Comments: Stephen Slifer / Ethan Harris
Co-Chief Economists, Lehman Brothers
How do you expect the coming recovery to shape up, especially in terms of its strength and the sectors that will lead and lag behind? How have you factored in the uncertainties surrounding terrorist activity and the war?
Like many others, we expect the economy to rebound in Q2. Our official ending date is March 2002. At that point consumer spending will turn upwards. After declining at a 4% rate in Q1, consumption expenditures will rise by 2.5%, 3.0%, and 3.5% in the final three quarters of the year. That obviously reflects a significant turnaround, but it is relatively modest by historical standards for the first several quarters of a recovery. After declining sharply (i.e., in excess of 10%) in both Q4 and Q1, investment spending should finally begin to turn around by midyear. It will probably still fall at about a 1% rate in Q2, but then rise at 2.5% and 6.0% rates in Q3 and Q4. Throughout the year government spending will consistently climb at rates between 2.5% and 3.0%.
In some sense, fiscal stimulus will keep the economy from falling as much as it otherwise would during the recession, and will help get the economy started on the road to recovery. Then, as the private sector begins to pick up in the spring, the pace of government spending will be gradually reduced
We have made no allowance for any further "significant" terrorist activity. If that should occur, and confidence declines sharply in response, we would revise our forecast lower. Using our definition of "significant" the anthrax scare does not seem to qualify. It has gotten a lot of headlines, but it does not seem to be causing any significant changes in consumer behavior. We have also assumed that the war does not spread into the Middle East. If that should happen and oil prices were to rise sharply, we would obviously have to lower our growth forecast.
The profits outlook is a crucial element in the recovery. What is your outlook for profits, and what factors will shape the profits recovery? Do your profit expectations square with those of investors?
We believe (more correctly, Jeff Applegate believes) that corporate profits will rise 12% next year. That is far less than the 20-30% gains we saw in the late 90's, but it is respectable. Companies in many industries such as autos, electronics, and apparel are facing an intensely competitive environment. As the economy recovers and costs begin to rise, profit margins for companies in those sectors will get squeezed. In an environment without pricing power, businesses need to pay particular attention to the cost side of their business to remain competitive. They also need to spend money on technology to make their existing workers more productive. With labor costs currently rising at a 4% rate, and the price of capital equipment declining at a 3% pace, there is a strong incentive for businesses to substitute capital, which is cheap, for labor, which isn't. This substitution of capital for labor caused much of the gain in productivity that we saw in the second half of the 90's. As productivity again begins to rises corporate profitability will be enhanced, but we are not going to see profits grow like we saw in the second half of the 1990's any time in the foreseeable future.
Consumers will likely play a major role in the strength of the recovery. In the face of low savings, heavy debts, and sharply reduced wealth, how much can we expect households to contribute economic growth next year? And can we expect any contribution from housing?
We expect consumption spending next year to rise from a low point of 1.5% or so to 3.5% (in real terms), which would be roughly in line with the growth in income. While a lot of attention is paid to the low savings rate, we do not agree that there is a savings shortfall in this country such that consumers need to cut back on spending for a protracted period to restore their savings balances. The low savings rate is the result of the way it is measured. It meant to measure savings out of current income. But in a decade during which the stock market rose sharply, consumers frequently took some of their realized capital gains and spent it. When that happens income does not rise (because that capital gain is not counted as income), but consumption does. By definition, savings and the savings rate decline. We found that if realized capital gains are included and the savings rate is re-calculated, the savings rate declined slightly from 10% in 1990 to 8% in 2000 (the most recent available data). In effect, the run-up in stock prices and the appreciation in property values is doing our saving for us. We simply do not need to sock away $100 from every paycheck to boost our savings balances.
The same basic argument applies to debt. It is true that we have taken on a lot of debt and the ratio of debt to income has risen sharply in recent years. But that represents the liability side of our balance sheet. The asset side has also risen dramatically as the result of the run-up in stock prices and the appreciation in property values. If we have more assets, we should be able to comfortably carry a somewhat higher debt burden.
The proof of the pudding is the following. If we are worried about our debt burden, or we feel that we don't have enough savings, we should have seen a much bigger drop-off in home sales and in car sales. Those are the two biggest items in our budget. If we are feeling nervous, for whatever reason, those purchases are the first to go. But they have held up remarkably well. So we strenuously disagree with the argument that the consumer is tapped out and unable to pick up his pace of spending. But we do agree that the pickup in spending next year will be constrained. Typically, in the first year of an expansion consumption spending climbs by 5% or more, but we believe that it will not grow as rapidly this time. As noted previously, we are looking for growth in consumption spending next year of about 3.5%, which would be roughly in line with the growth in income. If that happens, the savings rate should remain at a relatively low level.
Copyright 2001, Bloomberg L.P.
