Evans On The Economy -- Recovery Will Inch Along

Dec. 21, 2004
This year will be better than last, but not much better.

Those who put their faith in the index of leading indicators believe that the recession is just about over, and the recovery could start any time. While the leading indicators have never missed a turning point, they have given several false signals. The problem this time is that many key economic indicators fell so rapidly after Sept. 11 that a modest rebound was virtually certain, yet they still remain below their August levels. As a result, I am somewhat skeptical that the recovery is just about under way. However, even if real GDP were to inch forward this quarter -- and, in my opinion, that will not happen until next quarter -- the recovery this year will be more sluggish than usual for several reasons that have little or nothing to do with consumer confidence. Three major factors will cause a fairly anemic recovery this year, with real GDP rising an average of only 3% during the year. First, corporate profits will remain depressed, which means capital spending will not rebound. Second, not only will the unemployment rate continue to rise, but increases in total compensation will be far smaller than usual. Average hourly earnings will probably rise about 4%, but compensation derived from bonuses, profit sharing and stock market gains will fall. Third, the global recession, combined with the overvalued dollar, will continue to depress the growth in exports. Accompanying this fairly anemic growth, gains in the stock market will be minuscule. Many financial optimists apparently overlook the fact that the price/earnings (P/E) ratio of the market is currently about 25, compared with the long-term historical average of 17 during periods of low, stable inflation and balanced budgets. I am not suggesting the P/E ratio will return to 17 in the near future, but it is hardly possible that it will increase above its current value. Hence, the gain in stock prices will essentially be limited to the gain in profits. In many recoveries, profits rise at unusually rapid rates during the first year of the upturn, increasing by 20% to 30%. However, that will not occur in 2002; profits are predicted to rebound less than 10%, limiting increases in the broad-based market averages to the same percentage increase. The result will be a "jobless recovery," similar to 1991-92 when the unemployment rate continued to rise for 18 months after the recovery started. But why will profits be so weak? There is no great mystery here: The rise in sales will be smaller than usual, and margins will continue to be squeezed, with little or no pricing power for firms producing internationally traded goods accompanied by larger increases on the cost side. This will not occur for average hourly earnings, but for fringe benefits. Health care costs will rise 13% this year, and while some firms will offset those costs by requiring employees to pay a larger proportion of health insurance premiums, and other firms will simply drop health care coverage entirely, those options are not available to large firms with unionized contracts. Even firms whose workers are not unionized will find that cutting back on these benefits will cause an exodus of the most talented. Contributions to pension plans will rise because firms no longer have a "free ride" from rapidly increasing stock prices. Also, pressure will build during the year for firms to use a smaller proportion of their own company stock to fund these retirement plans. As a result, labor costs will rise faster than prices this year. Besides depressing capital spending, the downward pressure on profits will also result in further cutbacks in discretionary spending, less hiring, and smaller total compensation payments for those who do retain their jobs. None of this means that the recession will continue throughout the year; the economy should turn up either this quarter or next. But the initial upturn will be followed by subpar growth for the rest of this year. Michael K. Evans is chief economist for American Economics Group, Washington, and president of the Evans Group, an economics consulting firm in Boca Raton, Fla.

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