Don't look now, but at least a smidgen of optimism is brightening the economic outlook. After news that real gross domestic product contracted at a mere 1% annual rate last quarter, following three much steeper declines, many economists are nudging up their forecasts for second-half growth into the 2%-to-3% range. That pace would be twice the general expectation only a few months ago, and it would heighten the chances for a sustainable recovery.
Economists agree that a lasting turnaround depends on consumers, and without a stronger labor market, the upturn could fall flat. All that is true, but recoveries don't start with more jobs. In each of the past four rebounds, overall output, measured by real GDP, picked up first, and jobs afterward. Payrolls turned up one quarter after the 1973-75 recession hit bottom, three quarters following the 1981-82 and 1990-91 downturns, and seven quarters after the 2001 slump.
The same trend is shaping up this time, and second-quarter GDP data show why. Businesses liquidated inventories at a record annual rate of $141 billion last quarter after a decline of $114 billion in the first quarter. That's the largest two-quarter shrinkage since quarterly records began in 1947. Coming at a time when overall demand shows every sign of stabilizing, that has pushed down stockpiles too far, and businesses now have to ramp up production as customers reorder. It's a classic business cycle pattern.
The surprising depth of the inventory liquidation is a chief reason—along with firmer housing activity and consumers' enthusiastic response to the cash-for-clunkers program—forecasters are boosting second-half expectations. The jump in the Institute for Supply Management's July index of industrial activity, which showed big gains in orders and production, strongly supports the more upbeat view. If the economists are right, growth of 2% to 3% will be sufficient to generate at least modest job gains that will prop up consumer spending. It will also add to top-line revenues and help to revive bottom-line profits.
American businesses already are backing away from the cost-cutting frenzy that had exerted such a heavy drag on growth. The downtrend in new jobless claims through July means a diminishing pace of payroll reductions, and companies have greatly slowed the rate of their cutbacks in capital spending. After record declines of 19% and 39% in the fourth and first quarters, outlays for equipment and construction shrank only 9% last quarter.
More important, past cost-cutting will benefit profits for some time, and higher earnings will drive companies to expand their operations. With 337 of the companies in Standard & Poor's 500-stock index having reported, second-quarter earnings are on a track to decline 30% from a year ago, according to Thomson Reuters (TRI). But 74% of businesses beat analysts' expectations, the most since Thomson began keeping records in 1994, and companies are besting forecasts by a record amount.
The earnings surprises reflect companies' efforts to maintain productivity, which is crucial to protecting profit margins. Since the recession began in late 2007, profits per dollar of output among nonfinancial corporations have fallen from 11.8 cents to 10 cents in the first quarter of 2009. That broad measure of margins dropped to 6.3 cents at the low point of the mild 2001 recession.
The Commerce Dept.'s revisions to GDP suggest productivity, or output per hour worked, grew more slowly last year than current data show. But productivity typically falls outright in a recession, and for it to continue to grow at all in a downturn as severe as this one is highly unusual. Given that GDP fell only 1% last quarter while hours worked dropped 8.9%, productivity in the second quarter surged, holding down labor costs and adding further support to margins.
Unfortunately, defending profits in this recession has cost the economy 6.5 million jobs through June. But as companies boost their ordering and production in the second half, they will need to lift payrolls, too.