Fear Continues Its Reign

Despite higher profits and lower taxes, companies are still hesitant to spend cash and hire workers.
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Despite big tax breaks and improved corporate balance sheets, caution is still king in the business world. And it's not likely to dissipate anytime soon.

While corporate spending and hiring have picked up over the past year, it's clear the economy is still suffering from the overinvestment of the late 1990s. What's more, concerns about terrorism, soaring energy prices and a rapid increase in health care and pension costs are adding to a sense of hesitancy and leaving many firms in a state of limbo.

Over the past three months, additions to nonfarm payrolls have averaged just 103,000 per month, with more than half of those gains coming from either the government sector or temporary help services. Meanwhile, capital spending as a share of profits is sitting near a 30-year low.

A survey by the Philadelphia Federal Reserve found that just 23% of companies plan to increase capital expenditures significantly in 2005, compared with 33% that anticipate just a slight increase. About 30% expect no change, and 15% said spending would actually be lower.

This reluctance to spend has come as a surprise to some because companies are seemingly awash in cash. Cash liquid assets in relation to short-term liabilities rose to a 40-year high of 41.2% in the second quarter, according to Morgan Stanley.

In addition, companies have been showered with incentives to invest. Corporate tax rates have been lowered sharply and a federal depreciation benefit has allowed buyers of new equipment to write off an extra 50% of the cost of equipment bought before the end of the year. Mark Zandi, chief economist of Economy.com, said this benefit has recently been extended for small businesses.

Still, many companies aren't taking advantage of the special allowance. Just 24% of firms said spending would be higher this year as a result of the depreciation bonus, according to the Philly Fed.

A multibillion-dollar tax cut on overseas profits isn't expected to have a dramatic impact on investment either, according to economists at J.P. Morgan, who say most of the repatriated income will go toward stock buybacks, increasing liquid assets and rebuilding pension funds.


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, for one, has said it will use a large chunk of its windfall to pay down debt.

Analysts and economists say tax breaks have been relatively ineffective because the economy is still working through the excess capacity built up in the 1990s. Back then, companies were able to raise vast amounts of cash through stock and debt offerings and were spending billions of dollars on new equipment and employees.

Once the crash came and demand fell off, many of these firms found themselves with more inventory and more workers than they needed. Barry Ritholtz, market strategist at Maxim Group and a contributor to


, said the effects of the bubble continue to hang over the market four years later.

"We're still putting on band-aids from the crash," he said. "These guys are still the walking wounded from the



Ritholtz said companies aren't about to start spending aggressively until the capacity utilization rate moves up. Factory use was sitting at 77.2% in September, a historically low level.

He also noted that chief executives are wary about taking on risk or doing anything that might put corporate profits in jeopardy.

"After the rally in 2003,

executives actually saw their options make money for them, so they're very cautious to put that at risk," he said. "Some of it is self-interest, but some of it is also, 'Gee, I don't want to do anything that's going to put me at risk of missing my quarter.'"

Firms that have disappointed investors recently, such as

General Motors

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, have been punished, he said.

Jon Noonan, chief investment strategist at Appleton Partners, said the bubble "left a legacy of exceptionally high productivity," which continues to put a strain on the labor market.

This economy "has had great difficulty creating enough jobs to absorb the available supply of labor," he said. "Restated, there are too many people chasing too few jobs."

In such an environment, there's no need for companies to raise wages. Average hourly earnings are expanding at about 2%, near the slowest growth rate in 40 years, and the 12-month growth rate in real disposable personal income has fallen to just 1.6% from 4.5% at the end of 2003.

Just when this hesitancy among businesses will end isn't clear.

"I think it's going to take time," said Zandi. "It's a slow process."

Zandi said he isn't worried about the pace of capital spending, noting that it has been rising at a nice clip over the past year, but the weak pace of hiring is disconcerting, and it hasn't been helped by the depreciation allowance, he said.

"The accelerated depreciation benefit does weigh on job growth and induces businesses to invest rather than hire," he said. Zandi also believes the job market has been pressured by fears of terrorism, increases in health care costs and continued outsourcing.

Others say high energy prices are denting business confidence because companies are finding it hard to pass on these costs to consumers. According to the Conference Board, business confidence fell in the third quarter to the lowest level since the second quarter of 2003.

Maxim Group's Ritholtz said he doesn't expect this to improve much in the near future. He noted that it took Japan 14 years to unwind from a bubble that reached a peak in 1989. Although the U.S. cut rates faster and deeper than Japan did back then, the recovery process here could be painfully slow.

"We're not looking at a 15-year period, but certainly six, seven or eight years is not unthinkable," Ritholtz said. "We could have another three or four years to go."