With deference to Clint Eastwood’s 1967 classic western, our title aptly describes the current state of the world and the economy. The ugly and bad come first, and, if we’re correct, the good will come later. Certainly this is the order in which investors are viewing the market.

The ugly state of world affairs has troubled both consumer and corporate decision-makers. Clearly, the consumer has had a good run. Spending on durables, both auto and housing related, has been buoyed by an environment of lower mortgage rates and zero percent auto financing. There was no consumer recession as in 1990-91 when real spending (deflated for inflation) averaged .8% annually compared to the 3.3% average of the last three years. I expect that part of the economy will gradually weaken once interest rates begin to rise (more on that later). The rate of change of spending for consumer durables will most likely be halved in 2003 from the phenomenal average of 7.1% for the preceding three years. The negative effect of declining stock market values and flattening housing values will dictate higher savings rates for the next few years. The picture would be even less cheerful were it not for the prospect of improving employment beyond the second half of this year.

The bad part of the economy over the last two years has been corporate spending for capital goods. In stark contrast to consumer spending, capital spending for equipment and software declined an average of 4.3% in each of the last two years. The 1998-2000 capital spending boom exceeded all measures of financial prudence and strained corporate resources almost beyond repair. The subsequent decline in capital spending created havoc in other parts of the economy and that has created great uncertainty for consumers, i.e., unemployment and job security. As one can see in Chart 1, there is a highly correlated link between capital spending and employment. Once capital spending begins to grow again, employment will follow, as will consumer confidence. It is critical that this sector begin to expand . . . but the decision-makers see little light at the end of the tunnel.

When CFO’s or CEO’s consider new capital projects, they must judge whether or not the return on the incremental investment will help the cause of the corporation. Some projects are of a maintenance type, while others are brand new endeavors. Even before that consideration, the CFO must know if there is the capacity to borrow, or if the project will be paid for out of the corporation’s reserves or from profits. Over the past two years, corporate balance sheets needed to be repaired and capital adequacy improved. Furthermore, with capacity utilization ratios so low and pricing power absent, why should a CEO commit to new projects? This process necessitates a forecast of future macro- and micro-economic events. Any change in the level of uncertainty concerning the future will impact the capital spending decision. The prospects of a war with Iraq and its repercussions, both overt and covert, have stalled the decision-making for many American and European corporations.

THE GOOD
There are a number of positive events that will positively impact capital spending once we are beyond the many uncertainties ahead of us. First, we expect that the improvement in corporate cash flow, spawned by impressive gains in labor productivity, will improve the prospects for capital spending in 2003 and 2004. Beginning in 1998, capital spending relative to internally generated funds skyrocketed and the financing gap was made up by the issuance of debt. (See “If You Build It”) As a result, corporate debt as a percent of corporate net worth is currently high (57%) relative to historical averages (50.6%). Fortunately, the carrying cost of this debt has been declining as interest rates have fallen. Nonetheless, coverage ratios (income + interest/ interest) have fallen from the heights of the mid-1990s back to where they were in the last recession. (See Chart 2) However, when computed as cash flow + interest / interest, coverage ratios projected for 2003 appear respectable. Therefore we conclude that there is “borrowing” room to finance capital expenditures. Furthermore, the latest Fed survey of senior bank officers indicates a continued easing of lending standards for larger corporations. In 2002, the ratio of capital expenditures returned to its normal relationship. By next year, the financing gap (in dollars) should be reduced even more. This means that capital expenditures can be almost completely funded via internally generated funds (See Chart 3).

Secondly, the perception that there is excessive capacity will change once utilization begins to increase. As can be seen in Chart 4, capacity additions are only averaging about 1% year over year. With some modest improvement in demand, capacity utilization will rise. Our expectation is that industrial utilization will average 76.8% in 2003 vs. 75.4%. By 2004, capacity utilization could reach 78%.

The best comes last. Over the last four years, growing imports have taken market share away from U.S. producers. Net imports (after subtracting exports), as a percent of final sales to domestic purchasers has grown from 1.0% in 1995 to 4.8% last year. Much of this is the result of a stronger dollar, strong consumer demand relative to our trading partners and China’s entry into the World Trade Organization in late 2001. After the State of the Union address last year, however, the dollar began to weaken. As war with Iraq moved from possibility to probability, the weakness of the dollar vs. the euro and the yen accelerated. The weakness in the dollar is a boon for many domestic manufacturers because it eases the pricing pressure from imports. For the first time in almost two years import prices (yr/yr) have turned positive. (See Chart 5) Based on where the dollar is currently trading vs. our major trading partners, import prices (excluding energy) should stage a strong rebound. This will have salutary effect on corporate top lines and bottom lines.

Although the fourth quarter economic statistics have been dreary, there is the prospect of an improvement in the next couple of months. The current state of inventories is very low (See Chart 6) and I suspect that there will be some “pipeline” filling once the disposition of Iraq is known. All said, this year’s top line for non-financial corporations should improve over last year by 3.8%, aided by better pricing. Productivity should be reasonable at 2.8%, but nothing like the unsustainable rates of 2002. Pretax profit margins should expand modestly as well, with income advancing around 9.2%. Although this is not comparable to earnings for the S&P 500, it is similar to the 9.8% increase we expect for the S&P 500 cash flow per share. That should translate into a value of 910 for the S&P 500 by midyear, with a possible high valuation of 1000 near yearend.

John K. Dolan
Brian E. Schaefer

S&P 500: 854
January 30, 2003

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