Skittish Consumer Is Economy's Biggest Concern

The spendthrift American helped keep the U.S. economy out of a recession. But with the nation preparing itself for a protracted battle against terrorism, already-skittish consumers might become the economy's biggest problem.

It used to be that tax rebates, easing by the Federal Reserve and low inflation basically assured consumer resilience. But with the shock of the Sept. 11 attacks, uncertainty involved with fighting an underground enemy, the possibility of more layoffs, experts say, consumption is in danger.

In a report issued Monday, Richard Berner, chief U.S. economist at Morgan Stanley Dean Witter, revised his forecast for the American consumer, citing last Tuesday's terrorist attacks on U.S. soil. "Prior to those tragic events, I thought consumer spending growth was bottoming," Berner wrote. "Now, however, I believe the shocks from the recent terrorist attacks will tip the balance in the other direction. Consumer spending likely will weaken through year-end." Berner said he hasn't "officially updated" his forecast for gross domestic product as it's "premature to do that."

Fear Factor

"In no other period has our personal security ever felt so threatened," wrote Tony Crescenzi, chief markets strategist at Miller Tabak and head of BondTalk.com in a report. Pointing out that it's the first time U.S. civilians have been targeted, Crescenzi said consumer confidence and spending are "likely to fall sharply" as people now "find less satisfaction in their past spending ways" in favor of "life's simple pleasures like the smile of a child or watching the sunset."

Berner said the "very powerful set of negative factors in play now" would also offset the favorable impact of the tax rebates.

Economists also warn that wealth is being eroded by a downturn in the financial markets. History may suggest the stock market always rebounds despite a catastrophe. But "with terrorism you're never quite sure when it's going to end," said David Durrant, economist at Julius Baer Asset Management. He said comparisons to the 1990-91 Gulf war misses key differences.

According to Ned Davis Research, the Dow Jones Industrial Average lost 4.3% in the three weeks before America waged war against Iraq, then shot up about 20% two months later. Back then, investors were able to "price in" the war as the "enemy was directly in front of you," said Durrant. Also, most people believed that the Gulf war would be a short conflict. Durrant expects negative GDP growth of 1% to 2% in the third quarter, and flat to negative growth for the fourth quarter.

Corporations are already slashing their earnings and revenue estimates, citing Tuesday's attack. Oracle (ORCL Quote) warned Monday that its license sales would be hurt by disruptions that followed the attack on the World Trade Center.

Berner said in his report he expects the ongoing profit squeeze to trigger more cost-cutting by firms, and result in job losses and cuts to employee bonuses.

Chin Up

But the picture isn't all gloom. The unemployment level of 4.9% is still "very, very, low," relative to recessions past, said Durrant. There's also still "a lot of wealth" left from the bull market in the late '90s, he added. Given the grave events of last week, portfolio shrinkage might not weigh as heavily on people's minds.

And "The Fed's injection of liquidity will help assure that there's plenty of capital available for the nation to conduct its business," said Crescenzi. Kenneth Kim, economist at Stone & McCarthy Research Associates, agreed, noting also that lower interest rates are a psychological boost. "In times like these, the Fed has more of a cheerleading type of effect. That's critical given how fragile confidence is." Alan Greenspan and his team lowered short-term interest rates by another 50 basis points to 3% Monday. Many believe interest rates could be as low as 2% by the end of this year.

Crescenzi also pointed out that the $40 billion of emergency spending Congress approved last week will add about a half-point to GDP.

"The chances [for an upside] will be greatly enhanced if we get a resolution to safety and the security shock that we just got," said Morgan's Berner. "That will enhance consumer and business confidence, and be a big boost."