BUSINESS OUTLOOK

U.S.: The Economy Is Stable--Even If the Market Isn't

Skimpy inventories and a stimulative Fed point to continued growth

Stock investors have been fretting over the unusually high level of uncertainty hanging over this recovery. By June 19, those worries had pulled stock prices down about 7% in only the past month--and more than 12% since March. So now a new question has arisen: Will the stock market drag down the economy?

Probably not. First of all, far more alarming drops in stock prices--think the crash of 1987 or the 2000 collapse in the Nasdaq--have shown that the link between losses in stock wealth and drops in consumer spending is tenuous and that the impact is small. Housing wealth has proven to be far more crucial to consumers, and home values are still appreciating.

Second, the equity market is not the only source of funds for capital projects. Internally generated funds, mainly profits and depreciation allowances, now cover nearly 90% of corporate outlays for new equipment, buildings, and inventories. Plus, corporate bond issuances are growing rapidly, and bond investors see less danger of default. Risk premiums that companies must pay above the yield on riskless U.S. Treasuries have fallen this year.

In addition, declines in the stock market are usually associated with tightening monetary conditions. This time around, though, the Federal Reserve is exceptionally accommodating, and policy is likely to remain stimulative for months to come. That's partly why, despite recent stock market woes, economists believe that the recovery remains on solid ground and will accelerate into 2003.

ECONOMIC GROWTH this quarter is clearly slowing from its rapid first-quarter clip. But the latest data suggest that the cooler pace is temporary. Steady, if weaker, consumer demand has helped to shrink business inventories to a record low in relation to sales (chart). Inventory rebuilding will support further growth in orders and production in the second half, even as industrial production is already on the rebound. Finally, homebuilding remains surprisingly firm, as further declines in mortgage rates buoy demand.

To be sure, the bear market, if it worsens, creates a risk for the second half. But the declines so far don't necessarily signal future economic weakness; rather, they point to the soft spot the economy is now in. In this atypical business cycle, fraught with unprecedented risks fueled by geopolitical dangers and mistrust of Corporate America, stock prices have abdicated their usual role as an indicator of future economic activity. Stock investors are taking a very short-term view of the future, which is the chief reason why improving prospects for economic growth and profits are not yet reflected in share prices.

Clearly, the recent market slide has hit consumer confidence. The University of Michigan's sentiment index in early June fell 6 points. And a larger than expected 0.9% fall in May retail sales makes it seem as if consumers are opening up mutual-fund statements and then snapping their wallets shut.

But a closer look at the data shows that consumers are just slowing their spending in the second quarter, not throwing in the towel. For one thing, even with the early-June decline, the Michigan index is at 90.8, a level that historically has been associated with periods of at least moderate growth in consumer spending. Also, first-quarter consumer outlays were boosted by several special factors, most notably tax cuts, auto sales incentives, and unseasonably mild weather. Plus, May's drop in retail sales followed a 1.2% surge in April, and weekly sales surveys through mid-June show a strong rebound.

IF YOU WANT TO KNOW how consumers really feel about their financial future, look at their willingness to commit to a long-term mortgage. By that gauge, consumers are still upbeat. Housing starts in May soared 11.6% from April, the largest increase in seven years. And in June, homebuilders reported that market conditions, based on current and expected sales and buyer traffic through model homes, remain very good.

Why? Because mortgage rates are falling again. By mid-June, 30-year fixed rates slid to an average of 6.7%, the lowest level since the plunge just after September 11 (chart). Rates are declining again because expectations about when the Fed will begin to lift interest rates are being pushed further into the future.

The biggest danger from falling stock prices is the chance of them sapping even more business confidence, which could place an added drag on capital spending. However, business decisions on new equipment and inventories will be governed more by what companies see in their order books and on the bottom lines of their income statements. Those are both improving.

In particular, business inventories have shrunk to levels that assure a significant pickup in reordering. In April, stock levels at manufacturers, wholesalers, and retailers fell 0.2%, the 15th consecutive monthly drop, but sales jumped 1.8%, pushing the ratio of inventories to sales to a low 1.35. That ratio is far below its trend of the past 10 years, suggesting that inventories are generally at less than their desired level.

INVENTORY REPLENISHMENT explains why the industrial sector is on the mend. Industrial production rose 0.2% in May, its fifth monthly increase. So far in the second quarter, output is growing at a 3.2% annual rate, better than its 2.8% advance of the first quarter.

Factory output alone was also up 0.2% in May. Surprisingly, one of the strongest areas of production has been the tech sector, outside of telecom equipment. Output of computer and office equipment, as well as semiconductors, are up at double-digit rates vs. their levels of May, 2001. Thanks to healthy homebuilding, output of appliances and home electronics are growing solidly. And output increases in industrial materials indicate future gains in production: Factories are laying in supplies before revving up their assembly lines.

In the meantime, inflation is following its usual trend by slowing down in the first year of a recovery. Consumer prices were unchanged in May from April, and they are up only 1.2% from a year ago. Core prices, which exclude volatile food and energy, are up 2.5%, down from their 2.8% pace of November, 2001 (chart).

But while low inflation means consumers are able to get more bang for the buck, a lack of pricing power doesn't mean profits will necessarily get squeezed. Thanks to productivity gains, companies actually have cut the labor cost of producing each unit of product. That means profit margins are increasing, and any increase in revenues will immediately pump up the bottom line.

Investors have not yet grasped the brighter outlooks for both the economy and profits in the second half. That's why life on Wall Street is so dismal right now. But will the stock market derail the recovery? So far, at least, the data argue strongly against it.