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Saturday, July 19, 2003

On Which Business are we Bound?

Today some views on the US economy and the recovery. Firstly Stephen Roach. Stephen, like me, doesn't buy the rasmatazz, and is still extremely skeptical. His argument, business earning are rebounding, but they are rebounding from a very low base. In addition the globalisation of supply chains, and the rise of the outsourcing 'platforms', means that employment growth - like good lovin - is increasingly hard to come find. Does this mean that this gloablisation and outsourcing is bad? This is not the conclusion I draw. The problem is elswhere. Making manufacturing and a part of the serviecs sector more efficient, and at the same time stimulating growth and employment in the developing world, is not in itself a bad thing. The diificulat question is where the new growth and employment is going to come from in the OECD world? Remember that I was citing WW Rostow and the importance of sectors last week. Well here you have it: where are the new sectors? The ones which can support and sustain the living-standards-premium of the developed world. It won't be in care of the elderly, which is highly labour intensive, and fuelled by human capital from the third world. On some explanations, (Blanchard for one) much of the German, French and Japanese productivity spurt in the 1970's and 80's came from a shift out of a low productivity agricultural sector. So the problem for the US is not leaving a sector where it cannot compete in productivity terms, but into which sector will it more? The traditional answer has been technolgy and information. But it is here where a combination of rapidly falling prices and difficilties in establishing and protecting ownership rights, together with a level of uncertainty (and lack of visibility) itself associated with the very pace of change, continues to make things extremely difficult. Hence the question mark.

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.

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.
Source: Morgan Stanley Global Economic Forum

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