U.S.: After a Frugal February, the Consumer Rides Again

With the war over and retail sales up, the second half looks brighter

A quick glance at some of the recent economic data will tell you that it's way too soon to start celebrating a new dawn in the U.S. economy. Since this sham of a recovery began more than a year ago, expectations from the boardroom to the family room have been kicked around like a soccer ball, thanks to one extraordinary event after another. Trying to divine any sense of the economy's future has been all but impossible.

But maybe, just maybe, a first inkling of light on the horizon is signaling brighter days. One ray is the surprising speed and precision with which the war in Iraq was carried out, while keeping the oil fields safe, limiting collateral damage, preventing wider Mideast turmoil, and avoiding any new domestic terrorism. Big questions remain, of course, but the military achievements so far have bested nearly all expectations, and some of the uncertainty that had weighed so heavily on the U.S. and global economies is beginning to lift.

Another sliver of light is the U.S. consumer. Early data had suggested that a falloff in consumer demand was imminent. But in March, households served notice that news of the death of their spending was greatly exaggerated (chart). Moreover, household confidence bounced up in early April, obviously reflecting the successful war effort.

Improving the jaded attitudes of business executives and investors will be tougher. CEOs will measure confidence not by the way they feel, but by the volume of new orders they book. Wall Street, which is shifting its attention from Iraq to the economy and profits, is stuck looking at mostly dismal prewar data, such as the downbeat March reports on industrial production and payroll employment. The key postwar data won't arrive until late spring, and those will be the real test of how the second half is shaping up.

THE LATEST NEWS from households is especially encouraging. The Commerce Dept.'s measure of March retail sales rose 2.1% from February. Except for the auto-related surge in spending following September 11, when zero percent financing was introduced, that was the largest monthly increase in 10 years.

The Commerce results are in sharp contrast to the soft March sales reported by individual chain stores. But that performance is measured from year-ago levels. And in 2002, Easter occurred in March; this year it falls in April, making the year-ago comparisons for March look unduly weak.

Strong auto sales also boosted March's total, but even excluding cars, sales still posted a solid 1.1% advance. The strong March showing, plus an upward revision to February sales, means that economic growth in the first quarter may not be as dismal as some forecasters had feared. Moreover, weekly surveys of store sales in early April show an exceptionally strong pickup in buying activity, compared with March. That suggests that second-quarter spending is off to a solid start.

HOUSEHOLDS CONTINUE TO SHOW keen interest in buying homes. Actual building and sales data are still prewar, but mortgage applications through early April have picked up again after a steep slide in March. The four-week average of applications to buy a home stands at the highest level since last summer, as mortgage rates remain exceptionally attractive.

In addition, builders are upbeat about the future. In March, housing starts rose a solid 8.3%, reversing the weather-related drop of 10.4% in February. The National Association of Home Builders' index of market conditions in April held at the low March level, but the NAHB said that builders' optimism about conditions six months ahead surged. Builders noted that attention to the war had depressed sales temporarily.

On the refinancing front, applications are coming off their record high, hit in March, but the first-quarter surge means extra cash will help to support consumer spending in the second quarter (chart).

Given the bounce in household spending, it now appears that the weak winter data were distorted by the temporary effects of severe weather, war worries, and higher energy prices, all of which are now turning around. That was true for industrial production, which fell 0.5% in March, after a 0.1% dip in February. Excluding a weather-related drop in utilities output, production fell only 0.2% last month, and all of that reflects a drop in only one sector, auto output. Even there, the return of cheap financing should boost car sales this spring and lift production schedules.

If consumer demand continues to look stronger this spring, activity in the industrial sector will follow suit. Retailers have cut their inventories to levels that, when compared to sales, are extremely low by historical standards. The same is true for manufacturers and wholesalers. As demand picks up, reordering will feed into additional production very quickly.

ONE DRAG ON THE ECONOMY that will take a longer time to reverse is weak foreign demand. Yearly U.S. export growth in the first quarter was only half that of imports. Weak export gains won't prevent a recovery in industrial activity, but they will limit the rebound. The latest forecast from the International Monetary Fund projects only 1.1% growth in the euro zone this year, compared with 2.2% for the U.S., and only 0.8% for Japan. Moreover, the severe acute respiratory syndrome (SARS) outbreak in Asia threatens major damage to the economies of that region. U.S. exports to emerging Asian nations have accounted for more than half of the growth in overall U.S. exports in the past year.

Yet even though foreign demand is weak, U.S. exporters are reaping some competitive advantage from the dollar's depreciation over the past year. Perhaps more important, because the weaker dollar is pushing up import prices, some additional pricing power is starting to show up at the early stages of U.S. production, and the trend in the prices of retail merchandise shows less need for stores to discount so deeply (chart). Just a smidgen of pricing power will boost the bottom lines of many companies, especially since they will keep a close eye on costs this year.

One common view of the outlook right now is that the excesses of the late 1990s are still holding back the economy, and to some extent that may be true. However, after three years of cutting capacity, reducing inventories, adjusting balance sheets, restating earnings, and lowering expectations, it is becoming increasingly difficult to argue that those excesses remain major deterrents to growth.

That notion will be put to the test this summer. With war uncertainty lifting, the current exceptionally stimulative mix of monetary and fiscal policy will have the opportunity to work its magic on domestic demand, perhaps unfettered by any more extraordinary events. And just maybe, this recovery finally will start to act and feel like the real thing.

By James C. Cooper & Kathleen Madigan

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