Analyst Says Some Pain May Linger In Next Quarter

June 5, 2002
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GRAND RAPIDS — The length and severity of the current economic slowdown has had both Wall Street and Main Street tied up in knots. Is the worst of it over?

Joseph Keating, chief market strategist and chief fixed income officer for Fifth Third Bank, believes there may be some lingering pain ahead in the next quarter, but not a recession.

“I think the economy is basically feeling the impact of going about 60 miles per hour in a 35 mph speed zone to about 15 mph. in that same 35 mph speed zone,” he said.

Commerce Department figures indicate the economy grew at a surprisingly solid pace of 2 percent in the first quarter of this year, and that was much higher than anticipated, he said.

Consumer confidence — as well as investor and business confidence — took a hit with the softening labor market, the drop in stock prices and the decline in household net worth in 2000.

From 1995 to 1999, $7 trillion in wealth was created in U.S. equity markets, Keating pointed out. During calendar year 2000, $2 trillion of that $7 trillion increase was lost.

He thinks the lengthy presidential election last year had a negative impact on the economy as well. The S&P 500 declined more than 100 percent and about 75 percent of the decline in the Nasdaq occurred during the roughly six-week period following election Tuesday.

The auto component of industrial production has turned up over the months of March and April. Vehicle sales were down slightly in April, following a surge in January and February as the auto sector was trying to reduce inventories.

There was a 4.4 percent decline in construction spending between March and July of 2000, but since July the sector has been in recovery mode with a 7.2 percent rise in construction outlays.

Although housing starts and building permits in the first quarter declined 11.5 and 14.4 percent, respectively, new and existing home sales are approaching an all-time high, Keating pointed out. Similarly, retail sales shot up dramatically last month.

Unemployment claims have risen dramatically over the past six weeks and are roughly 50 percent higher than a year ago. Labor Department reports for April show the unemployment rate at 4.5 percent, which represents a two-and-a-half-year high.

Labor tends to fall off after the overall economy falls off, and likewise, tends to turn up after the overall economy turns up, Keating explained, and that indicates “there’s more pain to come on the labor front.”

Although the consumer confidence measure for April still shows a decline, there was a clear dichotomy last month in what consumers were saying and what they were actually doing in terms of spending, Keating noted.

According to the Michigan consumer confidence series, the measure of consumer confidence was up almost 5 percent in early May.

The consumer spending rate was 3.1 percent during the first quarter, with strong increases in spending on durable goods, particularly motor vehicles. As Keating noted, there was a 20 percent gain in auto purchases for the quarter due to aggressive discounting in the automotive sector that was focused on liquidating inventory buildups.

Business capital spending grew by 1.1 percent, with most of the growth, or 11 percent, occurring in investment in facilities.

“The business community now has a renewed focus on building physical plant capacity after structure outlays had declined in four out of the previous five quarters,” Keating observed, noting structure outlays were put aside then as business focused on computer expenditures in preparation for Y2K.

In recent months, rising energy costs and power generating capacity demands have spurred a significant rebound in business expenditures on energy exploration and in building utility facilities.

Expenditures on energy exploration represented slightly more than 75 percent of business capital spending in the first quarter.

Business responded to profit erosion in the last part of 2000 and the first part of this year by cutting back investments in business equipment. The back-to-back quarterly declines in equipment outlays were the first since the start of 1991 when the last recession was drawing to a close, Keating added.

“The silver lining in the manufacturing sector — and clearly the best news that was embodied in the GDP (gross domestic product) report — was actually the item that brought about the most significant drag on the economy’s growth rate in the first quarter, and that was a massive inventory adjustment in the first quarter.”

The manufacturing sector undertook a concerted effort to reduce inventories that adjustment was both quick and successful, and is now largely over, he said.

There remains, however, a level of uncertainty in the economy.

Concerns are mounting over the sharp deceleration in the labor market. That was what was behind the Fed’s surprise cut in the interest rate in April, the fourth in recent months.

For about six weeks now, Keating said, companies have been coming up with disappointing profit announcements: consequently, many announcements have been accompanied by plans to cut employment.

“The near term goal of the Federal Reserve is to keep consumers in the game,” Keating remarked. “If they don’t, they run the risk of another wave of unwanted inventories accumulating, and probably another round of production cutbacks and layoffs, which would only increase the downside risk in consumer spending.”

The other threat to the economy is the still dismal outlook for business capital spending, particularly on high technology equipment. An inventory overhang in technology persists and has to be removed before work can increase in the technology arena to move production higher, Keating said.

A potential spur to sooner-than-later growth in the high technology arena is the rapid product innovation and short product cycles inherent in the technology and telecommunications realm that could force the writing off of a large part of inventory overhang before demand has a chance to recover.

“We think that’s why we’re seeing such weakness in technology stocks,” Keating remarked. “We think investors are actually betting that we’ll see a good part of this inventory overhang having to be written off.

“We think the correction in the technology arena will persist through year-end, but we wouldn’t be surprised to see a pretty healthy snapback in technology spending as we move into 2002.”

Keating expects the economy to continue to give off some mixed signals for a while and that the current quarter will be another quarter of transition for the economy, possibly with a slightly lower growth. 

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