Business Slowdown? Don't Count On It

With profits strong and inventories down, capital spending should rally

As 2007 began, everyone was worried about consumers: How would their spending hold up as the housing slump wore on? Well, consumer outlays turned out to be the economy's star performer in the first quarter, with inflation-adjusted spending growing a healthy 3.8%, measured at an annual rate. Now, in the

wake of some puny-looking numbers on capital spending, economic anxiety has turned to the business sector. The question there: Will a cooler economy, rising labor costs, and a pileup of inventories cause businesses to slam the brakes on their plans to expand operations and hire more workers?

Clearly, the risks surrounding the outlooks for both businesses and consumers remain significant. Completely dismissing them would be foolhardy, especially on the heels of the government's latest report on real gross domestic product, showing the economy grew only 1.3% last quarter, the weakest pace in four years. Nevertheless, some good news from the quarter is helping to allay fears of a business-led retrenchment that could seriously damage the economy.

The GDP report showed business outlays for equipment and software rebounded last quarter after falling in the fourth. It said the drag from slower growth in business inventories lessened considerably. Plus, corporate earnings are coming in better than expected. All this bodes well for continued contributions from the business sector to overall demand, production, hiring, and wages in the spring and summer.

ALSO ENCOURAGING, the economy outside of housing continues to hold up well. Excluding the one-percentage-point subtraction from GDP growth last quarter because of a 17% drop in residential construction, the rest of the economy grew 2.2%. The housing drag was smaller than in the fourth quarter, and the downdraft in the second quarter is shaping up to be even less.

Moreover, economic growth may not have been as meek as the GDP numbers show. March data on construction spending, which included a large upward revision to February outlays, were not yet available when the government put together its initial GDP estimate. They turned out stronger than the statisticians had assumed. In fact, given the stronger pattern of other economic data at the end of the quarter, there's a good chance the second report on growth, due on May 31, will be an improvement over the initial reading.

Some of the recent weakness in business spending may well have been the result of temporary factors. For example, details from the GDP report show outlays for equipment rose 1.9% last quarter after dropping 4.8% in the fourth. Spending on high-tech gear was especially strong, with outlays for computers and peripherals up more than 30%. That gain suggests that at least some of the fourth-quarter weakness was related to delayed purchases of computers prior to the January release of Microsoft Corp.'s (MSFT ) Vista operating system.

OUTSIDE OF HIGH TECH, the housing downturn is obviously hurting business demand for construction equipment, but another temporary factor may also be at work: New environmental guidelines for heavy trucks, which went into effect on Jan. 1, appear to be depressing outlays for transportation equipment. Spending there has declined in each of the last two quarters but will most likely pick up in coming periods.

Outside Of Housing, Growth Looks O.K.
In addition, while homebuilding is in a rut, companies are plowing ahead with new factories, offices, and warehouses. In fact, based on the March construction report, business outlays for new buildings last quarter rose by more than the 2.2% rate quoted in the initial GDP report, perhaps by twice as much.

Businesses have also made significant progress in cutting back inventories. Slower inventory growth, which subtracted a huge 1.2 percentage points from the fourth-quarter GDP rate, robbed only 0.3 points from the first quarter. This adjustment is evident in the firmer tone of reports coming from the manufacturing sector.

Not only did factory production score its biggest advance of the year in March but April activity looks stronger as well. The Institute for Supply Management's index of industrial activity improved to 54.7% in April, the highest reading in nearly a year, pushed up by faster gains in orders and output. For the second month in a row, a growing share of companies said their customers' inventories on hand were less than sufficient.

PERHAPS THE MOST COMPELLING sign of the continued health of the business sector is the surprisingly strong performance of first-quarter profits. Despite a slowing economy and rising labor costs, the earnings of many companies are beating expectations.

Profits have indeed retreated from their double-digit pace of last year, but growth for the first quarter is shaping up in the high single digits. Economists at Citigroup (C ) note that, of the companies reporting so far, 57% are showing double-digit gains, and that excluding only five big homebuilders, earnings growth would be about a percentage point higher.

With 307 of the companies in the Standard & Poor's 500-stock index having reported, actual reports plus the current expectations for the rest suggest an earnings increase for the quarter of 7.2%, according to Thomson Financial (TOC ). Before the reporting season began on Apr. 1, analysts expected growth of only 3.7%. So far, 68% of companies have posted better-than-expected earnings, above the 60% average historical experience.

Earnings remain sturdy for several reasons. First, despite cooler demand in U.S. markets, foreign markets are still strong, and they account for an increasing share of U.S. corporate profits. Solid exports are lifting revenues, and the dollar's decline is boosting earnings as they are translated back into dollars.

Also, companies are keeping a tight leash on labor costs. Despite faster growth in wages, companies continue to slash benefits costs. According to the Labor Dept.'s employment cost index, such costs actually declined in the first quarter for the first time since the agency started keeping records in 1980. Benefits costs had reached a peak growth rate of 11% annually in the first quarter of 2004, and they have been slowing since.

The Factory Sector Is Getting Stronger
At the same time, productivity growth among businesses outside of homebuilding seems to be holding up. Given that residential construction has fallen about 17% from a year ago, with housing sector jobs down only about 4%, it would appear a big portion of the overall slowdown in productivity over the past year has been the result of weakness in home construction. Outside of housing, efficiency gains are helping to offset rising wage costs and lift earnings.

So despite last quarter's tepid GDP growth, businesses and consumers appear to be weathering the maximum force of the housing slump fairly well. That means as the housing drag lessens, the economy will be in a good position to post stronger growth in the second half of the year than it did in the first.

By James C. Cooper

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