Good News:
Business is Not as Awful as It Has Been

At the recent one day Group of Seven, or G-7, meeting in Rome, U.S. Treasury Secretary Paul O’Neill was quoted as saying, “The corrections that are taking place in the U.S. economy are putting us on a footing that will put us to higher rates of real growth fairly soon.” In the private sector, the press focused on PMC Sierra’s announcement that “things look soft across the board,” but we noted that management simultaneously emphasized that segments of its semiconductor business were experiencing strong design wins. AOL Time Warner’s CEO, Jerry Levin, says that advertising revenue has “stopped falling” and Oracle Systems’ CEO, Larry Ellison, says, “We’re seeing some of the big (software) deals come back. The economy doesn’t seem to be getting worse.”

Such preliminary and admittedly anecdotal signs of a trough in economic activity are occurring at a time when better news is emerging from a macroeconomic standpoint as well. Energy prices appear to be moderating, at least for now, which should forestall any inflationary tendencies in the U.S. economy. On the monetary side, the Fed has just made its sixth Fed Funds target rate cut in as many months and, on the fiscal side, taxpayers will be reaping the benefits of a tax cut and tax rebate checks within a few weeks. Corporations, taking advantage of rates that are much lower than they were at year end, are in the process of a major restructuring of their balance sheets.

Finally, and this is certainly no real news to common stock investors, is the fact that stock valuations have grown even cheaper, notwithstanding the absolute train wreck in the technology and telecommunications sectors. As earnings estimates in many industries have contracted, the corresponding prices of shares have also pulled back a somewhat greater amount, such that valuations are now even cheaper than they were at the end of the first quarter.

Six incidents of monetary easing in six months is the most aggressive policy action of Chairman Alan Greenspan’s 14 year tenure. These moves were deemed necessary because of the economy’s desperate need for liquidity. The Fed’s injection of liquidity has averted a credit crunch which appeared imminent and most certainly would have caused a recession. Now that rates are lower, the supply of loanable funds is expanding. The money supply is growing at a rapid clip and banks are finally beginning to trickle loans out to smaller borrowers. (Large, well-established companies always had access to loans.)

For large, non-financial corporations, this round of monetary ease has resulted in an undertaking by corporate managements to restructure balance sheets. Lower interest rates have allowed companies to extend the duration of their liabilities (that is, to issue long term bonds) and reduce dependence on short term borrowing, thus improving cash flow. Simultaneously, corporate money market fund balances increased at a 74% annual rate in the first quarter and time deposits increased 142%. Corporations have also sharply curtailed the issuance of commercial paper in the same period.

The result has been the buildup of large amounts of cash and cash equivalents on the balance sheets of the constituent companies of the S&P 500. Since this cash generates very low returns (low interest rates) it will eventually be spent. History shows that it most likely will be spent to purchase tangible assets. This portends another capital spending cycle, the timing of which will most likely begin when the Fed ends this round of easing.

If the Fed eases another 25 basis points at its August 21 meeting (as we expect) it could be the end of supportive Fed action for awhile. After all, it generally requires 6 – 9 months for the effects of a given change in interest rates to be felt within the domestic economy. If that holds true, we should just now (or very shortly) be experiencing the positive effects of the first Fed ease on January 3 of this year. The impetus to the economy from the other five rate cuts has yet to work through the system. In the absence of a recession or evidence of emerging inflation it makes sense, therefore, for the Fed to move to the sidelines for awhile and allow the economy to recover.

Once corporate cash begins to be used to purchase tangible assets, the new capital spending cycle would most likely mirror previous capital spending cycles, that is, it would carry a growth rate approximately three times real Gross Domestic Product (“GDP”) (10 – 20%) and would last for more than one year. High return products, especially those substituting technology for labor, would lead the new cycle, just as they did in previous cycles. We expect continued strong demand for items which round out a company’s internet “B to B” purchasing and inventory strategies, an expectation which, if realized, would be very positive for companies like Oracle Systems.

The rate at which corporations are accumulating cash has only occurred four other times since the end of the Vietnam War. In every case the corporate sector embarked on a sustained capital spending cycle. In the 1970’s they substituted capital for labor by “restructuring”; in the 1980’s they bought real estate and other companies; in the 1990’s they increased the efficiency of plant and equipment through the purchase of technology and repurchased their own and each other’s stock. We expect that history will repeat itself but that the capital spending cycle will not begin until the Fed has completed its round of easing.

With private capital investment constituting approximately 20% of GDP and with the capital spending cycle on deck but delayed for two or three quarters, it falls to the consumer, who constitutes approximately 70% of GDP, to lead the economy out of its current malaise. Fortunately, consumers have also somewhat restructured their balance sheets by refinancing mortgages and borrowing against equity to pay down short term debt. However, consumer debt has not been substantially reduced by this latest round of refinancing, leaving the American consumer vulnerable to a downturn in job growth. Any substantial increase in layoffs could squeeze the consumer and dampen consumer spending. We believe that the unemployment rate would have to exceed 5.5% before consumer spending would be choked off. While unemployment is on the rise from its current 4.6% level, we do not expect joblessness to become a problem for the economy as consumer confidence actually increased in June.

The consumer will also be receiving some help from Uncle Sam. Tax rebate checks are literally in the mail and will add ten full percentage points to personal income growth in the third quarter alone. We expect that a large percentage of these rebate checks (as well as a large percentage of the proceeds of lower tax rates effective July 1, 2001) will be spent rather than saved. Thus, President Bush’s tax cut will translate to a much-needed full percentage point increase to consumer spending this year, back loaded to the third and fourth quarters.

All in all, we expect that consumer spending will be up approximately 3.5% between now and year end, offsetting the dismal corporate sector. We further expect that the consumer will be more buoyant in the second half of the year because of lower energy prices, lower interest rates, a stable housing environment, tax cuts and, hopefully, a better stock market.

Despite all of this evidence that things may be on the verge of improving, the economic news has been just horrible. Industrial activity has declined for eight straight months and may well continue. Capital spending in the second quarter was even weaker than it was in the prior two quarters. Technology equipment spending fell 20% in the second quarter, on the heels of a 14% drop in the first quarter. Manufacturing capacity utilization is 76% and declining.

Despite this spate of negative economic news, it does appear that the U.S. economy will avoid a full-blown recession. First quarter GDP eked out an increase of 1.2% and, thanks to the U.S. consumer, the second quarter is likely to be about the same. One of the reasons we are able to avoid recession is because the banking system is in better shape than it was in previous downturns. The banks, in other words, should not take full responsibility for the excesses in the technology sector. The leveraged buyout mess of the late 1980’s was caused by excess lending by banks as were similar excesses in real estate lending and less developed country lending at other points in time. This time we do not enter a period of economic softness with a debilitated banking system. This could limit the magnitude of the downturn and set the stage for an earlier recovery. We estimate 2.0% annualized growth for each of the final two quarters of the year and now expect that real GDP will increase 1.9% for calendar 2001. We further expect that next year’s recovery will see GDP north of 3.5% in 2002.

Inflation is not likely to pose much of a problem. One need look no further than the slide in first quarter profit margins to correctly note that corporations had absolutely no pricing power – and still don’t. Increasing unemployment, falling capacity utilization, declining profit margins and slowing growth abroad is not a scenario that generates high inflation. In fact, the two pockets of inflation observed in the first quarter, energy and health care costs, were supply driven, not demand driven, and supply imbalances can be remedied over time. We see inflation moderating to end this year up 2% or so, with the possibility of an even lower number in 2002.