No Recount Needed -- Market Fears This 'W' More Than Anything

In this bowl of alphabet soup that's being utilized to describe this economic slowing, several scenarios -- V, U or L -- are being discussed; right now the market seems to believe it'll be something between the V scenario (a sharp recovery) and a U (a longer downturn and a slower recovery).

But there's another scenario out there -- a W scenario (nothing to do with the current resident of the White House), which entails a brief rebound in economic strength that calms the markets and consumers, followed by a business-led plunge in growth that ultimately pushes the economy into a recession.

Right now, there's a sharp difference in the data that focus on businesses and those focus on consumers. There's ample evidence to show that consumers are still spending money and remain relatively confident that things will be OK, while businesses are looking at things through a much foggier set of lenses.

The assumption for the coming months is that a rebound in consumer spending following the end of last year will pull the economy from its straits, and ensure that it moves to a period of growth again. It's clear that consumer spending improved in the early months of this year after dropping sharply in November and December, and consumer confidence rebounded in March.

The hope would be that consumer spending, currently buoying sectors such as housing and automobiles, will remain strong, causing companies to hold off on further layoffs or deals with a squeeze in profit margins for a couple of rters, anticipating a rebound in demand.

Lower interest rates would spur consumers to continue to borrow money, and the resultant demand causes production for durable goods items to increase -- such as in the automobile sector, which was thought to have been successful in reducing inventories in recent weeks. Because the consumer accounts for approximately two-thirds of overall Gross Domestic Product, the possibility exists that consumers can lift the economy out of the malaise.

Mind Your Own Business

Despite the contribution consumers make to GDP, with the exception of a couple of months at the end of the year, consumers' spending habits have been relatively steady.

So what's caused the decline is business investment, which has dropped dramatically in response to overspending by companies that aren't seeing any kind of return on investment.

Paul Kasriel, economist at Northern Trust, noted today that in the last five years, production of capital goods (that's business investment) outpaced the production of consumer goods by 7.7%, the highest difference between those two measures in 50 years. What fueled this investment boom was demand for technology, but especially easy credit from the Federal Reserve , which kept interest rates reasonably low through 1995 to 1998 -- and then lowered rates in response to the Asian crisis, which resulted in more money funneled into companies for use on capital investment.

Now, companies are paying the bill as credit tightens, and that's destroying business spending. Profits are being squeezed as companies cope with rising labor costs and lack of demand. It isn't just an inventory correction -- when companies get rid of inventories, they can increase production -- but what happens when nobody wants what you're producing?

Then the factories are useless, and that's why production drops, and companies don't need all the equipment and capacity. That's why orders of nondefense capital goods (excluding aircraft), a key measure of spending, rising at a 26% year-over-year rate in June, is now down to nothing. A continued decline in business investment -- as companies pare production capacity to reflect reduced demand -- will hurt growth.

Spending Dries Up Nondefense Capital Goods (ex- aircraft), year-over-year growth

Source: Commerce Department

In addition, companies, realizing workers are hard to attract, have held onto employees like grim death, despite all the public consternation over layoffs. With profit margins expected to decline further and labor one of the biggest costs for companies, the unemployment rate, still a very low 4.2% as of February, won't stay that way forever.

"Given the squeeze on margins and the slowing in business that companies are seeing, do they want sustained productivity growth, or do they want to avoid layoffs?" said Richard Berner, chief U.S. economist at Morgan Stanley Dean Witter, who is expecting a mild recession in the third quarter this year.

The cutback in workers would force consumers, which have spent the last several years spending, putting money in stocks and not saving money, to re-evaluate their current spending decisions. They'd stop spending after thinking things were going well -- and the recession, which seemed like a remote possibility, would finally occur.

The Fed could help avert this by spurring business investment through more rate cuts. That might help investment, and needs for technology enhancement won't disappear overnight. That, in addition to a reasonable level of spending by consumers, could keep the economy out of recession. That would also juice consumer spending as well.

"There's absolute risk of a setback next quarter, where we're supposed to get a recovery, but we just won't because of a setback in confidence, that causes car sales to fall and causes production plans to be set back," said Tony Crescenzi, chief bond market strategist at Miller Tabak. "Right now, I've got to go with the outcome of monetary ease and lower interest rates benefiting consumers, and consumers bringing the economy back to life."

Then there's the nightmare scenario: the Fed, seeing a rebound in consumer demand, stops cutting rates because they see prices rising (which they are). The inflation squeezes companies to the breaking point, and the third line of that W commences.