the previous month. And on Jan. 28, the Conference Board reported that its consumer-confidence index fell to 79, from 80.7 in December, the lowest level in nine years. "We're assuming the economic and competitive environment will continue to be difficult," says Karen Houget, CFO of Federated Department Stores Inc.

The bleak outlook is prompting companies across the spectrum to lower their earnings guidance. Cost-cutting helped average corporate earnings grow at a relatively robustly pace in fourth quarter, 2002--Thomson First Call is expecting gains of nearly 13%. But it sees profit growth falling to 9% in the first quarter and just 6% in the second. Worse, First Call figures that 7 of the 11 sectors that make up the Standard & Poor's 500-stock index will tally lower profit growth for the first quarter than analysts had expected as recently as January.

Add it all up, and the economy has stalled considerably. Data due out on Jan. 30 were expected to show that gross domestic product growth slowed to below 1% in the fourth quarter, following the 4% surge in the third, according to Morgan Stanley. And expectations that GDP growth would hit 3% to 31/2% in the first half are now being trimmed to 2% to 21/2% by some economists. That kind of growth almost certainly will mean more unemployment. David A. Wyss, chief economist at S&P, believes the jobless rate could hit 61/2% by midyear, up from 6% now.

This combination of war jitters, weak profits, and slowing growth is affecting not just the stock market but the dollar, too. After dropping 18% against the euro in 2002--its worst annual performance since 1987--the dollar fell 3.5% more in January. Currency experts say the slide that started last February also reflects a longer-term cyclical downtrend. Three years of stock market losses and low interest rates are driving foreign investors back home or to higher-yielding assets elsewhere, such as emerging markets. The growing U.S. current-account deficit is also a problem. The gap is now as wide as 5% of gross national product--historically a trigger point for a dollar sell-off. "The currency will have to adjust," says Rebecca Patterson, senior currency strategist at J.P. Morgan Chase & Co.

Given the continued pall over the economy, the question is whether it will finally begin to gather the strength for a sustained rebound in the second half. Much, of course, depends on what happens in Iraq. Clearly, if things go badly or the U.S. gets bogged down, all bets are off. Oil prices would skyrocket, and investment would remain frozen. But what if the war is executed swiftly and uncertainty disappears? Optimists predict that a quick victory would lower oil prices, spark a market rally, boost confidence, and prompt businesses to dust off spending plans.

Perhaps--but it might not be so easy to resolve the economy's underlying problems. Excess capacity left over from the boom remains a major brake on growth. U.S. manufacturers are using just 73.6% of their facilities. "We have a way to go," says S&P's Wyss. Consumers are becoming increasingly tapped out. Many corporations, too, remain saddled with heavy debt and weak balance sheets, curtailing their ability to expand. But ultimately, demand will be the big hurdle. Without a pickup in orders to fuel growth, the recovery will remain tepid.

Much will depend, too, on whatever stimulus is passed. In coming months, Congress and the White House will be locked in a death struggle over Bush's economic package, which opponents deem too expensive and insufficiently stimulative. If the economy remains weak, pressure for stronger short-term stimulus will grow. Once the horse-trading is done, perhaps by midyear, bipartisan support may grow for extra money for cash-strapped states. New tax breaks for business investment could also be added. But the only thing certain these days is uncertainty itself.

By William Symonds in Boston, with Rich Miller and Richard S. Dunham in Washington, and bureau reports

    Before it's here, it's on the Bloomberg Terminal.