Taking a Cue from Investors
The financial markets smell economic recovery in the air. Share prices are soaring as investors bet on a second-half rebound of the economy, fueled by tax cuts and ultra-easy monetary policy. After rising by 15% in the second quarter, its best performance in 4 1/2 years, the Standard & Poor's 500-stock index added to its gains as the new quarter began, rising a further 2.8% in early July. And the dollar is back in favor as foreign investors see the U.S. leading the way to global recovery. Even the tanking bond market reflects rising hopes for an economic upswing: Bond investors are shucking off their fears of deflation and fleeing the safety of low-yielding government securities for riskier equities.
The investor enthusiasm is starting to percolate into corporate suites. Encouraged by the ebullient stock market, CEOs are starting to shift their focus from fortifying their balance sheets to expanding their businesses. That bodes well for the recovery. It has been cautious corporate chieftains who have been mainly responsible for holding the economy back by keeping such a tight rein on investment and hiring. While they're not yet partying like it's 1999, top executives are clearly feeling better. "Three, four, five weeks ago, we were very despondent," says G. John Pizzey, president of aluminum maker Alcoa (AA ) Inc.'s primary products group. "Now, we may be headed in the right direction."
The positive signs are multiplying. Corporate confidence jumped in the second quarter to its highest level in a year, according to a Conference Board survey of 100 executives. Why? "Their stock is up, and that puts them in a better mood," says Ken Goldstein, an economist with the business research group. It's a spending mood. Capital spending, especially on information technology equipment, is reviving. The moribund mergers and acquisitions market has come alive, with everyone from old-line manufacturers to New Economy software houses taking advantage of the runup in the value of their shares to buy up other businesses. On July 8 alone, three deals totaling nearly $4.5 billion were launched. Even the scandal-plagued market for initial public offerings is showing signs of life.
Still, a robust turnaround is hardly a sure thing. The risk is that investors may get carried away in their enthusiasm. Share prices, especially for technology companies, have already risen a lot (page 22). A further price spike followed by a sudden sell-off could spook corporate CEOs, sending them scurrying back to their foxholes. In the bond market, the global nosedive has already driven up long-term interest rates sharply. If the sell-off goes too far, the rate hike could squelch the still-buoyant housing market and puncture consumer confidence, which is already a bit shaky because of increasing unemployment levels.
So far, though, the rise in rates hasn't hurt a bit. The main effect has been to drive investors to buy stocks instead of bonds. In July, net inflows to U.S. bond mutual funds slowed to about $1.9 billion a week from over $4 billion in March, according to strategist Thomas McManus of Banc of America Securities ( BAC ). At the same time, net investment inflows into U.S. stock funds are running about $2.6 billion -- in contrast to the $2 billion-a-week outflow in March.
The reviving stock market is acting like a tonic for business executives. A June survey by Goldman, Sachs & Co. analysts found that 24% of information technology managers of big companies expect more tech spending in the second half of 2003. The message was much the same from a separate survey carried out by the National Association for Business Economics. Its roundup, released on July 8, found that capital spending rose in the second quarter for the first time in more than two years. And further increases are in store, partly because of stepped-up depreciation tax breaks that were recently passed by Congress. "We are seeing some signs of a recovery," says Daniel C. Ustian, CEO of Navistar International (NAV ), the Warrenville (Ill.) manufacturer of big trucks and engines, which is now boosting production. The bad news: There's no break in the bleak job market, where unemployment rose to a nine-year high of 6.4% in June.
Perhaps nowhere has the bounce in the stock market had more of an effect on reviving corporate spirits than in M&A. On July 7, aluminum maker Alcan (AL ) Inc. weighed in with a hostile cash-and-stock bid for rival Pechiney of France valued at $3.85 billion. That was followed the next day by a $2.2 billion bid by truck-axle manufacturer ArvinMeritor (ARM ) Inc. for Dana (DCN ) Corp., a $1.3 billion all-share bid by data storage maker EMC (EMC ) Corp. for corporate software provider Legato Systems (LGTO ) and a nearly $1 billion stock-and-cash offer by trucker Yellow (YELL ) Corp. for rival Roadway (ROAD ) Corp. The flurry brought the total values of deals through the first eight days of the third quarter to nearly $21 billion, according to Thomson Financial. That compares with $93.4 billion for the entire second quarter and $70.1 billion in the first.
Encouraged by the rebound on Wall Street, a few executives are even daring to approach the market with initial public offerings. Fledgling companies raised $1.8 billion through IPOs in the second quarter, nearly triple the pace of the first. The revival has continued in July, with some $677 million worth of deals in the first eight days of the month alone.
But it's in the bond market where companies have raised the bulk of their financing. According to Moody's Investors Service (MCO ) U.S. companies took advantage of the interest-rate bottom to issue $220 billion worth of bonds in the second quarter, up 20% from a year ago. Junk-bond issues alone soared by 61%, to $46.3 billion.
Sure, corporate-bond yields have risen with the gusher of new supply. But Moody's chief economist John Lonski points out that they're still historically low. The yield on 25-year industrial company bonds rated A stands at about 5.9%. Although that's above June's 5.6% average, it was way back in 1967 when rates were last at these levels.
The story is much the same in the housing market. Even with the recent reversal in yields, mortgage rates are near their lowest level in decades, at about 5 1/2% for a 30-year loan. "Anything under 6% is terrific," says National Association of Home Builders chief economist David Seiders, who sees the housing market remaining buoyant this year.
What's more, Seiders expects any further rise in mortgage rates to lag behind Treasuries. Why? As rates rise, homeowners will be less likely to refinance their mortgages. That will make mortgage-backed bonds more attractive to investors, who won't have to worry about having their investment paid off early. In turn, that should reduce the 200-basis-point premium over Treasury rates that issuers of mortgage-backed bonds have had to pay, Seiders says.
There's no doubt, though, that the fading of the refi boom will take a bite out of the economy. For the past few years, homeowners have used successive rounds of refinancing to take tens of billions of dollars in equity out of their houses. All that cash has kept consumer spending strong even as the economy has struggled. This year, though, homeowners will cash out $20 billion to $30 billion less from refis than in 2002, says David A. Wyss, chief economist at Standard & Poor's, which, like BusinessWeek, is a unit of The McGraw-Hill (MHP ) Companies. But that shortfall will be more than offset by income-tax cuts just now showing up in workers' paychecks, he says.
Ever since the economy hit the skids in 2001, investors have been pining for a full-fledged economic upswing. Yet something has always happened to dash those hopes: the terrorist attacks of September 11, the scandals of Corporate America, or the war in Iraq. Now -- once more -- investors are gearing up for a recovery. This time around they may finally be right.
By Rich Miller in Washington and David Henry in New York with Michael Arndt in Chicago