Business Outlook: U.S. ECONOMY
THE BUSINESS BOOM IS QUIETING DOWN
Corporate America was on a roll in 1994. Led by consumers, the economy boomed--and so did profits. Flush with cash, businesses shelled out big bucks for everything from fancy computers to larger inventories to new buildings to house it all.
Sounds too good to last--and it won't. After seven interest-rate hikes by the Federal Reserve, the corporate roll isn't coming up sevens anymore. So far in 1995, consumers continue to signal that they have lost some of their urge to splurge, especially for cars and homes. And U.S. companies are starting to feel the impact. Order books, while far from empty, aren't filling up as fast. Production lines are slowing a notch. And some past price hikes aren't sticking.
As a result, profits won't look as bubbly, either. Last year's upbeat earnings reports are likely to be replaced by downward revisions to 1995 earnings estimates and negative surprises. And weaker cash flow, not to mention the higher cost of capital, will quiet the boom in capital spending (chart). Although corporate balance sheets are far from a disaster, fewer funds will be available for new projects, weakening another key prop under this four-year-old expansion.
As the year wears on, the business slowdown--and its impact on corporate earnings--may test the stock market's upbeat tone. The bulls sent the Dow Jones industrial average over 4200 on Apr. 4. Stocks are rallying mainly because investors believe the Federal Reserve is bringing the economy down for a soft landing. But what investors may have overlooked is that a soft landing also means softer earnings.
THE MORE SUBDUED TONE of business is unmistakable in the latest soundings by the nation's purchasing managers. Their March index of industrial activity--comprising production, orders, delivery speeds, inventories, and employment--fell sharply for the second month in a row, to 51.4%. That reading, which is the lowest in 11/2 years, is just above the 50% line dividing expansion from contraction in manufacturing. The index is far below its peak of 59.9% hit in November.
In addition to the marked slowdown in new orders and output, the purchasers' report also flashed clear signals that past market tightness for many goods appears to be unwinding. The percentage of purchasers reporting slower deliveries has fallen substantially in recent months. As if to confirm that slack, fewer purchasers are reporting increases in the prices they pay for materials and supplies (chart).
The cooldown in commodity prices is a big reason why the government's index of leading indicators fell 0.2% in February. The index has gone nowhere since last August, a sign of slower growth to come.
Signals such as these are why the Fed put monetary policy on hold at its Mar. 28 meeting, and signs are growing that the Fed may forgo action at its May 23 gathering as well. First-quarter economic growth is shaping up to be exactly what the Fed wants to see: 2.5% or less. That pace would be the slowest since the summer of 1993 and about half of the fourth quarter's 5.1% growth rate of real gross domestic product, which the Commerce Dept. just revised up from 4.6%.
WITH A COOLER ECONOMY in the outlook, the bottom lines of many companies won't look as hot, either. Along with its GDP revision, Commerce also reported that corporate profits in the fourth quarter posted a good gain, in line with BUSINESS WEEK's recent aggregation of individual companies.
However, annual earnings growth is flagging. Before-tax operating profits--adjusted for changing inventory values and differences between tax-based and replacement-cost accounting--were up only 4.9% from a year ago. That's down from peak growth of 35.9% in the third quarter of 1993. For 1995, the weaker dollar will boost earnings of offshore operations, as those profits are converted into dollars, but earnings from domestic operations account for 90% of the total.
Margins are likely to come under increased pressure as well. Profits as a percentage of real output of nonfinancial corporations trended higher for four years. But that margin hasn't budged since hitting 12.7% in the second quarter of 1994. As the cyclical slowdown in productivity growth continues in 1995, unit labor costs will grow faster at a time when pricing power will be limited by waning demand.
The key consequence of weaker profits could be less capital spending. Net cash flow--retained earnings plus depreciation--has slowed markedly as well. As a result, companies are experiencing a growing gap between their outlays for new investments and the internally generated funds necessary to pay for those projects. This so-called financing gap, which leads the growth rate of business investment by about a year, was the widest on record in the fourth quarter.
With companies spending freely on equipment, buildings, and inventories, businesses must turn to the credit markets, where the average yield on AAA-rated corporate bonds has risen more than a point, to 8.1%, since the Fed began tightening. That raises the "hurdle rate" that a potential return on an investment must clear to justify its cost--just when softer business conditions raise uncertainties about the future.
SO FAR, there is little evidence that the demand slowdown is only fleeting. That's especially true for consumer spending. Real purchases of goods and services fell 0.1% in February, and March surveys of retailers look uninspiring. March car sales fared better than in February, but they are still below their fourth-quarter pace. In all, first-quarter consumer spending appears to have risen at an annual rate of about 2.5%, well below last year's trend.
The outlook for consumers hangs on job growth, and on that front, some letup seems on tap. Through February, help-wanted advertising in the nation's major newspapers had fallen well below its fourth-quarter level, after a two-year uptrend. And at the end of March, the four-week average of first-time jobless claims had risen to an eight-month high.
In addition, construction was a drag on first-quarter growth. And given the weakness in housing, which accounts for nearly half of all construction outlays, it will remain so in the second quarter. Total spending, adjusted for inflation, fell 0.5% in both January and February, the first back-to-back decline in a year.
Not all construction activity has tanked. While residential building in February fell below its year-ago level for the first time in 31/2 years, outlays for factories, offices, and other commercial buildings soared 20.1% ahead of a year ago, reflecting the strength in capital spending (chart). But business outlays are only about a fifth of the total.
To be sure, businesses aren't about to gut their 1995 capital budgets--intense competition in the global marketplace won't allow that. However, a slower economy, weaker cash flow, and higher borrowing costs will make companies a lot pickier in their spending.BY JAMES C. COOPER & KATHLEEN MADIGAN