IN THE MIDST OF A BRIEF STORM

We are in the middle of a stormy period in the U.S. economy that seems to have come about very fast and has recently worsened. In the last four months, the manufacturing sector has lost nearly 370,000 jobs, and the latest employment report indicated that even service-sector job growth had stalled last month. The unemployment rate now stands at 4.5% compared to its low of 3.9% last October. There has been a steady barrage of bad news on the corporate earnings front too. Cisco Corporation, star of the Internet revo-lution, stunned the market and perhaps even Greenspan when it reported that its sales of routers fell by 30% rather than growing by the double-digit rate it has displayed in the last 10 years.

Although the 2.0% first-quarter GDP growth rate beat economists' predictions of almost zero growth (it was much higher than what was experienced the quarter before), the situation is not as rosy as it looks. A $43 billion decline in imports helped shore GDP growth in the face of a sharp inventory correction of $63 billion. The drop in exports indicated that the foreign sector has now also weakened. Non-residential investment managed to eke out an anemic 1.1% growth, but investment in information processing and equipment fell sharply in April.

One bright point in the latest GDP report was the strength in consumer spending, which grew by 3.1%. Housing starts and car sales have remained strong in the last few months. However, with sharply lowered consumer confidence, consumption growth is expected to slow sharply. Inflation seems to have picked up again thanks to high oil prices, which can make the Fed and the bond market too very nervous. However, the Fed has clearly shown its intent by doing the surprise inter-meeting rate cut on April 18. The Fed seems committed to easing the rates further, and perhaps it will take bold steps to ensure that this sharp slowdown does not turn into a recession.

The Economic Forecasting Center forecasts the following:

* Expect the Fed to cut rates by another 100 basis points in the next three months to ensure that the steadily weakening U.S. economy doesn't morph into an outright recession. This stormy period will be brief, another two quarters at the most, before a recovery begins in the latter part of this year. The forecasted rate cuts buy the Fed additional insurance against the possibility of an outright recession. The inventory overhang in the economy is almost gone, and soon the growth in investment will provide a strong platform from which to grow.

* Real GDP growth, mainly due to the first quarter's higher than expected rate, will average only 1.8% in 2001. The unemployment rate will steadily rise to peak at 5.1% later this year. In 2002, the economy will grow by 3.0% and then again by 3.4% in 2003. This is close to the trend rate of growth of the economy. The forecasted average unemployment rate of 4.7% in 2001 is sharply higher than the 4.0% rate seen in 2000. In 2002, the unemployment rate will average 4.9% before retreating a bit to 4.8% in 2003.

* Inflation was 3.4% in 2000 and will again be in the 3% plus range in 2001 before coming down to the 2.8% range in 2002 and 2003. The funds rate will be 3.5% by late summer and stay there until 2002, before it is raised to 4.0% later in 2002 to combat a mild bout of inflation that will accompany the recovery.

* The 10-year bond rate will rise to the 5.7% range by early 2002. As a result, the prediction for the 10-year bond rate is to average 5.3% in 2001, rise to 5.8% in 2002 and then rise a bit more to 6.0% in 2003. The 30-year bond rate, which until recently was lower than the 10-year bond rate, will also rise to an average of 5.7% in 2001 and then rise further to 6.4% by 2003. This reversion of the yield curve back to its normal shape happens as the liquidity effect weakens as the economy weakens.

* Pretax corporate profits are expected to drop by 3.0% this year. There will be no immediate rebounding of profits in 2002 as productivity gains will temporarily moderate. Thus, the resulting pressure from the cost side and near normal growth in the coming year will result in moderate profit gains. The rebound finally occurs in 2003 when profits grow by 8.7% following the reversion of productivity back to its long-term trend.

Now, what does this all mean for the stock market? Rate cuts usually imply large gains in the stock market indices in the following 12 months. The rallies in the stock market seem to be happening after every rate cut but don't seem to stick. The reason for this lack of sustainability is simple. The drop in stock prices this time around, which started with the tech bubble getting pricked late last summer, is primarily a correction of valuations and not so much a loss of the future forecasted revenue stream, the rationale being that most of the tech sector could never have been valued that high by the earnings potential criterion. The PE ratios were simply out of sync with reality. So if these stocks weren't ever valued according to fundamentals, then the current softening is not to be blamed for the present downward trend. However, as the economy recovers down the road, companies with strong fundamentals will justify the old adage that rate cuts lead to stock price gains. For the rest of the pack, mostly tech stocks, it will be a long road to recovery ahead.

By Rajeev Dhawan
Director of the Economic Forecasting Center