U.S.: With Spending Paralyzed, the Economy May Just Limp Along

Consumers as well as businesses appear to be waiting for the war's end

Business plans are only as good as their underlying assumptions. One critical assumption executives made when laying out their 2003 company forecasts was that any war in Iraq would be over by the start of the second quarter, and its end would bring stronger demand that would let companies reap the benefits of two years of cost-cutting and productivity gains.

Well, it's now April, and after two weeks of fighting, earlier expectations of a quick and clean ouster and disarming of Saddam Hussein are giving way to prospects of a longer and potentially messier U.S. involvement in Iraq, especially given the unanticipated resistance of the Iraqis. As a result, uncertainty continues to hamper planning, depress sentiment, and send markets up and down like yo-yos.

Even before the war, economists were cutting their expectations for first-quarter growth to levels similar to the fourth quarter's poor 1.4% pace. The latest prewar data are generally awful. Consumer spending in February fell for the second month in a row, something that hasn't happened since the last recession began two years ago. And in March, purchasing managers said industrial activity has tumbled to levels also not seen since the recession. Now, forecasters are slashing second-quarter expectations, and the unknowns about the war and its aftermath are throwing second-half projections up in the air as well.

Fearing that a prolonged effort to secure Iraq and maintain peace in the region will curb demand, business executives are starting to rethink 2003, which they had hoped would be a breakout year for Corporate America. New perceptions on the slower execution of the war could also delay and reduce tax cuts previously expected to kick in by midsummer. All this threatens to keep capital spending in mothballs, turn hiring plans into layoff contingencies, and cut into profit expectations for the second half.

THE WAR'S TOLL on the boardroom is clear in a survey of chief financial officers conducted by Duke University's Fuqua School of Business (chart). The poll, taken in March on the eve of the war, shows that the percentage of CFOs in the first quarter who were "less optimistic" about the economy was higher than at any time in the past two years, including after September 11. Companies were deferring capital projects because of war-related uncertainty, with two-thirds saying they were spending cautiously or holding off on all capital investment. Also, the survey showed the CFOs' expectations that the longer the war, the more their companies' revenues would suffer.

Worries about profits are also being voiced by Thomson Financial First Call, which surveys analysts' earnings expectations. It pointed out that the ratio of negative to positive pre-announcements for first-quarter earnings has risen to levels not seen since the last recession. That "does not provide much encouragement for the second quarter of 2003," First Call noted.

DESPITE THE DARK CLOUDS over business, many companies do have the ability to move forward with spending plans as well as the streamlined cost structure to make money. But nothing will happen until the war is over. According to the Commerce Dept.'s latest data on economywide corporate profits, profit margins for nonfinancial corporations, measured as profits per unit of output, at the end of last year had inched back up to their highest level since mid-2000 (chart).

The upbeat Commerce numbers on fourth-quarter profits were surprising given the quarter's sharp slowing in growth, strongly suggesting the benefits of productivity gains. Operating earnings for nonfinancial corporations rose 6% from the third quarter, more than making up for that quarter's 2.5% decline.

Moreover, net cash flow at nonfinancial companies has been on a steadily rising trend for nearly two years. For all of last year, it was sufficient to cover 90% of all capital expenditures among nonfinancial companies, similar to the coverage in the mid-1990s as the investment boom was taking off.

These results show that by improving productivity, cutting costs, and gaining some amount of control over their excess capacity, many companies have positioned themselves to take full advantage of the increased demand that was supposed to burst forth after the war -- demand that would then be turbocharged by tax cuts and stimulative monetary policy.

That may yet happen, but for now, the economy must continue to negotiate a treacherous path. The U.S. involvement in Iraq is shaping up to be more protracted than what businesses, households, and investors expected when the first laser-guided bomb found its target. Amid the unpredictability of the war and its consequences, the business sector is hard-pressed to make sense of the future and meet existing sales-and-profit goals.

THE GROWING CONCERN is that the economy's weaker-than-expected showing so far this year will continue into the second half. The main worry is consumer spending, which fell in January and February and doesn't appear to be bouncing back in March, according to weekly store surveys. That suggests that real consumer outlays, as they enter into the gross domestic product data, grew at an annual rate of only about 1% in the first quarter. That would be the weakest quarterly showing for consumer spending in 10 years.

Auto makers have brought out 0% financing again to try to lure buyers in April. Their success will be a key indicator of the willingness of households to keep spending this quarter and beyond. A second-half boost to consumer spending was supposed to come from the Bush tax plan, which at one point had been expected to add about $100 billion in fiscal stimulus from mid-2003 until the end of 2004. Now, concerns about the cost of the war are already making politicians rethink the magnitude of the cuts, and a protracted conflict could delay any plan. If consumers keep their wallets closed for a while, the recovery would be at risk.

Another particularly ominous economic report was the March Purchasing Managers' Index, showing a third consecutive drop in industrial activity. The three-month decline in this highly watched indicator is the largest in about 20 years, and the weakness in March was across the board, from orders to production to employment. Taken together, the recent erosion in consumer spending and industrial activity, along with evidence of a weakening labor market even before the war started, suggest that the overall economy limped into the second quarter.

With all this playing out in the middle of a war of unknown length and consequences, it's easy to see why businesses are resigned to sitting tight. Right now, economic players all appear to be waiting for the war to end. The question is, will the recovery shrivel away before the war is over?

By James C. Cooper & Kathleen Madigan

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