The debate over the strength and durability of the recovery remains intense. Even if the current upturn mimics past norms, in which strong recoveries follow severe recessions, many analysts still believe a surprisingly solid second half won't prevent the economy from faltering in 2010. The big worry, of course, is consumers and the lack of income needed to repair their ragged finances.
What gets overlooked, however, is the totally opposite state of affairs in the business sector, which may be more important to the recovery's trajectory than household balance sheets. American corporations have rarely if ever emerged from a recession so lean, financially fit, and ready to respond to growth. That's important, because companies do the hiring, and their ability and willingness to expand is a crucial gear in the economy's growth machine.
Businesses were already trim heading into the recession: After the 2001 downturn, both payrolls and capital spending grew at the slowest pace in any post-recession period. Then came the cost-cutting frenzy of the past year, allowing profits to turn up strongly in the second quarter, based on Commerce Dept. data, even as overall domestic demand fell. With demand set to grow at least modestly in the second half, the upturn in profits will continue. A decisive return to profitability was a key feature of the recoveries from the severe recessions of the 1970s and 1980s.
Outside the finance sector, the rock-solid condition of corporate balance sheets was clear from the Federal Reserve's latest data. One standout factoid: Nonfinancial companies in the second quarter had a $156 billion surplus of cash flow relative to their capital spending, a surfeit that allows companies to finance all of their current outlays for equipment and construction without borrowing (chart). Except for 2005, when companies were allowed a one-time repatriation of foreign earnings at a reduced tax rate, that is the largest surplus on record.
Many businesses are already investing some of that cash in new equipment as they ramp up output in response to firmer demand and skimpy inventories. Both orders and production of business equipment have turned up in recent months. Outlays for new construction are sure to remain depressed, but spending for equipment appears to be rebounding faster than in past recoveries. Historically, growth in capital spending and hiring have been tightly correlated.
Through the second quarter, much of the more than adequate cash flow of nonfinancial corporations went to beefing up their holdings of financial assets. Since the end of last year, the ability of liquid assets to cover short-term liabilities has increased back to the record levels that existed prior to the recession.
Companies also have taken advantage of the rallies in the stock and bond markets. They have eliminated a lot of short-term debt, replacing it with more predictable long-term obligations at a low fixed rate. The annual rate of corproate bond issuance averaged $488 billion in the first half, up significantly from $141 billion in the second half of last year. Plus, corporations became net issuers of stock in the second quarter for the first time in seven years, eliminating the drain on cash flow from stock buybacks over that period.
Of course, none of this matters for hiring unless businesses can count on stronger revenues. However, recent data suggest demand, especially by consumers, looks stronger than expected. August retail sales jumped 2.7%, and the surprise was the breadth of the gains outside of the cash-for-clunkers boost. Rising housing starts suggest homebuilding will contribute positively to growth for the first time in 31/2 years. Exports are rising, and government outlays certainly will increase.
As business conditions improve, with companies able to respond quickly, more hiring will not be far behind. Income is always the chief driver of consumer spending, and once jobs begin to turn up, consumers will not likely cause the recovery to falter.