TCS Daily

Fear Of Terrorism Won't Spur Recession, But Other Factors May

By Kevin Hassett - September 13, 2001 12:00 AM

Tuesday's tragic events have caused all Americans to pause from their normal activities and mourn the lost. As time has passed, our thoughts have also turned toward the perpetrators. On Monday, the chief concern of many was the fear of recession.

Today, that has been replaced be a strong desire for retribution. Many recognize that a quick return to our normal activities is a patriotic necessity and that we cannot allow the terrorist the satisfaction of causing a significant economic disruption. Such focus suggests to me that a paralyzing wave of fear will not sweep us into recession. The terrorist may have expected such a result, but if they did, they vastly underestimated the character of the American people.

But if fear will not cause a recession, will something else? For that, we can as always rely on the fundamental indicators. A number of these turned positive this past week. Most notably, regional surveys of manufacturers are suggesting that manufacturing is finally beginning to pick up.

Whether the good news sticks is an open question. As I mentioned in the previous Greenbook, profit growth will be a key factor determining how quickly we can resume a healthy upward trajectory.

This has dropped off sharply over the past year, providing the most important piece of bad economic news that has been driving the stock market and the economy downward. Firms expand when they see promising future profit opportunities, and contract when money stops pouring in. This is exactly the pattern we have seen this time around. Investment spending, for both capital goods and inventories, responded to the negative profit news big time.

Equipment spending, for example, dropped a whopping 15 percent in the second quarter of this year. Now that there are signs for increasing unemployment, it is likely that consumer spending will soften. If we are to avoid the kind of coordinated drop that spells recession, then investment spending will have to at least level off.

So the key question right now is this: Should firms be optimistic enough about future profits that they can resume their capital spending? That now depends on which of two views is correct.

We are at the end of an unprecedented investment boom. Firms invested in new machines at a higher rate in the late 1990s than we ever experienced (at least by some measures.) Some new-economy thinkers have argued that this boom occurred because the tech revolution increased productivity so much that firms just had to buy machines. To the extent that high-tech companies at the vanguard are in trouble, that merely reflects the fact that capital markets have panicked and pulled away financing. If financing had not dried up, profits would have been right around the corner. Others believe that a tech-led bubble gave entrepreneurs free money to play with, and they spent this free money on foolish projects with poor future prospects. Firms are expiring now because they deserve to.

Of course, there is anecdotal evidence on all sides. My colleague Jim Glassman, for example, lays out a fairly convincing case that is about to harvest profits from its many billions in capital investments., on the other hand, listed its wonderful sock puppet as one of its primary assets at liquidation. How can we tell which type of story is more correct on average?

For that we need to head to the aggregate statistics. There, we can look for a couple of things. First, did accelerating losses in the few sectors overpower healthy gains everywhere else? If so, then we can return to a beneficial trend simply by stopping those losses. And second, are blue chip firms buying up distressed tech firms like crazy (in order to acquire their presumed valuable future profit stream), or are the firms piling up the losses being thrown on the scrap heap? The latter might be the case if capital was used to dig "dry holes".

Sadly, all of the possible indicators are less positive than they could be. Profits have declined across the board, rather than being concentrated in a single industry. To be sure, some industries have been more hard hit than others. Telecommunications equipment firms, for example, have experienced a profit downfall, headlined by the $19.2 billion loss posted by Nortel in the second quarter. But other sectors have seen significant declines as well. Motor vehicle firms are experiencing profit woes, as are food producers. This suggests that the losses are fairly widespread, and that the demise of a few big losers could not be enough to break the trend.

If cash-rich firms were buying distressed firm at bargain prices, it would show up in the data as a surge in mergers and acquisitions. If the dry-hole theory is correct, however, we should expect to see a big increase in bankruptcies.

The bankruptcy data clearly favor the dry-hole theory. To track bankruptcies, I accessed the number of bankruptcy filings in U.S. courts by month. The number has increased sharply in recent months, climbing from a low of about 2600 last summer to almost 4000 in March of this year. While we don't have the data yet through the summer, there can be no question that the picture has worsened.

The merger data also are more consistent with the dry-hole theory. To track M&A activity, we collected data back to 1994 on all transactions bigger than $1 billion from the Wall Street Journal and then aggregated them up to get an estimate of total activity in the United States. The picture painted by this exercise will be incomplete, because there are many little transactions each quarter that we miss, but the broad-brush pattern should be fairly indicative of the general trend. The story told is quite striking. M&A activity has declined sharply in recent quarters. In the second quarter of 2000, for example, the total value of all U.S. corporate acquisitions was almost $500 billion. In the second quarter of 2001, the total is less than 1/10 that amount, coming in around $48 billion. Clearly, all types of transactions are on hold, even acquisitions.

Put it all together, and the new-economy story certainly has taken a few lumps. Distressed assets are landing on the scrap heap, suggesting that profitable opportunities from the Nasdaq decline may be few and far between.


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