Economic Trends
By Michael J. Mandel
Capital Spending: Further Cuts?
What will happen with business investment in the wake of the September 11 attacks and the initial stages of the U.S. retaliation in Afghanistan? One unpredictable factor is business confidence, which will rise or fall on the success of the military campaign.
Whatever happens to confidence in the short run, though, Corporate America is starting from a financially vulnerable position, according to economists at J.P. Morgan Chase & Co. And that makes capital investment especially liable to additional cuts.
The reason for this vulnerability is that corporate spending on equipment and buildings still far exceeds the amount of cash that companies are generating internally (chart). The latest figures show that this difference between capital spending and internal funds--also known as the "financing gap"--was running at an annual rate of $251 billion in the second quarter of 2001. That's down from the peak financing gap of $329 billion in the fourth quarter of 2000, but it's still quite large by normal standards. To put it another way, companies are having to raise 28% of their investment funds from external sources. That's compared with the historical norm of 10% to 20%, according to the J.P. Morgan Chase economists.
A big financing gap means that companies have to borrow heavily to support investment at a time when the economy is in turmoil. That's not what most chief executives want to do. Instead, they want to reduce dependence on debt during uncertain times. "Capital spending is still unusually high relative to cash flow," notes Calvin Schnure, a senior economist at J.P. Morgan Chase, "With any recovery being pushed out a quarter or two, firms will want to postpone or cancel a lot of outlays."
There are mitigating factors, observes Schnure. Balance sheets are in relatively good shape. Companies have a lot of liquid assets, and they took advantage of low interest rates in recent years to refinance their long-term debt. And cash flow has stabilized because of dividend cuts and cost-cutting.
Nevertheless, excessive dependence on the credit markets seems less and less appealing as the world seems more dangerous and the economy turns sluggish. Capital investment may have quite a bit more to fall before hitting bottom.
Health Care Is Looking Healthy
The September employment report gave few reasons for optimism. Even though most of the data does not reflect the effects of the September 11 attacks, the report still showed a 199,000-job decline, the largest in more than 10 years.
Yet some industries were still adding workers. In particular, the health-care sector, outside of government-run hospitals, grew by 29,000 jobs in September, equal to its average growth over the previous three months. In fact, over the last year, health care has generated 283,000 jobs, making it the second-biggest source of new jobs. The only industry with a bigger gain over that period was education, which added 338,000 workers.
Indeed, employment outside of health and education shrank by more than 500,000 jobs over the last year. Thus, even before the attacks, U.S. growth was being driven by health and education. And that may persist even after the U.S. recovers from this downturn.
Hurting in Lockstep
In the past half-century, there has never been a global recession. Even when the U.S. was deep in the mire, the world economy as a whole kept on growing. In 1991, for example, the U.S. economy shrank by 0.5%, but the global economy expanded by 2.7%. In 1982, the U.S. reported negative growth of 2%, while the rest of the world grew by 2.6%. Expansion in one part of the world more than made up for contraction elsewhere.
No longer, says Giles Keating, chief economist at Credit Suisse First Boston in London. He and an increasing number of other forecasters predict that the world will plunge into its first global recession since World War II this quarter and next. And for 2002 as a whole, global growth will be lucky to hit 0.7%, the lowest level since World War II.
That's in part the result of globalization, which means economies around the world move more in tandem than they used to. International trade now accounts for almost 20% of global gross domestic product, up from just 10% a decade ago. So manufacturers in one region are hurt more than they used to be by slowdowns elsewhere. It's not just exporters that are affected. Markets for many products are now completely international, with prices determined globally rather than locally. "That means domestic-oriented companies in one region feel the full blast of falling demand in another," says Richard Reid, chief equity economist at Schroder Salomon Smith Barney in London. "Their profits suffer, investment falls, and confidence falters." Meanwhile, the financial markets are more interlinked and liquid than they were. The capital that kept the emerging markets growing through past U.S. recessions nowadays can be yanked out at the first sign of trouble.
To make matters worse, Japan's troubled economy cannot provide the world with an engine as the U.S. stalls. The Asian Tigers, which hardly ever registered recessions, are now heavily dependent on exports to the U.S. and Japan for their vitality. And forget Europe: Economists say its structural problems mean that it can't buck the global trend. Those economies that are still growing--China, for instance--aren't big enough to act as global locomotives. "It's a gloomy picture," says Keating. "The hope is that a global response by policymakers can get things moving again."
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Copyright 2001 , by The McGraw-Hill Companies Inc. All rights reserved.
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