Compass Points

Economic Commentary

Weathering Uneven Economic Growth

by Denise Harrison

In the last commentary, storm clouds gathered on the horizon...what could increase the intensity of the storm and turn an economic slowdown into a recession?

1. A significant stock market correction will cause consumers to rein in their spending. Recently consumers went into debt because they felt wealthy due to their significant (but unrealized) stock market gains. As this speculative bubble bursts economic growth will halt as consumers change their spending patterns.

2. Excess capacity develops as firms bet that current growth rates will continue into the future. (Naive expectations.)

Let’s look at these two phenomena in depth:

The wealth effect: consumer irrational exuberance?
Significant asset appreciation continues to give consumers a false sense of security. During the fall of 1998 consumers spent more than they brought home in their paychecks giving the economy a negative savings rate. This happened in spite of the stock market downturn in the August/September timeframe. Many thought that this downturn would give individual investors a dose of reality and many of these investors would turn to more conservative strategies by building up a cushion for the proverbial “rainy day”. Instead spending increased, as cheap foreign goods continued to flood the US market.

The inflation that normally accompanies the latter stages of an economic expansion has been largely offset by lower commodity prices as many areas of the world work through their financial difficulties. Where is inflation hiding? It is present on the financial asset side as consumers continue to invest in the stock market even though price to earnings ratios have reached unprecedented levels. Investment turns to speculation creating an asset bubble. This bubble feeds on itself until a simple pinprick, any significant economic event, pops it and all who were riding with the current fall precipitously from the sky.

In 1990 the Japanese stock market saw its asset bubble spiral upward to 40,000. This growth was funded by easy money that allowed the speculative boom to continue over a long period of time. When reality punctured the market it crashed to 14,000 in 1998. Many investors in Japan saw their investments shrink by 60% or more. This devastating change in wealth makes it difficult for Japanese investors to think about spending their way out of the current two-year economic decline.

Here in the US an economic slowdown would cause this bubble to burst earlier and the decline in consumer net worth would not be as devastating as seen in Japan. However, if speculation continues to spiral ever higher the fall will be substantially greater causing consumers to pull vigorously back on the reins of their spending and emphasizing a downward plunge for the economy. The earlier this bubble is burst the faster the recovery.

Capacity: how much is too much?
Consumers were not alone in their spending, as in the fall of 1998 business debt exceeded corporate profits. Many firms invested in capacity to meet rising demand, assuming, of course, that demand would continue to rise. Now capacity utilization is declining as the US economy growth becomes uneven. Graph 1 Recently business investment surpassed after tax profits, which means that business debt is growing faster than profits; a trend unsustainable in the long term. This slowdown in utilization occurs in some specific segments of the economy:

  aerospace - worldwide demand slows

financial institutions - consolidations cause firms to make cuts to gain operating efficiencies 

oil - as the price of oil drops below prices experienced in the trough of the mid 1980’s

shipping - ships depart from foreign ports full of cheap products for the US, but many return from the US with excess capacity as the economic crisis slows the demand for US goods abroad

International Growth Varies by Region
Eleven European countries adopted the Euro on 1/1/99. This common currency reduces the risk and cost of doing business with and within the European Monetary Union (EMU).

David Marcus, Franklin Mutual Advisors says, “No one European nation is a world power, but as a unified force Europe hopes to command a world-power status. The continent has 350 million consumers (vs. 260 million for the U.S.), and the lowered trade barriers and decreasing tax rates the EMU may bring should benefit its economy”.

Europe - the move to a common currency should aid competition and enhance corporate efficiency, enabling growth.

Latin America - will move slowly out of its recession. Mexico is poised forGraph 2 growth after it hit bottom twice in the last five years.

Asia - we may have seen the bottom, however, this only means the end of the decline rather than signaling that a recovery is in progress. While some countries will begin the slow path to recovery, others will feel a double bottom much like Mexico has in the 1990’s.

Overall the global horizon sees very slow but uneven growth in 1999 as long as there are no significant shocks to the world economy. One possible wildcard is the Y2K problem. Forecasts concerning this problem range from dire destruction to business as usual. You need to develop plans for potential business disruption as January 2000 rolls around.

What can be done during uneven economic growth:
1. Review market segments and evaluate growth and profit projections in light of the changing environment.

2. Give employees a realistic vision of the future - you can lower turnover by painting a realistic picture.

3. Stay close to your purchasing decsions to make sure that you are getting the full benefit of lower commodity prices.

4. Ensure that suppliers and customers a plan for Y2K.

The sooner economic expectations fall in step with economic reality the less chance of significant recession. An economic slow down now is better than a significant recession later.

Questions from last quarter’s economic commentary:
In the last economic commentary we discussed the composite leading indicator index that acts as a precursor of economic activity. Included was a list of the variables that make up the indicator. One of readers asked how the “slower deliveries” statistic was calculated.

Vendor performance, slower deliveries index: This index measures the relative speed at which industrial companies receive deliveries from their suppliers. Slowdowns in deliveries increase this series and are most often associated with increases in demand for manufacturing supplies (as opposed to a negative shock to supplies) and, therefore, tend to lead the business cycle. Vendor performance is based upon a monthly survey conducted by the National Association of Purchasing Management (NAPM) that asks whether their supplies deliveries have been faster, slower, or the same as the previous month. The slower deliveries diffusion index counts the proportion of respondents reporting slower deliveries, plus one-half of the proportion reporting no change in delivery speed. (Source: The Conference Board)

Denise Harrison lives in Wilmington, North Carolina and is a consultant for the Center for Simplified Strategic Planning. She presents the workshop, Simplified Strategic Planning for Small to Mid-Sized Companies. For more information about Denise, check out her bio page at the seminar site.

© Copyright 2007 Center for Simplified Strategic Planning

For more, click here for a free subscription to Course and Direction.

Copyright, Center for Simplified Strategic Planning, Inc., Southport, Connecticut 2000-2007