U.S.: Will War Bring Down the Rickety Recovery?

With nerves on edge, only the housing market looks solid

Pollyanna must feel very lonely right now. A new round of pessimism is ruling the day as war with Iraq appears more imminent. Consumers are less confident about the economy. Business executives are so skittish they won't invest in their companies' futures. And wary investors are sending stock prices tumbling. Could this triumvirate of gloom trip up the recovery?

That's the new worry. On the surface, the economy's prospects seem good. At the end of 2002, consumers were hanging in there, and home sales and construction were still going strong. Plus, the White House and the Federal Reserve are putting a massive amount of stimulus in the pipeline.

None of that may matter in early 2003, however, if the attention of consumers and businesses is riveted on military action in Iraq--with its possible unintended consequences. For months, the Iraq situation has been on the minds of the markets and economic forecasters, but now, this heightened level of anxiety comes at a bad time: just when the economy is trying to climb out from its fourth-quarter soft patch. The Fed recognized these risks at its Jan. 28-29 policy meeting, at which it left interest rates unchanged, but it did not hint at any further cuts in rates. It noted that "oil price premiums and other aspects of geo-political risks have reportedly fostered continued restraint on spending and hiring by businesses."

The reluctance of businesses to expand or add new inventories or increase their payrolls is a sign that business confidence remains in the dumps. This corporate paralysis adds to broader worries about the economy. Consumer confidence dropped in January, as expectations fell sharply (chart). And President George W. Bush's State of the Union address on Jan. 28 only focused more attention on the urgency of the Iraq issue.

CONSUMER SPENDING IS THE GLUE holding this rickety recovery together, and that's the key sector to watch early in 2003. The combination of job worries and rising energy prices is already draining consumer confidence. Now, louder war talk and its negative impact on the stock market are weighing more heavily on the consumer's psyche.

In January, the Conference Board's index of consumer confidence fell to a nine-year low of 79, from 80.7 in December. "With the threat of war looming, consumers have grown increasingly cautious about the short-term outlook," says the Board's Lynn Franco.

The good news is that, despite households' growing worries about the future, they noted a general improvement in their present situation. Their assessments of current job market conditions improved, perhaps related to the recent downtrend in new claims for jobless benefits.

But expectations tend to drive consumer spending. That index fell seven points, to 81.4, held down by concerns about future job gains. Still, the expectations index is above the 70-75 range when worries begin to slow spending. In fact, January surveys of retail chain stores show brisk activity.

THE TREPIDATION OF Corporate America is the biggest drag on this recovery. Recent numbers show that, after making slow progress in the first half of last year, businesses pulled back considerably in two critical areas last quarter: capital spending for equipment and outlays for inventories. Now, with the outlook unclear for the months immediately ahead, many executives will remain stymied and unable to help the recovery.

Through December, factory orders were going nowhere. In particular, core orders for capital equipment, which exclude the volatile ups and downs in commercial aircraft and defense, dipped 0.1% after falling 3.1% in November. For the quarter, orders declined after increasing during the first half of 2002 (chart). Core shipments of capital goods last quarter dropped for the first time in a year.

Relentless anxiety over Iraq, the economy, and profits is also slamming the stock market, which creates its own psychological drag on businesses and households. The Dow Jones industrial average has lost some 700 points since Jan. 14. Note, however, that the drop has occurred despite evidence that the recovery in corporate earnings continues to make good headway. BusinessWeek's preliminary tabulation of fourth-quarter corporate profits shows that income from continuing operations, excluding extraordinary items, is up 37% from the year before (page 30).

Another downdraft from Iraq is higher oil prices, with very large consequences for business costs and household budgets, especially given the very cold winter across most of the country. Oil prices continue to hover at around $33 per barrel, up $6 from only two months ago. Higher fuel costs will probably shave only a smidgen off first-quarter economic growth, but the bigger concern is what happens when the shooting starts. Every recession since the early 1970s has been preceded by a steep runup in oil prices.

ONE SECTOR THAT CONTINUES to buck the gloom-and-doom trend is housing. Fueled by 30-year fixed mortgage rates that are still below 6%, new single-family home sales rose 3.5% in December, to an annual rate of 1.08 million. Existing home sales, meanwhile, jumped 5.2%, to a 5.86 million clip. Both new and existing home sales reached new highs in 2002 (chart). As a result, a record 68.3% of households now own their homes.

Home sales are unlikely to make huge gains in 2003, but they probably won't collapse either. Mortgage rates will start rising again only when the credit markets sense that the Fed is ready to raise short-term rates, and that's a long way off. Meanwhile, income growth should be solid enough to support homebuying. The biggest obstacle could be supply: In December, builders had only a 3.8 months' supply of new homes for sale, while the current inventory of existing homes would last only 4.2 months. Both are historically low levels.

Sparse inventories, however, are pushing builders to break ground on new projects. The Housing Market Index compiled by the National Association of Home Builders, which measures builders' assessments of market conditions, stood at 64 in January, down just a bit from December's 65. Taken together, the readings of the past two months are the highest since early 2000. The frigid weather might skew the government's January data on housing starts and construction jobs, but a return to more normal winter weather in February would allow the numbers to bounce back.

Until the tensions with Iraq are resolved, however, homebuilders may be the only optimistic group in the economy. The collective gloom among consumers, executives, and investors hasn't yet derailed the recovery. But right now, this economy has very little maneuvering room between expansion and recession, and it cannot afford many missteps.

By James C. Cooper & Kathleen Madigan

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