Compass Points: The Alphabet Soup Economy

The Alphabet Soup Economy - Irrational Pessimism?

Graph 1 Memories of eating alphabet soup as a child are generally quite pleasant thoughts of getting through the meal with light diversionary games. The questions raised by the alphabet soup economy are, in contrast, much more somber. The irrational exuberance of the late 1990’s and early 2000 has given way to a bear market, a manufacturing sector (Graph 1) that is in recession, trouble in the “invulnerable” tech sector and a severe drop in consumer confidence. (Graph 2) There is no longer a question as to the legitimacy of the decline. Whether or not we see an official recession, the significantly lower growth rates of the past several quarters feel like one. The big question now is how long will the bad times last? A couple of popular theories seem to be swirling around in our economic alphabet soup with a few fringe ideas thrown in for good measure.

Graph 2

The “V” Camp Optimists

The “V” camp believes the economy will recover as quickly as it fell off. They believe a recovery will be well underway during the latter half of 2001. This group sees inventories as a key driver. The response by industry to falling demand was swift and decisive. This was made possible by previous investment in information technology. They argue that this quick reaction will also allow for the quick run off of excess inventory and a resulting pick up in demand by the end of the year. They further believe aggressive rate cuts by the Fed and tax cuts by the Bush administration will buoy consumer confidence and create growing demand even before the effect of the cuts fully works its way through the economy. They acknowledge that a key will be a pick up in capital spending - particularly technology spending. (Graph 3)

Graph 3

The Pessimistic “U” Camp

The “U” camp believes that the recovery will be much slower, possibly not until mid to late 2002. This camp sees the reverse wealth effect as being the key. They believe that the shock from declining personal portfolios (Graph4) and the sharp increase in corporate layoffs will keep consumers from returning to their robust spending habits. A domino effect would result with continued depressed corporate profits, higher unemployment, a continued bear market and a protracted slowdown in capital spending. They also point to the vulnerability of our large trade imbalance and the threat of foreign capital fleeing if the dollar weakens. They do tend to believe that as fiscal stimulus slowly works it’s way through the economy a recovery will begin.

The Doomsayer “L’s”

Graph 4 A minority point to the possibility of an “L”. They believe that fundamental problems with the US economy will cause the downturn to be particularly long and painful. They point to significant overcapacity in the technology industries that will delay the necessary pick up in capital spending. They also believe severely eroded confidence will cause consumers to return to more historic savings rates. While admirable, this change would have disastrous consequences on GDP growth. They also see energy and healthcare, among other factors keeping the threat of inflation alive and the potential for stagflation.

What’s a company to do?

It is not clear at this point which of the alphabet soup scenarios will play out. Regardless of the length of the downturn, certain fundamental management principals apply. Operating in a down economy requires toughness on the part of senior managers. Not just toughness in being able to carry out cutbacks. But toughness in remaining true to the companies long term strategies. The key is even tighter focus than in good times. Down markets require companies to focus on two things - innovation and productivity.

Product or service innovation is critical because there is a more limited pool of dollars being chased by you and your competitors. Innovative suppliers will be more likely to capture those scarce dollars. Increased productivity is critical to holding on to profits with decreasing volume. The extra benefit to companies that take this approach is that once their markets do turn around, these initiatives will cause profits to rise exponentially and their competitive position to be stronger.

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