Why Layoffs and Cutbacks are Comingand Soon

With demand sagging and funds for expansion drying up, Corporate America is under more pressure than ever to hit the brakes

Fragile economies are always vulnerable to shocks. This year the U.S. has been hit with two: an oil-related surge in inflation that slammed consumer spending last quarter, and a near-collapse of the financial system that is hammering growth this quarter. The double blow has left American businesses reeling and prospects for growth looking bleak. The speed with which companies, both domestic and foreign, are cutting back is striking. Some forecasters now think the economy could contract as much as 4% this quarter, a shrinkage reminiscent of the severe 1981-82 recession.

The pressures on businesses to pull back on capital spending and hiring are far more intense than they were during the 1990-91 and 2001 recessions. Already, companies have reduced outlays for equipment and software for three quarters in a row. Business construction also has begun to sag in recent months as older projects are completed and plans for new ones are shelved for lack of financing. Companies are certain to step back even more quickly in coming quarters.

Corporate decisions to expand are based largely on perceptions of demand, and right now prospects both at home and abroad are increasingly discouraging. The 0.3% dip in third-quarter real gross domestic product was worse than that top-line number implied. Domestic demand in the U.S. fell a steep 1.8%, led by a plunge in consumer spending. U.S. demand posted its first annual contraction in 17 years, and that downtrend has further to run.

Despite cheaper gas, consumers are spending less again this quarter amid tight credit and mounting job losses. October retail surveys were weak. The month's 10.6 million annual rate of car sales was the lowest since 1983 and well below the poor 12.5 million rate averaged in the third quarter. Although a projected 33% drop in the quarterly average of gas prices will add some $140 billion to household buying power this quarter, consumers are more apt to save that windfall than spend it.

The falloff in October business activity was remarkable. The Institute for Supply Management's indexes for both manufacturing and nonmanufacturing fell sharply. The latter hit a record low, while the factory gauge fell to a 26-year low. A majority of the companies surveyed in both sectors said they had been affected by the financial-market turmoil. The plunge in the ISM's index of export orders, also to an all-time low, was especially worrisome for future growth. It suggests exports, the largest single contributor to demand growth this year, are about to cave in under the weight of a global recession and a stronger dollar.

Weak demand isn't the only brake on business expansion. All sources of funding, including profits, debt, and equity, have either dried up or become too costly. Internal funds are shrinking as profits fall. So far in the fourth quarter, the ratio of negative to positive earnings guidance from companies is twice the long-run average, says Thomson Reuters (TRI), and the slowdown overseas further worsens the outlook. Over the past year the $81 billion rise in profits from abroad has cushioned the $197 billion drop in domestic earnings. That support will fade next year as domestic profits remain weak.

Even now, the gap between cash flow and capital spending is close to a record, forcing companies to seek external funding at a difficult time. A record 83.6% of banks tightened their lending standards for loans to large and midsize companies early in the fourth quarter, a far more pervasive squeeze than in the past two recessions. In the credit markets, borrowing rates on the bonds of moderately risky, investment-grade firms skyrocketed to 9.5% in late October.

Up till now, the business sector's relatively healthy balance sheet, conservative hiring and expansion in recent years, and well-managed inventories have helped the economy avoid a deep corporate retrenching. But major cutbacks are set to ripple through the economy in a recession that may hit harder than many forecasters had expected.

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