The market plunge this summer is weighing on Corporate America. Companies seem to be frozen, waiting to see how much damage, if any, has been done to the recovery. This tendency to pause during a shock is classic business behavior, but it also cuts into economic growth, adding a new question for the outlook: When will business shake off its uncertainty and move forward with confidence into the future?
A big danger is that the stock market and the economy will feed off each other in a way that could hurt the recovery. Bear in mind that for several months, investors ignored the good economic news, focusing instead on corporate crime. The irony now is that investors are paying more attention to the economy--but just as new reports suggest that prospects for the second half are taking a turn for the worse.
The wave of corruption scandals means that businesses have expended a lot of time and resources addressing new accounting and governance issues. Planning has suffered, borrowing is down as lenders demand higher-risk premiums and companies table new projects, and equity financing has been crimped by weaker stock prices. This corporate vacillation is beginning to affect the economic data (charts). Ordering has slowed, companies are trimming the hours worked by their employees, and a few are actually shedding some of their temporary workers.
Economists are showing new caution, too. For example, forecasters at J.P. Morgan Chase & Co., who were expecting 4% growth in the second half, have cut their projection to 2.75%. Economists whose numbers were already in the range of 2.5% to 3% are saying, "We told you so." And the double-dippers, who see a second round of stagnation or outright recession, are getting bolder, although their ranks are still thin.
TO BE SURE, the events of this bear-market summer will be felt in the economy during the second half, but by how much? Businesses may choose not to replace worn-out equipment or expand. Many will be hesitant to lay in new inventories; some will wait before expanding their payrolls. And on the consumer side, some households will choose to save more and spend less.
These patterns are already evident. In June, new orders took a nosedive, including bookings for capital goods. The nation's purchasing managers said the order slowdown continued in July. The Institute for Supply Management's index of industrial activity dropped from 56.2% in June to 50.5% in July, the steepest decline since just after September 11.
Then came the July employment report. Payrolls posted essentially no growth last month, and the jobless rate held at 5.9%. Those numbers weren't out of line with the recent pattern of labor-market stabilization. What was new, however, was an 18-minute plunge in the overall workweek, to 34 hours--the sharpest fall since early 1996, when a blizzard hit the East Coast.
A steep 24-minute decline in the factory workweek, after a steady rise since November, along with a cutback in plant overtime, was especially disconcerting for the outlook. Remember, the factory-sector cutbacks in late 2000 were the best indicator of the economy's coming weakness, and the sector's upturn in late 2001 was an important signal of the recovery.
Few businesses actually made significant cuts in their payrolls in July, but temp agencies did see a big drop--of 35,000 jobs--after four consecutive months of increases. Falling temp jobs in 2000 foreshadowed the broader 2001 payroll losses, and their upturn this year had been a good omen for overall payrolls later on.
BUT AT THE SAME TIME, demand by both consumers and businesses remains strongly supported by low interest rates, generous tax breaks, solid income growth, a more competitive dollar, rising productivity, and a rebound in profits.
Consumers, in particular, show few signs of flagging. Retailers noted a certain amount of sluggishness in July, but nothing ominous. And car dealers received a rousing response to their 0% financing deals. Cars and light trucks sold at an annual rate of 18.1 million vehicles in July, the second-strongest month on record, up from 16.5 million in June and 15.7 million in May. Auto makers are already boosting their third-quarter production plans in order to replenish inventories.
Consumers are still buying houses and refinancing existing mortgages, according to the trends in loan applications. Because of falling mortgage rates, refi activity in late July was approaching the record levels seen last year. Cash-outs and lower payments will put additional money in shoppers' wallets.
In addition, household real income, after taxes and inflation, has grown 5% during the past year. Tax breaks and falling inflation have offset labor-market weakness. In fact, real income is growing well faster than the 3.1% pace of real consumer spending (chart). That means consumers have been able to lift their savings rate from 1.9% of income a year ago to 4% in the second quarter. Consumers have been able to add to their cushion and still spend at a healthy clip.
THE CURRENT JUMBLE of opposing trends--solid demand but no strong pickup in jobs--stems partly from the nature of this business cycle. In other words, mild recoveries tend to follow mild recessions. Add in the corporate scandals and their impact on the market, and it's easy to see why businesses and investors perceive this recovery as weak relative to past upturns and especially when compared to the boom conditions prior to the recession. The fact is, economic growth over the past three quarters has averaged almost 3%. Few would complain about this growth rate during an expansion, but in this recovery, it is considered feeble.
Erroneous or not, this perception of subpar growth is prompting the credit markets to believe the Federal Reserve's next move will be to cut interest rates. Fed officials themselves downplay that prospect, but they do admit that the balance of risks in the outlook is now slightly more tilted toward weakness than strength.
Policymakers will decide whether to adopt that stance formally when they meet on Aug. 13, although almost no one expects a rate cut at the meeting. Fed watchers, however, are pushing their expectations of the next hike further into the future, and that outlook is encouraging market rates to move lower. So overall financial conditions are actually easing without the Fed's lifting a finger.
In a nutshell, the risks in the outlook have increased, and that's why so many companies are holding their breath. But solid economic fundamentals are still supporting growth, and excesses in capacity and inventories have already been pared away. That means businesses should soon be able to breathe a sign of relief as the signs in coming months confirm that a moderate recovery remains in place.
By James C. Cooper & Kathleen Madigan
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