July 6, 2009
Two weeks ago this column suggested that the recovery, once it begins, would be characterized by modest growth, not a vigorous V-shaped recovery. A major reason for that conclusion is that consumer spending in the quarters ahead should be subdued for a variety of reasons – the consumer already has far too much debt relative to income, credit is available only to the most credit-worthy borrowers, consumers today are far more inclined to save any excess income than spend it, mortgage rates in the past month have backed up by 75 basis points, and gasoline prices have jumped from $1.40 to $2.40 per gallon.
The consumer represents about two-thirds of the overall economy, but what about the businessman and capital spending? The accompanying bar chart tells the story. Capital spending is in a freefall as firms try to cut costs and restore profitability. In the past two quarters investment spending across all sectors of corporate spending — new structures, industrial equipment, software, and residential investment — has fallen at the fastest pace since the depression.
The biggest problem at the moment is surplus capacity. The factory utilization rate has declined to 65.0% and is still falling. Historically, the utilization rate in the manufacturing sector has averaged about 80%. There is no reason to build a new factory, re-tool the factory floor, or upgrade the computer system. Surplus capacity abounds. Indeed, manufacturers today are more interested in cutting production and shuttering factories than in building new ones.
Do not expect a revival of corporate investment until such time as several factors fall into place. First, industrial production has to climb again, which is unlikely to begin until late this year. Second, capacity utilization needs to climb from its current range of 60-65% to at least 70%. Another necessary ingredient will be a return to profitability. Given the diminished prospect for consumer spending, corporate profits are likely to remain under pressure through the end of this year and probably into the spring. Finally, given the less than robust outlook for corporate earnings and internally generated funds, corporate America needs access to more readily available external funding. At the moment corporate spreads are sufficiently wide to make borrowing rates prohibitively expensive for all but the most creditworthy borrowers. Banks need to be willing to accept a slightly higher degree of risk and make funds available to a wider group of corporate borrowers, particularly small businesses. Against this background, capital spending will not provide any stimulus to the economy until the middle of next year.
What about government spending which represents 18% of the economy? Remember that this category includes state and local government spending as well as federal expenditures. As shown in the accompanying pie chart, state and local spending represents 11% of the economy. But this category will surely decline next year as states sharply curtail spending to balance their budgets.
Federal government expenditures which amount to 7% of the economy will add significantly to GDP growth in the second and third quarters of this year. The Congressional Budget Office is projecting a 30% increase in spending for fiscal 2009 which ends on September 30 – just over three months from now. While they may fall short of the projected gain in spending, look for federal government expenditures to add significantly to GDP growth in the next two quarters. When the next fiscal year begins in the fourth quarter of this year, be aware that the CBO is projecting a somewhat slower pace of federal government spending in fiscal 2010. Thus, any contributions to GDP growth in the next couple of quarters will not be sustained.
So let’s see. We anticipate a moderate pace of consumer spending in 2010, combined with a likely further decline in both capital spending and state and local government expenditures. The only offset will be a boost from federal government spending during the next couple of quarters. Adding up those bits and pieces is likely to produce GDP growth next year of 2.0-2.5%, not the 4.5% pace we typically get in the first year of expansion. While the bad news is that 2.5% GDP growth is relatively modest, the good news is that growth at that pace will keep the Fed on hold for a long time to come.
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