No Recession. Not Much Comfort, Either


By Margaret Popper The stock market may have bottomed -- and the way it has taken into account disappointing earnings from companies like Cisco (CSCO) and Intel (INTC) implies that it has. And while gross domestic product growth for the first quarter came in at a surprisingly robust 2%, corporate earnings are still at least two more quarters away from beginning their turnaround.

You heard me right: Corporate earnings are likely to be lower than their year-on-year comparisons through at least Sept. 30.

The earnings recovery will depend on achieving a delicate balance between capital and consumer spending. Here's the tricky part: About the time that inventories have corrected and companies start investing again, consumer spending is likely to be at its weakest.

If layoffs don't get too bad before inventories correct, the proposed tax cut and a somewhat stronger stock market might help keep the consumer in the mall. But even if lower consumer spending puts pressure on earnings, with employment still near historic lows and labor prices still rising, it will pay for companies to substitute capital for labor. Whether earnings turn around before the end of the year depends on whether corporate spending comes back enough to offset lowered consumer demand.

Although we won't see year-on-year earnings growth for a while yet, here's the good news: The worst part of the earnings decline is probably over. Standard & Poor's 500 earnings dropped an estimated 21% year-on-year for the first quarter of 2001, according to S&P statistics. S&P projects that will be followed by a 12% year-over-year decline in the second quarter, no growth in the third quarter, and 16% year-on-year earnings growth in the fourth quarter of 2001. For the year, the S&P 500 should be down about 5%.

10% INCREASE. Now those numbers do not include the effects of the Fed's easing. The way S&P looks at it, it takes a year for Fed rate cuts to have an impact on earnings. A half-point cut generally translates into a roughly 2.5% gain in earnings, according to David Wyss, chief economist for Standard & Poor's. So the Fed's recent rate cuts alone should bump up corporate earnings to the tune of 10% between January and April of next year.

In the meantime, the forces that will affect earnings boil down to two elements: capital spending and the consumer. Ironically, although capital spending may rebound to trigger an earnings turnaround in the second half, right now, the sharp cutbacks are the reason earnings are so disappointing. We won't know the first-quarter capital-expenditure numbers until Apr. 27, but Wyss predicts they will reflect a 16% decline vs. the first quarter of 2000. While that will get better in the second quarter, according to Wyss, the picture won't be exactly wonderful. S&P's official estimate is for a 5% decline in capital spending in Q2, 2001, vs. Q2, 2000. That's about the same as the decline in the fourth quarter of 2000.

Beyond the second quarter, it's hard to tell what will happen with capital spending. Opposing forces are at work here. On the downside, second-quarter earnings will be weak, which means companies will have less cash to spend on capital improvements. They will have implemented the layoffs announced earlier in the year, which should cause a drop in consumer confidence and, probably, consumer spending as well. To date, consumer spending has been the main buttress of earnings, so it would be disastrous for corporations if consumers close their wallets.

RELATIVE BARGAIN. On the other hand, corporate spending also has an important role in generating corporate earnings, and companies have compelling reasons to make capital investments. Shareholders' impatience with disappointing earnings could put pressure on CEOs to cut costs through capital improvements. Even though labor prices aren't rising as fast as they were, they're still rising at a time when capital-goods prices -- especially for technology products -- are dropping. U.S. Labor Dept. employment-cost index numbers released on Apr. 26 showed that compensation costs increased by 4.1% in March, 2001, vs. a year earlier.

Capital investment looks like a bargain by comparison. "Corporations are cutting prices like crazy, and that helps clear the market of excess inventory," says Maury Harris, chief economist at UBS Warburg. "Capital expenditure is still about the substitution of capital for labor in a tight labor market. If you do the calculations, there is still a reason to substitute capital for labor." Of course, wage pressure might also increase layoffs.

Although consumer spending seems to have held up in the first quarter with 3.5% year-on-year growth, the declining consumer confidence numbers released by the Conference Board on Apr. 24 indicate that trouble may be ahead. Consumer confidence is the lowest it has been since 1996. "We're predicting consumer spending will slow to 1.2% growth in the second quarter," says Wyss, who adds: "The second half depends on the tax cut." That could put an extra $85 billion back into consumers' pockets if something like the bill that's in the Senate gets passed, Wyss says. Whether or not consumers will spend their windfall remains a matter of some debate.

COURAGE TO SPEND? The apparent stabilization of the stock market and the continued strength of the housing market might give consumers the confidence to spend their tax cuts rather than save them. These factors shore up the consumer's confidence by creating a sense that their wealth is reasonably safe. If layoffs don't get too much worse, it could be enough to keep earnings on course and the economy out of recession.

The bottom line: We may achieve the delicate balance between consumer and corporate spending that will allow earnings to turn around in the fourth quarter -- and keep the economy out of a recession. "We have two things going for us," says Mary Farrell, strategist at UBS Warburg. "The Federal Reserve and the fact that we don't have the level of inventories that we used to get in slowdowns." That should mean layoffs won't take too much of a toll on consumer confidence, and we'll get off with a kinder, gentler business cycle for the New Economy. Popper covers the markets for BW Online in our daily Street Wise column


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