A Real Recovery Is Coming Into View
You've heard this forecast before: The economy will pick up in the second half. That's what economists were saying -- wrongly -- this time last year. Now, they're peddling the same line for 2003. Should we believe them this time?
You bet. The combination of positive supports for stronger growth is the most powerful since the boom turned to bust three years ago. Everything from stimulative policy to friendlier financial conditions to waning geopolitical uncertainty is falling into place. These factors will serve as fuel to keep consumers spending, plus they'll provide the higher octane needed to rev up capital spending on new equipment and facilities. That has been the missing link between this wannabe recovery and the real thing.
THE SIGNS POINT UP
"Absent further shocks, there is every reason now to expect confidence and activity to rise sharply," says Ian Shepherdson at High Frequency Economics. That's the general view of the 30 economists polled by BusinessWeek in its midyear outlook survey. All but one forecaster expect growth in the second half to be stronger than in the first. The only real disagreement is over how much stronger. On average, they foresee 3.5% growth in the second half, picking up to 3.75% in the first half of 2004. However, 19 of the forecasters see at least one quarter of 4% growth or higher in the coming year, and several think their projections are more likely to be too low than too high.
Economists also admit to being off the mark last year. Joseph Liro at Stone & McCarthy Research Associates acknowledges his overly optimistic forecast for 2002 with a ready "mea culpa." But forecasters can be forgiven for missing the shocks that occurred. The fact is, the recovery was starting to pick up steam early in 2002, after the tragedy of September 11. Then last spring, corporate scandals sent the markets and business confidence skidding. Autumn brought yet another jolt, as the Bush Administration began to beat war drums. That drew down a darker veil of uncertainty, further depressing the stock market and business sentiment. "The economy has been suffering from chronic shock fatigue," says Michael Carey at Crédit Lyonnais.
Now both consumers and businesses seem poised to kick it up a notch, especially with both the Federal Reserve and Capitol Hill ready to help out. "There's enough stimulus from monetary and fiscal policy to make a strong recovery likely," says Henry Willmore at Barclays Capital (BCS ) The economic bang from the Bush tax plan promises to add somewhere between 0.5 and 1.5 percentage points to growth in the coming year, say the economists. Adds Donald Straszheim at Straszheim Global Advisors: "The most important aspect by far of the tax bill is the cut to 15% on dividends, which greatly raises the attractiveness of those assets." That, plus the cut in the rate on capital gains to 15%, will add an estimated $23 billion to the economy over the next year and a half, on top of the $120 billion in tax breaks for wage earners and the nearly $50 billion in incentives for businesses.
Even absent the tax cut, most economists were expecting a second-half rebound. Overall financial conditions, including interest rates, stock prices, and the dollar, are more accommodative to growth than at any time in three years. Stock prices have rallied, and the economists, on average, expect the Standard & Poor's 500-stock index to rise about 7%, to 1,070 by June 30, 2004. The dollar is down from its restrictively high levels, especially against the euro. Banks' lending standards are less stringent. And in the credit markets, the spread between corporate and Treasury bonds has narrowed sharply, a clear sign that the markets are assigning a lower level of risk to investment activity.
These financial boosts should extend into 2004. Because the Fed will remain on guard against deflation, forecasters expect policymakers to keep short-term rates low well into next year, even as the economy perks up. That means long rates will also stay exceptionally low -- a boon for housing, mortgage refinancing, and the repair of household and corporate balance sheets.
Moreover, both households and businesses will eventually benefit from lower oil prices. The price of oil is down from its peak of $38 per barrel just before the Iraq war, but it remains close to $30, in part because of the delays in getting Iraqi oil flowing again, even as natural gas prices remain high. Still, most economists expect oil to be cheaper a year from now. The rule of thumb is that lower oil prices add about 0.5 percentage points to growth for every $10-per-barrel decline.
DEMAND LIES WAITING
Most important of all, healthier financial conditions and a potent policy mix boost the outlook for capital spending, the key to a strong and sustained recovery. Corporate outlays for tech equipment are on the rise, and the trend in capital-goods orders is turning up. Gene Huang at FedEx (FDX ) notes that the two-year slide in business construction is bottoming out. "Hopefully, this is an indication that the adjustment phase in capital spending is approaching an end," he says, "if it hasn't already ended."
Not only are external financial conditions the brightest in three years, but internal sources of funds, boosted by rising profits and depreciation and lower interest costs, have improved. The cash flow of nonfinancial corporations has swollen to levels far above those seen during the late 1990s boom. In the first quarter, cash flow was sufficient to cover 90% of all capital spending, the highest such coverage in a decade.
At some point, businesses must satisfy their growing pent-up demand for equipment. "Much of the equipment we have in our factories and workplaces is just plain wearing out," says Diane Swonk at Bank One (ONE ). "Indeed, evidence suggests we have now underinvested after overshooting the mark in the late 1990s." The data bear her out. For the past five quarters, capital spending by nonfinancial corporations has lagged behind depreciation. That means the stock of productive assets in the economy is shrinking, something that has never happened in the post-World War II era.
If so, the coming rebound is hardly the stuff that deflation is made of, and, in fact, none of the economists think deflation is a serious threat. Kurt Karl at Swiss Re ticks off four reasons: The Fed is prepared to take strong action, service-sector inflation is currently near 3%, the dollar's decline is lifting prices of imports and the goods that compete with them, and stronger growth will make deflation a moot point. Robert Shrouds at DuPont (DD ) is more direct: "Face it. Greenspan has won. This is price stability. What's the problem?"
That may be true, but a couple of nagging problems remain. One is the labor markets. Cost-conscious companies, intent on boosting productivity and profits, will keep hiring in check. Another issue is weak growth abroad. "Help from the G-8 countries is needed, says Allen Sinai at Decision Economics, "particularly through easier monetary policy in the euro zone, Britain, and eventually in Canada." However, much-needed structural reforms in Japan, Germany, and the rest of the euro zone are equally crucial to getting global growth back on track.
Of course, just as accounting scandals and war derailed last year's forecast, another shock could make this midyear forecast feel like déjà vu all over again. But absent a new jolt, the forecasters make a strong argument that the conditions for the long-awaited rebound are now firmly in place.
By James C. Cooper & Kathleen Madigan
With James Mehring in New York