2002 Preview: Market Pulls Hare, but Economists See a Tortoise Year

First things first: If the U.S. comes out of recession as swiftly and as strongly as investors seem to expect, there are going to be a lot of red-faced economists in 2002.

Stock and bond markets have been forecasting a robust recovery. The benchmark S&P 500 climbed 6% following Sept. 10 on the belief that, even in the aftermath of the terror attacks on America, corporate earnings will grow quickly this year.

Meanwhile, the yield on the benchmark 10-year Treasury rose to 5.1% from 4.8% in expectation that the Fed soon will be raising rates to prevent the economy from growing too quickly and courting inflation. None of this is completely far-fetched: The Fed cut rates 11 times last year, fiscal policy is incredibly stimulative and, historically speaking, economic growth has been very rapid coming out of recession.

But it is very hard to find economists as sanguine as the markets are on 2002. Most believe the economy has yet to reach the trough (many investors believe that it already has), reckoning that recent signs of stepped-up business activity are a snapback from the severely depressed levels that followed Sept. 11 rather than the start of something new. The economy's trough, according to the consensus, will come sometime late in the first quarter. Economists also believe that the first stages of recovery will be muted.

Sonic Bust?

The difference between this recession and most past downturns is that this time around, it wasn't the specter of inflation and the Fed's clamping down on inflation that caused problems for the economy, but companies gone amok spending on tech equipment that was often overpriced and often unnecessary.

The first half of 2000 was the peak not just of a stock investing bubble but of a business investment bubble. When businesses started reining in investment, the companies that made all that tech equipment, which had been steadily building their infrastructures in anticipation of sustained growth, saw the bottom fall out.

This business-led downturn has been hard to deal with. For one thing, rate cuts don't work as quickly, because rate cuts more directly help the consumer and housing, both of which have held up well through the recession. For another, with all of that investing in new equipment, corporate America has scads of excess capacity. With the capacity utilization rate at 75% (its lowest since the early 1980s), companies aren't running efficiently.

Slow and Steady Wins the Race Early strength makes for a short expansion
Recession's Trough	GDP Growth Following Quarter	Length of Subsequent Expansion
1971 Q1	11.7%	36 months
1975 Q2	3.6	58
1980 Q4	7.3	12
1983 Q1	4.7	92
1991 Q2	2.3	120
Source: Census Bureau; National Bureau of Economic Research

This is not to say that the economy won't get better next year, says Aubrey G. Lanston chief economist David Jones -- just that it won't be a real barn-burner of a recovery in its initial stages. To start with, consumption will begin to pick up. Close on the heels of that, businesses that have been trimming inventories will begin building them up again -- a process that in itself can add significantly to growth.

Dubya

But business investment, the third piece of the growth puzzle, won't return until fresh demand has sopped up all the excess capacity.

"Even going out to 2003, it's going to be hard to boost business investment again," says Jones. "I'm beginning to think it might be a W-shaped recovery, with one leg up in the middle of this year and the next leg later."

How Low Can You Go? The fed funds target gets cut

Source: Yardeni.com

Other forces may dampen the speed of recovery. Long-term rates remain high relative to the fed funds rate, hampering fresh mortgage refinancing activity and corporate bond issuance. The geopolitical situation is iffy. A stagnant global economy will be a drag. A large comet may crash into Greenland.

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Besides the drawn-out recovery in business spending, the biggest worry for the economy is that a rising unemployment rate will cause serious consumer retrenchment. But the rising jobless rate may not be as much of a problem as some think. For one thing, a rising unemployment rate is always a feature of recession. For another, says Banc of America Securities chief economist Mickey Levy, "Businesses have been so aggressive in laying off people, it could be, instead of lagging behind, the unemployment rate peaks earlier than normal."

On the inflation front there's been a lot of argument on what the year will bring. Some worry that inflation is going to come scudding toward U.S. shores, thanks to a flood of liquidity supplied by a too-aggressive Fed. Others have worried that the Fed will run out of room to cut rates before the economy revives, and that that will lead to the kind of across-the-board fall in prices, or deflation, that's plagued Japan.

Between the Tackles

Most economists reckon neither extreme will occur. Instead, the U.S. economy will revive, but low utilization rates and weak overseas economies will make it hard for companies to raise prices. "Pricing power looks pretty weak," says Morgan Stanley chief U.S. economist Richard Berner. "That's a testimony to extra capacity and that consumers have long had the upper hand. They're aggressively seeking and demanding discounts and bargains." Abetted, Berner adds, by the ability the Internet gives them to do rapid price checks and make sure they're not getting rooked.

U.S. Companies Twiddle Their Thumbs Capacity utilization plunges to lows

Source: Federal Reserve

Good for the consumer, bad for profit margins at the outset. And good for the long-term growth prospects of the economy, because the Fed won't be stepping up rates as quickly over the year as the market thinks.

"The Fed doesn't tighten much in the first year of recovery, because it wants the economy to grow fast," says Lehman Brothers co-chief economist Ethan Harris. "Yes, the Fed's going to have to eventually hike rates a lot, but I think it occurs over a long period of time." At the year's midway point Harris sees the funds rate at the current 1.75% (after bouncing back from a drop to 1.5% at the January meeting). The fed funds futures are pricing in a rate of 2% by then. By year-end, Harris forecasts a funds rate of 2.75%.

In truth, the consensus among economists that the economy's recovery will be less robust than the historic norm might be better for long-term investing prospects in the U.S. than the rapid recovery markets are forecasting. The recovery from the 1990-91 recession was also slow, but it ushered in an era of low inflation and the longest economic expansion the country has ever seen.

In contrast, a quick recovery with growth so strong that the Fed soon would be clamping down hard on the screws, while great for short-term investing prospects, might not last very long. In fact, in the postwar period the strongest recoveries also have been the shortest. Raise a glass to the hope the market's got it wrong.