11/16/98 U.S.: DON'T BE FOOLED BY THE STRONG DATA

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U.S.: DON'T BE FOOLED BY THE STRONG DATA
The profit outlook is bleak, and households will feel the backlash
The world is breathing a little easier. Asia's hemorrhaging has stopped, and the financial firewall around Brazil seems to be holding. The Federal Reserve and other central banks are cutting interest rates, bringing cheer to stock markets, especially in the U.S. And now comes word that during the global economy's summer from hell, the seemingly unflappable U.S. economy grew a solid 3.3% amid a continued acceleration in workers' pay and benefits. So we must be out of the woods, right?
Don't bet on it. Nothing could spell out the coming slowdown in the U.S. more clearly than the third-quarter reports on gross domestic product and employment costs, along with the October update from the nation's purchasing managers. The data highlight the ongoing reversal of fortunes between Corporate America and Household America: Amid tight labor markets and weak pricing power, profits are suffering even in a strong economy. But for households, the flipside of rising labor costs and weak pricing is fatter paychecks and more buying power.
Trouble is, this shift in the nation's bounty from capital to labor has its limits. Faced with weak profits and an unfOrgiving Wall Street, companies are making investment and hiring decisions that are already starting to slow economic growth.
Moreover, the split sets up a tricky dilemma for the Federal Reserve. The strength in household spending, fueled by solid job and wage growth, is sure to embolden the Fed's hawks, who only four months ago had voiced dissent over not raising interest rates to fight inflation risks in '99. BUt at the same time, increased global uncertainty requires the Fed to keep rates down to assure that credit flows smoothly through the financial markets to corporations, even at a time when bank credit continues to roll freely to households.
LAST QUARTER'S GDP REPORT looked strong. But in reality demand is slacking off (table). The Fed's own survey of economic activity noted that growth ''moderated in September and October.'' Growth over the summer was boosted by inventories, which grew by $57.2 billion, up from $38.2 billion in the second quarter. But much of that reflected renewed stock building of cars after a strike crippled output at General Motors Corp. (GM). That plus for growth is not being repeated in the fourth quarter.
Domestic spending, however, slowed from its torrid 6.7% growth rate in the first half to 3% last quarter. And that slowdown could be traced to the divergence between households and businesses: Consumer spending, up 3.9%, continued to provide a key support for the quarter's overall growth, while capital spending fell 1% last quarter, the first decline since the 1990-91 recession.
Business investment was dragged down by a drop in construction activity, but outlays for equipment barely rose last quarter. A GM strike-related plunge in spending for transportation equipment helped to pull down the third-quarter total, but even excluding that sector, outlays have slowed this year. Quarterly spending growth in all equipment categories was below their average gains during the previous year.
WHY THE SLOWDOWN? Flagging profits play a big role: Companies aren't generating enough cash to justify further increases in capital budgets. And tighter credit conditions mean companies can't easily finance purchases.
In addition, businesses don't need to add to their production capacity when weak foreign demand is cutting overall orders and output. The GDP report showed that exports last quarter fell for the third quarter in a row, even as slower U.S. demand reined in import growth a bit. The trade gap widened further, although by less than in the first half.
That softness in demand, both from abroad and at home, is clearing out order books and cutting into factory production. The nation's purchasing managers' index of industrial activity fell to 48.3% in October, the lowest level in two and a half years and below the 50% mark, indicating that U.S. manufacturing is in a recession (chart). Orders were a big drag, especially export orders. That index plunged in October to 42%, a record low.
The downshift in demand means that businesses won't be able to boost their profits by increased sales volume. Of course, strong growth hasn't helped them so far. Even though the economy expanded by 3.4% during the past year, profit growth fell to zero. Why? Labor costs are still rising much faster than most companies can mark up prices, and productivity is not growing fast enough to offset that gap.
The third-quarter employment cost index of wages and benefits rose a greater-than-expected 1% from the second quarter, and the pace from a year ago accelerated to 3.7%, the fastest growth in more than six years. Wages, up 4.3%, haven't grown that fast in eight years. And benefits, whose slow growth had been holding back the overall pace of labor costs, are also accelerating now. They were up 2.7%, pushed higher partly by rising medical-care costs (chart).
THE PROBLEM FOR PROFITS: Heading into 1999, labor costs will continue to rise rapidly at a time when investment is slowing, and when slower economic growth is very likely to depress productivity growth. That will leave many companies with only one option--cut payrolls. And when that happens, the consumer juggernaut will finally lose steam.
So far, though, the slowdown has not progressed that far. Indeed, despite having some questions about the future, households are still basking in the brightness of their current economic conditions. Consumer spending slowed to a 3.9% growth rate last quarter, from 6.1% in the first half, but the slowdown really was not that great. Excluding purchases of cars and trucks to eliminate the ups and downs caused by the GM strike, outlays rose 5.1% last quarter, only slightly slower than the 5.6% pace in the first half. And in the fourth quarter, car sales started off with a bang. Also, housing showed another good gain last quarter, posting a 6.8% increase.
Keep in mind, though, that part of the third quarter's spending spree was financed by households dipping into their savings. In fact, the savings rate was negative in September for the first time since 1933. And in coming months--with the stock market no longer a dependable source for extra cash--households are likely to expect bigger pay raises to finance any buying increases.
However, there is only so much economic pie to go around. At some point, the shift in good fortune from Corporate America to Household America will stop. The latest data suggest that companies may be reaching the breaking point, and households will feel the backlash.
BY JAMES C. COOPER & KATHLEEN MADIGAN

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GRAPHIC: Anatomy of a Slowdown

CHART: Purchasers Say Orders Are Sagging

CHART: Labor Costs: Growth Is Picking Up