Recession! Recovery? Risks and Uncertainty
by Denise A. Harrison
Recession was the topic of our July 2001 Economic Commentary we discussed possible shapes for the recession:
V sharp decline, steep recovery
U moderate decline, moderate recovery
L sharp decline, no recovery
W double dip recession
In hindsight we have had the benefit of a U recession, a moderate decline in overall economic growth. Unfortunately, a recession characterized by a moderate decline is often coupled with a moderate recovery, not the steep upward slope provided by a V recession. A potential W, or double dip recession often challenges a U recovery when risk and uncertainty abound on the geopolitical front. This moderate recovery can stall as risk and uncertainty enter the picture threatening the slow upward momentum.
Changing Economic Engines
Consumer spending is sluggish during most recessions; however, consumer spending remained robust during this past downturn. Low mortgage rates increased the number of first time homebuyers fueling the furniture and the white goods markets (washing machines) as first time buyers furnished their newly acquired property. In addition, low mortgage rates resulted in homeowner refinancing; lowering monthly payments, which in turn provided households with more free cash flow to spend.
The drop in interest rates stimulated consumer demand during the recession, however, now rates are so low there will not be another drop large enough to further stimulate demand. Increased consumer spending will not be the engine to fuel economic growth for this recovery; we will have to look elsewhere. Where? Business.
During the past several years, businesses invested less than the historical norm. While there is still excess capacity, businesses will step up their investment for the following reasons:
They have to replace machinery and equipment. Typically two thirds of capital spending is replacement demand. During the recent economic slump businesses delayed the normal replacement cycle. These investments cannot be postponed indefinitely. As businesses are forced to catch up investment spending will increase.
They now have the money to spend. Businesses are in a better position to invest with stronger overall balance sheets and cash flow. The recent recession forced many businesses to cut back their most unproductive areas. During good times many businesses doing not take the time to prune the deadwood. Recessions force the deadwood to be cleared out, providing a healthier platform for growth in the future. Cash is no longer funneled to unproductive areas of the corporation.
They need to upgrade their information technology systems. During 1998-1999 companies made significant investment in information technology to prepare for Y2K. Now these technology investments are four years old. Many companies will be replacing this four-year-old technology with more powerful systems that are far less expensive than the systems purchased four years ago.
They need to remain competitive. Businesses need to invest in innovation and productivity enhancements in order to remain competitive. One cannot stand still in the marketplace, competitors will continue to invest in new products and services and if a company remains stagnant it will lose its market position. This too will stimulate business investment.
The dollar's decline is a double-edged sword. Goods made in the US are relatively cheaper and this is good news for exporters. The flip side of the sword is many companies depend on foreign goods and labor to provide key inputs for their processes. These goods and services will become relatively more expensive, squeezing profitability.
Over the last several decades China has been viewed as a land of untapped market potential. Many companies invested only to find that market conditions did not result in the desired demand and/or the business environment did not welcome outsiders. The undeveloped nature of both the Chinese economy and the rule of law, which is required for an efficient market economy, did not exist and many of these investments were abandoned.
Recent history indicates that both the market and market conditions are maturing. The Chinese economy grew by 8% in 2002. The Chinese have developed a taste for cars produced in China by American companies. General Motors sold over 100,000 cars in 2002. Inevitably demand will increase for other consumer goods both durable and non-durable as disposable income rises across the population.
As the Chinese economy makes the transition to a market based economy the journey will not be smooth. Growth rates will fluctuate, product piracy will continue and investment risk will not evaporate. Still early indicators suggest China will provide a significant market for growth in the future.
One significant risk to the economic recovery is the uncertainty caused by geopolitical events. Iraq, North Korea, Venezuela and the overall war on terrorism are indicators that risk is pervasive across the globe. The turbulence provided by world events results in a cautious attitude towards significant investment. Any event that poses significant risk to the economy could turn the U shaped recovery into a W, a double dip recession. Scenario planning is a must during these turbulent times.
Denise Harrison is a consultant with Center for Simplified Strategic Planning, Inc. She can be reached via e-mail at
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