Business Outlook January 15, 2009, 5:00PM EST

The Business Slowdown Turns Serious

First consumers, now companies. Their hard cutbacks will hurt now but will set the stage for a rebound later in the year

By James Cooper

The sharp acceleration in job losses in the final quarter of 2008 makes it clear that U.S. businesses headed into 2009 in all-out retrenchment mode. Up to now, the drag on economic growth from the corporate sector has been modest, but in the classic recession pattern, the main focus of the economy's downturn is now shifting from consumers to businesses. Companies are not only slashing labor costs; they are also shelving spending plans for new equipment and construction and making deeper cuts in inventory levels. All this is adding a new dimension to the economy's weakness and promising exceptionally gloomy readings on growth this winter.

Capital spending on new machines, factories, and offices is starting to take a big hit. Through the third quarter, companies had made only small reductions in their equipment outlays, and construction spending continued to rise. Now, businesses are reacting to two new factors: the plunge in consumer spending that began in June and sharply tighter credit after the Lehman Brothers implosion in September. Both have pummeled business confidence and further darkened profit prospects for 2009.

The surest sign that the weakness in capital spending is intensifying comes from the job market. Yearly growth in payrolls and business outlays for plant and equipment are tightly correlated. The recent acceleration in job losses implies large spending cutbacks beginning in the fourth quarter and extending into 2009. So far, real expenditures are still above their year-ago levels, but in the comparably severe recessions of 1973-75 and 1981-82, they posted peak-to-trough declines of about 12%. Spread over a year, a drop that size would subtract 1.2 percentage points from economic growth.

Equipment outlays appear to be falling sharply, which should be evident in the report on fourth-quarter gross domestic product on Jan. 30. Through November, orders for capital goods, excluding defense and aircraft, had dropped at a 28% annual rate from the third quarter. It's not just sagging U.S. demand, either: Inflation-adjusted exports are on a path to post their largest quarterly decline in 35 years. This overall weakness virtually assures another steep decline in equipment outlays in early 2009.

So far, business construction spending has continued to grow, but signs of a downturn are emerging. Jobs in business construction, which had been slipping since early in 2008, began to fall at a much faster rate last quarter. Vacancy rates for industrial buildings are up sharply, and those for offices are also on the rise. As projects begun in 2008 wind down, business construction is set for a steep fall this year. Empty space, tight credit, and the recession will prevent new projects.

Businesses are also making deeper cuts in inventories. Companies have been nipping and tucking their stockpiles for a year, but now more serious recession-size reductions are needed as unsold goods pile up. In downturns since the 1950s, inventory pruning has accounted, on average, for about two-thirds of the total drop in real GDP. This time, efforts to shrink auto inventories will add an especially large drag on growth. Auto output is expected to plunge at a 60% annual rate this quarter, according to Ward's Automotive Reports.

The reaction to slumping sales and profits is especially evident at small businesses, where confidence in December dropped to the second-lowest reading since the National Federation of Independent Business began tracking it 35 year ago. The NFIB said average jobs per company fell by the most in history, and capital spending plans dropped to a level not seen since the 1973-75 recession. Also, a record percentage of companies continued to liquidate inventories.

Deep and rapid adjustments by businesses to slumping sales, while painful now, may be a plus for growth later this year. If policy efforts succeed in reviving demand, companies will be well positioned to gear up output, hiring, and spending. However, the cutbacks are only now beginning.

Cooper is BusinessWeek's senior editor and senior economist and writes the influential Business Outlook column.

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