How's Business? -- Economic Commentary by Stephen Roach

In a post-bubble era, the state of business matters more than ever. The time-honored workhorses of America’s cyclical recovery -- consumer durables and residential construction -- have already pulled the economy far enough; they never fell during the recession of 2001 and have since risen to new highs in the anemic upturn that has followed. Now it’s up to the business sector to take this cycle to the next level if the economy is ever to make the transition from a weak recovery into a vigorous expansion. As I see it, without the added impetus of hiring and capital spending, US economic growth will remain subpar and the case for deflation will remain very much intact.

The pressure on the business sector arises by default. That’s because the other sectors that normally drive cyclical recovery -- namely, consumer durables and homebuilding activity -- are already operating at sharply elevated levels. In the first quarter of 2003, personal consumption expenditures on durable goods stood at 10.5% of real GDP -- down fractionally from the 10.9% high of 3Q02 but well above the post-1960 average of 6.6%. Similarly, residential construction expenditures stood at 4.2% of real GDP in early 2003 -- equaling the highest share since early 1989. In my view, in order to eliminate the threat of deflation, the US economy needs to accelerate from its 1.7% post-bubble growth path of the past three and a half years to approximately a 4% growth trajectory -- and remain on that more rapid path for at least a couple of years. Inasmuch as this added impetus is unlikely to come from the extended sectors of consumer durables and homebuilding, by process of elimination, the burden of acceleration falls largely on the business sector.

Most feel such a development is now at hand. In his midyear testimony to the Congress, Fed Chairman Alan Greenspan argued that the US corporate sector is poised for recovery. To hear the stock market tell it, it’s only a matter of time before earnings-driven businesses break out of their funk and deliver on the capital spending and hiring fronts. Ultimately, this is where the rubber must meet the road on the missing pieces of this cyclical recovery. Without employment growth and capex, the US economy will have an exceedingly difficult time in breaking out of its post-bubble malaise. This is where I continue to have my greatest skepticism on the case for imminent recovery.

First of all, I don’t buy the notion that Corporate America is now riding the wave of a vigorous rebound in earnings. Yes, corporate profits are up -- but it’s a modest rebound from a very low base. As measured in the national income accounts, overall economic profits (adjusted for depreciation and inventory accounting distortions) were up 6.7% (y-o-y) in 1Q03; for the nonfinancial corporate subset -- a better gauge of the business earning power that tracks underlying economic activity -- the comparison was +7.5%. Given the earnings carnage that occurred in the most recent recession, these relatively modest gains hardly speak of a restoration of corporate vitality. Maybe that’s coming -- and that might explain why the stock market is so thrilled -- but rest assured it hasn’t happened yet.

But it’s the trends in profit margins that are even more revealing. For the nonfinancial corporate sector, pre-tax profits as a share of business product -- a proxy for profit margins that normalizes for the subpar recovery in output -- rose to 8.7% in 1Q03; while that’s well above the 7.2% low hit in 1Q01, it’s far short of the most recent peak of 12.8% hit in 3Q97 and nearly 1.5 percentage points below the post-1970 average of 10.1%. Moreover, it has taken fully eight quarters for this earnings share to climb only 1.5 percentage points from its low; by contrast, eight quarters after the earnings trough of the previous seven business cycles, this same pretax earnings share for nonfinancial corporations had risen by 2.9 percentage points -- essentially double the gain in the current cycle. In other words, while earnings are finally starting to beat expectations of now overly cautious Wall Street analysts, corporate profitability is lacking in its normal cyclical vigor and has not improved nearly enough to repair the damage that was done in the last recession. As I see it, despite all the talk about operating leverage, there is more hype than substance to the current rebound in earnings.

Moreover, I think the so-called earnings recovery is overblown altogether as a factor determining the business sector’s capex and hiring decisions. Nor can the answer be found in the aggressive corporate balance-sheet restructuring of the past few years. In my view, the real story lies in the persistent lack of pricing leverage and what that tells us about the lingering overhang of excess capacity. Lacking in pricing leverage, businesses would be foolish to exacerbate that problem by adding to supply. The anecdotal evidence remains supportive of this view. In my conversations with US corporate executives, two common themes emerge from the capital spending discussions -- domestic capex remains limited to replacement and capacity expansion is increasingly focused on China. While I’m oversimplifying a bit, this is not too far from the mark of what the aggregate data have shown. The counter to my argument is that this is yesterday’s story -- that since the ratio of capital spending to depreciation is now at a 50-year low, the capacity overhang has finally been worked off. Under those circumstances, and in the context of improved earnings and a reduced cost of capital, the consensus believes that capacity-short businesses are about to change their ways and begin adding to scale.

I remain very suspicious of this conclusion. For starters, I disagree that a low capex-to-depreciation ratio should be construed as an overshoot that points to an imminent snapback in business fixed investment. To the contrary, this is precisely the result that should be expected in the aftermath of one of the biggest capital spending bubbles in modern history. The only way businesses can pare the resulting overhang of excess capacity is to take investment below depreciation -- and that’s only starting to happen. But there’s a good deal more to this story. In today’s increasingly open global economy, it is ludicrous to consider capacity in the narrow domestic sense. The question of business scale -- whether its capital or labor -- now needs to be seen in a much broader context. With globalization come global supply chains and global supply curves. That’s long been true in tradable goods and is now increasingly true in once “non-tradable” services. The Chinas of the world are coming on stream rapidly as manufacturing outsourcing platforms. The same can be said for IT-enabled outsourcing of an increasingly wide range of services from India. As a result, the very concept of capacity is more amorphous than ever.

My advice is to take businesses seriously when they continue to complain about a lack of pricing leverage. The macro inflation data support that verdict all too well: America’s core CPI increased at only a 0.9% average annual rate in the first six months of 2003 -- less than half the 2.0% pace of the preceding six months. This dramatic deceleration was driven equally by goods and services; for “core goods,” deflation deepened to -2.4% in the first half of 2003 (from -1.4% in the second half of 2002), whereas for “core services” inflation slowed to 2.4% over the past six months (from 3.4% in the final six months of 2002). Like it or not, this is symptomatic of an unrelenting and increasingly widespread loss in pricing leverage -- a phenomenon that is consistent with a persistent overhang of excess capacity that will continue to constrain capital spending. And that’s exactly what companies are telling us. The latest CEO survey of the Business Roundtable reveals that only 14% of the nation’s largest 117 companies are planning an increase in capital spending over the next six months -- down from an 18% reading of three months ago.

Lacking in pricing leverage and demand visibility, it should hardly be surprising that Corporate America continues to grimace when asked the most important question of all -- “How’s business?” In today’s climate, cost cutting remains the credo, and capital spending and hiring will continue to be missing in action until that mind-set changes. Try telling that to the stock market, the Fed, or to a bullish forecasting consensus.

The author of this articles raises some key points about capital spending but one needs to delve into the details in order to get a clearer picture of the current situation. He is spot on with the importance of manufacturing to economic growth. There are currently two major contributors to GDP growth in our current economy - manufacturing and services. But when we look at the service sector in detail we see that the only real contributors in this sector are health care and education. The debate over whether or not we are better off with more education and health care is best left to another discussion.

Manufacturing, on the other hand is tangible and is easier to quantify the true benefits. Manufacturing in the US is facing difficult times. There is still a tremendous amount of excess capacity out there. The author has lumped all manufacturing together and it should probably be divided into high tech and traditional. The huge surge in capital spending in the late 90s was mostly in the high tech sectors brought on by the dot com and telecom bubbles. Some of that has been worked off, with computers and office equipment operating at over 80 percent. But communications equipment is running at below 50 percent capacity.

The excess capacity in traditional manufacturing is primarily due to a significant downturn in those sectors brought on by a series of events going back several years beginning with the Asian crisis, the devaluing of the Euro, 9/11, lack of faith brought on by Enron, etc. With the exception of automotive, which has slipped below 80 percent in the last couple of months, durable manufacturing is operating at exteremely low levels. Aerospace is at below 60 percent, construction and farm equipment are around 65 percent, and fabricated metal products are just below 70 percent.

It will take a prolonged period of steady increases in output for businesses in these sectors to consider any investments other than to replace existing equipment. China is a big problem as well. Chrysler just sent letters out to many of their suppliers telling them that unless they can meet the costs in China (they used the term "lowest cost nations") they will no longer do business with them. This mindset will only further erode our manufacturing base. Alos, a recent study came to the conclusion that about half of the auto suppliers in North America will probaly go under in the next several years.

Without any expansion there will be no added manufacturing jobs. In order to compete on a now global basis we cannot do it based on cost. When faced with the prospect of building a new plant one has to consider all of the factors. Why set up a plant here where you have to face uncountable regulations or in a place like China where none exist? It is not just labor costs that are driving businesses away.

The area that we excel in is creativity. The area that I work in invloves a lot of technology ranging from the simple to the extremely sophisticated. The companies that are doing the best are the oones that are the most creative and whose products depend on a lot of high-level engineering. The ones making commodity type products are all struggling.

When talking to users of this area's procucts, the thing that keeps coming up is service. People remember the company who resolved a problem right away as well as the company that brushed them aside. Just look at the auto sector. There is a perception that Japanese cars are more reliable than American cars. When Ford tried to duck and run from the Explorer/Firestone problem that only reinforced that perception.

For every dollar of manufacturing output another $1.25 is created directly. The only other sectors that produce more are mining, agriculture, and construction which produce about $1.30. But agriculture and mining only account for a little less than two percent of GDP each and construction about five. Manufacturing is between 15 and 20 percent of GDP. While the service sector takes up a bigger piece of the pie (40 percent) it only generates an additional 50 to 60 cents for every dollar. Government takes up 13 percent and we know where that takes us.

So, the author is right that we may not see any significant growth in manufacturing for a while and employment gains may be some time after that. When he concludes that it is now left up to the business sector (services) to drive growth, that is not all that encouraging. It takes a lot more growth in the service sector to get a significant kick in general economic growth. We can only cut each others lawns to drive growth for so long.

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