David A. Gaffen
What Does the GDP Mean in the Fed's Fight to Save Corporate America?
David Gaffen
04/27/01 - 05:50 PM EDT
in its mission to revive corporate America? The 2% rate of growth in the first quarter was better than expected. As far as the Fed is concerned, which after its last rate cut was gravely concerned about "unacceptably weak" economic growth, the main worry now is the business sector -- namely, the withering of profits. The Fed's April 18
statement makes it seem as if that's become the central bank's mission, saying "the persistent erosion in current and expected profitability, in combination with rising uncertainty about the business outlook, seems poised to dampen capital spending going forward." Now that the markets have digested the stronger-than-expected GDP numbers, it's time to look at what the numbers mean for both the Fed's rate-cutting initiatives and the outlook for U.S. industry, especially tech, for the rest of 2001. Investment in equipment and software fell 2.2% in the quarter, the second-straight quarterly decline, as companies pull back from spending money on new products because the economy is in a profits recession. That's not as bad as expected, but companies see it worse because they're looking at revenue, not through the eyes of the government's seasonally adjusted world of data. With the economy expected to grow about 2% in the second quarter, corporate profits don't figure to improve much in the next quarter, or in the third quarter, for that matter. Economic growth modestly north of 2% normally hasn't been terribly kind to corporate profits. Average S&P 500 earnings growth when the economy grows 2% to 2.9% is about 4.2%. Less than 2%, and profit growth is usually negative, according to Morgan Stanley. It stands to reason that the economy generally benefits when corporations see steady increases in profits. It enhances companies' desire to spend more money and invest in new technology, which spurs economic growth, creates jobs, etc. But low interest rates aren't going to produce that alone; only time will heal those wounds, which is why the Fed's work is probably nearing its end. "I don't know how many companies can go out and borrow the money," says Asha Bangalore, economist at Northern Trust. "Balance sheets are so poor they're not in a position to borrow very easily." The massive self-inflicted debt load, at its worst levels since the late '80s, is just one of a number of problems for the corporate sector. Rising labor costs, falling productivity, and persistently high energy costs also are eating into profits. Without much in the way of an expected improvement, that's going to hurt business investment for quite some time, even if the consumer continues to motor along at a reasonably steady pace. So, it's of great concern to the Fed's credibility how focused it is on the profitability of companies in the corporate sector. A steady rebound in economic growth, to the tune of 2% to 2.5% this year, isn't going to enhance corporate profitability much, but for an overall performance it isn't bad. Will the Fed keep cutting rates to improve the profit outlook? "Lower interest rates can help cushion the blow; they can help lower borrowing costs and offset other costs for companies, but they're not likely to lead to a quick reversal in demand," says Mark Vitner, capital markets economist at First Union Securities. "We have to have final demand pick up before profits pick up." That's why the economy is at an inflection point right now. If the consumer continues to spend money, and manufacturers increase production in response to this demand, the main drag on the economy is going to be the investment sector -- but rate cuts, a blunt tool, won't be able to address the problems there. The fed funds futures are guessing the funds rate will bottom out at 4%. That could change if the labor market continues to weaken, as recent initial jobless claims reports have suggested, because the Fed's going to endeavor to be more aggressive in fighting a breach in consumer confidence. It can't ignore businesses completely -- capital does control the labor, after all, and that's one reason the Fed's been aggressive in trying to assuage the business sector that they're doing their best to help. At some point, however, businesses will have to fend for themselves.