CHICAGO/NEW YORK (Reuters) - In recent weeks, a number of investors and economists have declared the recession all but over based on a handful of seemingly positive signs, including a flurry of better-than-expected earnings from U.S. companies.
They may be getting ahead of themselves.
Aggressive cost-cutting through layoffs and capital expenditure reductions has, it’s true, helped many companies report profits that surpassed analysts’ estimates.
But beneath what can be perceived as “green shoots” of recovery, experts say, lie the germinating seeds of what could be a much deeper, more prolonged recession.
“I think the clear and present danger is the negative feedback loop for the economy,” said Greg Peters, head of global-fixed income and economic research at Morgan Stanley in New York.
“If people are getting laid off and if capital expenditures are being pulled back, then that has a cascading effect that is much more long-lasting on the economy.”
Analysts and investors argue that while job, capex and R&D cuts may shore up individual profits temporarily, they are bad news in the aggregate. They swell the ranks of the unemployed, reduce the wages of those who keep their jobs, and hurt an already struggling economy by further crimping consumer and corporate spending.
And that will only ricochet back on the companies themselves, reducing demand for their products and services and putting additional pressure on their sales and margins.
“As corporations cut payrolls and deleverage they are acting perfectly rationally,” said Robert Reich, the former U.S. Labor Secretary under President Bill Clinton who now teaches at the University of California, Berkeley.
“But if that’s what every corporation does, we’re going to end up with far more job losses and in a deeper economic hole. Who’s going to be left to buy all the goods and services these companies produce?”
The list of U.S. companies able to report better-than-expected results for the most recent quarter because aggressive cost cuts offset falling sales is a long one.
It includes appliance maker Whirlpool Corp, advertising powerhouse Omnicom Group Inc, specialty glass maker Corning Inc, wireless telephone service provider Sprint Nextel Corp, drug maker Pfizer Inc tool maker Black & Decker Corp, and Kraft Foods Inc.
Based on the number of earnings that beat forecasts, one would never guess the United States is in the midst of the worst economic downturn since the Great Depression. According to Thomson Reuters Director’s Report of the 365 S&P 500 companies that have reported earnings so far this quarter, 65 percent delivered better-than-expected results.
“In the aggregate, companies are reporting earnings that are 10.4 percent above the estimates, which is above the 1.6 percent long-term average” based on figures since 1994, John Butters, director of U.S. earnings at Thomson Reuters, wrote in his “This Week in Earnings” report last Friday.
But the cuts behind those beats add up, too. U.S. data due out this week is expected to show that employers cut another 620,000 jobs in April, according to a Reuters poll of economists, lifting the unemployment rate to 8.9 percent. That is up from 8.5 percent in March — double what it was just two years ago and the highest level since 1983.
Over time, those cuts — and the distress they cause — become part of a self-reinforcing cycle, hurting consumer spending, which is responsible for the lion’s share of U.S. economic activity — and further pinching corporate results, experts said.
In fact, it is already happening. Although this past quarter was marked by a number of earnings surprises, it was also noteworthy for the number of companies that cut their forecasts, citing a deteriorating sales environment.
“We are still seeing forward earnings estimates being adjusted down,” said Keith Wirtz, president and chief investment officer of Fifth Third Asset Management, which manages $22 billion.
To be sure, some pretty powerful voices are sounding a more upbeat note about the economy.
U.S. Federal Reserve Chairman Ben Bernanke said on Tuesday that the recession should end this year, as long as there is no relapse of the credit squeeze that has strangled the economy. And the Business Council, a private group of top U.S. CEOs, said its members see light at the end of the tunnel and are expecting a rebound, at least in the United States and China, next year.
Still, perhaps too many executives are talking like Harold “Terry” McGraw, the CEO of publisher McGraw-Hill Cos Inc, who stressed last week that “cost containment will be a priority for us all year.”
As a result, Wirtz said he expects companies to remain “lean and mean ... slow to add expense early into the recovery phase.”
And in a system where one man’s expense is another man’s paycheck, that kind of discipline is bad for the economy.
This conundrum, identified early in the 20th century by economist John Maynard Keynes as “the paradox of thrift” or the “paradox of savings” is, of course, one of the major headwinds facing the economy as it struggles to pull out of the downturn.
Simply put, consumers are now saving when the economy really needs them to spend and businesses are now relentlessly firing and cutting costs when the economy really needs them to be hiring.
The result, according to Keynes: declining incomes across the board.
Which is why Reich believes President Barack Obama’s stimulus plan, which injects $787 billion into the economy over two years through tax cuts and spending, does not go far enough and may need to be expanded.
“In this environment, the government has to step in as the spender of last resort,” he said.
Reporting by James B. Kelleher and Jennifer Ablan, Editing by Martin Howell and Matthew Lewis