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Neither Boom Nor Bust

The rocky road to economic recovery is pockmarked with ruts, bumps, and potholes; e.g., the stock market, consumer confidence, and employment to mention only a few. How bad are they? Can we dodge any of them? Is there a detour on a smoother road?

Even though we have no map to navigate on our 2003 journey, we need not drive into the future with no idea of what we might encounter. We have two guides to help us: Robert Fry, DuPont's senior associate economist, and Brendan Lowney, VP, macroeconomics, at Resource Information Systems Inc. (RISI). During interviews conducted in November 2002, they identified the obstacles that lie ahead and pointed out the smoother stretches on the road to economic recovery.

Fry and Lowney believe the economy will continue to grow, albeit sluggishly. US real Gross Domestic Product (GDP) grew at an annual rate of more than 3% in the third quarter of 2002, Fry says, “but the momentum slowed late in that quarter, pulling fourth quarter growth down to around 1 percent.” This year, Fry expects GDP to grow at 2.4%, which compares to the long-term trend of 3.0% to 3.25%.

“Thanks to falling interest rates and President Bush's tax cuts, disposable income rose at a 5 percent annual rate from June 2001 to August 2002,” Fry says “which helped real retail sales rise during that period at a 7.1 percent annual rate. Furthermore, interest rates are at their lowest level in several decades. This prompted homeowners to refinance their mortgages. They either opted for a lower monthly payment, which leaves them with more money to spend at the end of the month, or they took the money out of their homes in a lump sum and put it into the garage by buying a new vehicle. People probably figured the economy is weak and their portfolios are down the drain, so they bought a SUV to cheer themselves up. Motor vehicles have replaced Prozac as the anti-depressant of choice.”

Fry gives credit to American consumers for keeping the economy moving. “They almost single-handedly pulled the economy out of the 2001 recession with little help from either business investment or exports.” But, he cautions, they can't keep it up indefinitely. “If the economic recovery is to continue, investment and exports must pick up while growth in consumer demand fades to more sustainable levels.”

Employment, however, set no record. “It was down 13,000 in September 2002 and in October fell another 5,000. That means employment has increased by only 5,000 jobs in the last ten months even though we are supposed to be in a recovery, and 5000 jobs is essentially zero. That's 5,000 out of 131 million.”

Consumer Confidence — Better or Worse?
So much for a smooth road. Now for the bumps. Fry identifies them as “rising oil prices, declining stock prices, and a reluctance of businesses to hire more employees amid the uncertainties about the recovery and the concerns about a possible war with Iraq.

“Until October of last year, gasoline prices had risen little since April, despite an increase of $4.00 per barrel of crude oil,” Fry notes. A 40-cent-per-barrel increase in crude oil causes a one-cent-per-gallon increase in gasoline. This boosts consumer spending on gasoline by about $1 billion per year, money consumers cannot spend on other items.

“Until investment and/or exports pick up,” says Fry, “the economy will remain heavily dependent on mortgage refinancing and consumer spending for continued recovery.” Unfortunately, the refinancing boom can't last forever, as it relies on continued declines in mortgage rates. Weak growth, low inflation, and the Fed's latest cut in interest rates — to 1.25% — could help pull down mortgage rates further, but when rates stop declining, refinancing activity will drop sharply. Fry expects interest rates to remain “on hold” through the first half of this year.

“Even with refinancing activity at record levels,” Fry says, “consumer demand sagged in September and October as motor vehicle sales dropped sharply from the extremely strong levels seen in July and August.”

The University of Michigan's consumer sentiment index showed no recovery for 2002, says Fry. “It stood at 91.5 in August of 2001 and dropped to 81.8 in the aftermath of September 11. In May of 2002 it rose to 96.9, but five months later it was down to 80.4 — lower than it was after the terrorist attacks. We begin 2003 without knowing whether consumer confidence has improved or worsened.”

As consumer confidence went up and down, so did the stock market. Ever since the September 11 attacks, the stock market has risen one day and fallen the next. “The day before the terrorist attacks, the S&P 500 stood at 1092.5,” Fry says. “By September 21 it was down to 965.8. In January 2002 it rose to 1172.5, which turned out to be the high for the year. By October of last year it was down to 776.8, the lowest level since 1997, a swing of 385.7 points. As important as the stock market is to individual investors, the overall economy pays little attention to it. Some say the stock market has forecast nine of the last five recessions.”

Inventories Are Flat
Part of the problem with GDP, according to Lowney, is “the plunge in inventories. In the 1990s conventional wisdom said that because supply management was better, up and down swings in inventories would not play as big a role as they have in the past. Nevertheless, the downward swing in inventory in 2001 was a greater percentage of the entire economy than we have seen since the 1970s. It was bigger than we had in the devastating l980-82 recession and also bigger than we had in the 1990s. That theory was dismissed. True, supply management is better today, but the forecasting isn't. Today, inventories are flat.”

In the meantime, consumer spending is the engine that keeps the economy moving. However, Fry believes it cannot do the job by itself. “It needs help from other sectors in the economy,” he says and adds, “although investment in producers' durable equipment and software has bottomed out, recovery has been weak. Investment in information technology has stopped declining because of the need to replace old equipment and software. But the continued problems of the telecommunications industry and the lack of new applications software that require new computers are preventing a strong rebound.”

Fry warns, “Even with refinancing at record levels, there are signs that consumer demand is slowing. Retail sales declined in September and October as motor vehicle sales fell from strong July and August levels. If investments and exports fail to rise as consumer spending slows, government could fill the gap temporarily by boosting spending and cutting taxes. But the economic benefits of government spending are limited, and political considerations could block further tax cuts even though the US economy could handle a larger budget deficit.”

The economy won't get much help from real investment in industrial structures, which has fallen by more than half since early 2001, according to Fry, and investment in office buildings, which is down nearly as much due to high vacancy rates. “Excess capacity in many industries, disappointing growth in corporate earnings, and depressed stock prices also discourage capital spending. And if US companies do increase their capital expenditures, the over-valued dollar will lead them to do much of it abroad.”

A Strong Dollar
Exports may not come to the aid of the economy, either, says Lowney, due to the strong dollar. “The value of the trade-weighted dollar has risen by about 30% since 1995, and US companies have a difficult time competing with offshore imports. But we believe it is unsustainably high and will weaken somewhat; not to where it was in 1995, but by the end of this year the dollar could be at about 110 per euro and 68 to 70 cents per Canadian dollar.”

Lowney also sees some overall benefit to the strong dollar. “It tends to keep inflation down because import prices are lower [than domestic prices] and also because import competition intensifies, and it limits the pricing power of US firms. If you're the Fed or an American consumer, you want to keep inflation in check. The strong dollar helps do just that.

“I think a weak dollar would be beneficial to the US economy because it needs more stimulation now,” Lowney adds. “A strong dollar has an effect similar to increased interest rates. It represents a tightening of monetary policy. A weakening dollar, conversely, is roughly analogous to lower interest rates, which represent an easing of monetary policy.”

Definition of deflation: When my prices fall through the floor. That may be one way to define it, but Lowney defines it like this: Too little money chasing too many goods. “Yes,” he says, “deflation occurs when prices fall, and some deflation is good. For example, today's PCs cost less than yesterday's. That's fine for one product line, but when it happens across the whole economy, too little money chases too many goods and that's bad.

“The remedy, of course,” Lowney continues, “is to print more money or lower interest rates. The reason the Great Depression wasn't just the Great Recession is that the money supply collapsed. I don't see that happening today.”

One of the bumps in the road to recovery, Lowney says, is overcapacity. “Manufacturers increased capacity in 1999 and 2000 to meet an expected increase in demand. But the recession of 2001 reduced demand and America is stuck with too much capacity.

“The telecommunications industry is the most blatant example of overcapacity. They laid a lot of cable that will not be used for years; in the meantime, some glass fiber plants have been closed.

“Lower consumer spending is another [bump],” says Lowney. “It will slow down when the mortgage refinance game is over. Another factor that will take a bite out of consumer spending is the lack of pent-up consumer demand. Usually, during recessions consumers stop spending. When times get better, they buy refrigerators, furniture, and other things. This time, however, we have ‘spent-up’ demand. Consumers bought what they wanted and needed before the 2001 recession.”

The stock market is another of Lowney's bumps. “It has had a negative effect on retirement plans. People have seen their 401Ks become 201Ks. Although the stock market has trended upward since October, it still has a long way to go.”

The new year won't be all bumps and potholes, of course. For one thing Lowney cites the rebound in business investment spending. “It rose by about 6.5 percent in the last quarter of 2002.”

Furthermore, he says, “Income growth has remained fairly strong. The primary driver of growth is the increase in productivity. It has grown despite the recession and the sluggish economy. And, there is strong correlation between real wage growth and productivity growth.” Lowney also credits tax cuts with a boost in disposable income.

Economic growth, Lowney says, will be below the long-term growth trend of 3.25%. “It will be better here than in Europe and Japan, but not enough to lower the unemployment rate, which will hover around 6 percent. We are going to have a slowdown in consumption, relative to where it has been and relative to its trend. Investment spending will be relative to where it has been, at least until the end of 2003. Government spending will add to growth as well.”

Will We Have War with Iraq?
“Uncertainty is the enemy of investment,” says Robert Fry. “America is uncertain and wondering what will happen, which is doing more damage to the economy than a war would.

“Will there be a war; will there not be a war?…Will the allies go along with us, or will we have to act on our own?…Will it be a short war or a long one that gets us bogged down?…Will it disrupt oil supply or won't it?…And so on. All of this uncertainty,” Fry says, “has an impact on business investment in plants and equipment and on personal investment in stock portfolios.”

America also wonders about oil prices.

Fry answers, “The industry has a three- to five-dollar risk premium built into oil prices right now. If the shooting starts, prices could spike, but they could come right back down very quickly.

“If you look at what happened during the Gulf War,” Fry continues, “oil prices spiked for 15 minutes and then came right down quite sharply. This time, if the US and its allies have success without involving oil wells, I think prices will come down again.”

War with Iraq has other consequences. As Lowney says, “It will increase government spending and in the short term can help the economy. In the medium and long term, an increased government share of the economy tends to be detrimental. It takes money that could be invested in private enterprise and puts it into the government.

“My gut feeling is that it will be a short war,” Lowney says, “with no more than a one- or two-quarter effect on economic growth.”

However, like Fry, Lowney has concerns about the destruction of Middle East oil production capacity. “In that case, you would have sustained high oil prices until that capacity came back on line. The US is much less dependent on oil than it was 20 years ago, but it is still a major import. Forty-dollar crude would have a significant dampening effect on economic growth.”

Lowney continues, “Iraq is second only to Saudi Arabia in oil reserves, but they haven't been producing much since 1990 because of the UN sanctions. So, two or three years out, if the war in Iraq goes well and there is a friendly government involved and the investment flows to get their capacity back on line, I think that would have a positive effect in regard to lowering oil prices.”

For the next 11 months, Lowney says, other than Iraq, investors should keep their eyes on the return to corporate profitability and the employment picture. “If firms can be profitable, layoffs will be forestalled, and unemployment can stay below 6 percent. On the other hand, if firms are not profitable, more layoffs are possible, consumer confidence may fall, and the economy may suffer another round of layoffs. That's why profitability is so important.”

All things considered, Fry sees “growth at around the long-term trend of 3.0 percent to 3.25 percent. We had a few down months late last year, and we may have a few more early this year. Then, the economy will probably start to grow again with about a 2 percent growth in manufacturing production and 3 percent GDP in round numbers.”

Now we know what those ruts, bumps, and potholes are, and in spite of them, it looks as though we can make some progress — albeit a bit slowly — on the road to economic recovery. But then, anything worth having is worth fighting for.

Robert C. Fry Jr. joined DuPont's Economists' Office in 1987 following a three-year stint in Conoco's Coordinating and Planning department. As senior associate economist, he analyzes and forecasts global macroeconomics and its impact on DuPont. He assists DuPont businesses by interpreting economic data and using it to forecast DuPont performance. He is also the author of the monthly newsletter, “Current Business Developments.” Robert received his B.S. in economics from Ohio Univ. and an M.S. as well as his Ph.D. in economics from Harvard. He is past-president of the Board of Visitors of the Honors Tutorial College of Ohio Univ., a member of the Economic Roundtable of the Ohio Valley, and the National Assn. for Business Economics. He is a frequent speaker at trade association meetings and DuPont customer events.

Brendan K. Lowney has analyzed the global macroeconomy for Resource Information Systems Inc., Bedford, MA, since 1994. He has directed RISI's Macro Service since 1997 and edits RISI's Monthly Economic Commentary. He is responsible for US and international macroeconomic analysis and forecast work, which forms the basis for RISI's industry projections. He has spoken at numerous conferences in North America, South America, Europe, and Asia. He completed all coursework toward a Ph.D. and holds a Master of Arts degree from Boston College in economics. He earned his B.S. degree in mathematics and economics at Union College in Schenectady, NY.

Robert W. Marsh, former executive director of the Association of Industrial Metallizers, Coaters & Laminators (AIMCAL), is a retired marketing communications manager for ICI Americas, where he managed advertising, sales promotion, and product publicity for Melinex polyester films. Prior to joining ICI, he handled a variety of advertising assignments for the DuPont Co.

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