Jubak's Journal
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Economic forecast: more pain than you thought
Chances are, we're in for a period of restructuring that could last for years, not quarters. Trends in the auto industry show just how much change is yet to come.
By Jim Jubak
Well, there, someone finally put the notion out where everybody can hear it: The current economic malaise might not be the bust part of the normal boom-and-bust economic cycle, but something more profound and long-lasting. The recovery, in that case, will be measured not in quarters but in years.
Because it was Alan Greenspan doing the talking, of course, a bit of translation is in order. Heres what the Federal Reserve chairman told the Senate Banking Committee on Feb. 11: Once the uncertainty caused by impending war fades, well know if we are dealing with a business sector and an economy posed to grow more rapidly -- our more probable expectation -- or one that is still laboring under persisting strains and imbalances that have been misidentified as transitory.
In other words, the Federal Reserve still believes that were in a normal business slump caused by a collapse in capital spending. That slump, it figures, has been extended by the unwillingness of businesses to invest because of the uncertainties created by the possibility of a war with Iraq. Once those uncertainties vanish, businesses will begin spending again, and the Federal Reserves interest rate cuts will be enough to get the economy rolling again. Thats the Greenspan hope and the outcome that he thinks is most likely.
But he wont rule out the possibility that this isnt just a normal slump and that there are structural problems in the economy that wont easily respond to the Federal Reserves available medicine.
Greenspans vague suggestions
What kind of structural problems? Greenspan didnt get specific -- and thats too bad. The investing press is already full of books and newsletters about the coming depression, and Greenspans vagueness is likely to add fuel to that fear-mongering.
So let me step in and make explicit what I think Greenspan was hinting at. The possibility facing the economy and investors isnt another Great Depression or anything like that. Instead, were looking at a replay of the massive restructuring of U.S. business that took place in the late 1970s and 1980s.
The bad news, if Im right, is that the current economic mix of slow growth, anemic profits and rampant uncertainty isnt going to vanish over the next few quarters. Anyone who remembers that earlier restructuring knows how much pain those years produced as jobs vanished and specific companies went under. Many workers didnt find comparable jobs for months, and some never did at all.
The good news, however, is that U.S. businesses are likely to emerge from this, as they did from the restructuring of the 1980s, as the most efficient and lowest-cost producers in the world. For some period, until the next restructuring perhaps, U.S. companies again will be the kind of job creation and profit machines they truly were in the first half of the 1990s.
Decade-long restructuring
You wont be able to see proof that this restructuring is actually taking place until its more than halfway over. Thats about how long it takes for the kinds of economic changes that Im talking about to show up in the official statistics. But I think you can already find solid evidence that the United States, and indeed the global economy, is in the early stages of what could be a decadelong restructuring. That evidence can be found in anecdotes from individual industries and companies and in the logic of the current global economic competition.
I find the case convincing. Here it is in bare-bones form.
Start with the personal anecdotes we all know of someone who has lost a good job and is convinced that it is never coming back, no matter what the economy does. Its a good idea to take these stories seriously. Theres always the problem of selection bias, since we all tend to emphasize facts that fit our worldview. But such anecdotes are also the leading indicators of real change. Put enough together and you have a statistic at some point in the future.
For example, just a few days ago I was talking to the travel agent that I use for certain trips. She works for a midsize company thats managing to hang in even though the airlines have cut or eliminated all commissions to travel agents. But she knows plenty of companies that have gone under and plenty of travel agents who are now out of work. Those people will never get their jobs back, she said to me in a sad but matter-of-fact tone. Even if the airlines get their customers back, even if the resorts start filling all their rooms, theyre going to keep selling through the new low-cost channels theyve developed. Nobody is going to increase costs once revenues pick up.
The view from the auto industry
Add in what you know from the headlines about individual companies in industries that are central to the U.S. economy. For example, you know that the car companies have been laying off workers. General Motors (GM, news, msgs), for example, laid off 15,000 workers in December 2000 and has kept up a pattern of shutting divisions (Oldsmobile) and individual plants and trimming production at other units. Its hard to get an exact count of the companys workforce today thats comparable to the count of 2000 because of all the spin-offs (parts division Delphi (DPH, news, msgs) was spun off to the public, for example). But if you look at all the operations that now comprise General Motors and add in the layoffs at companies such as Delphi, the current head count in the United States comes out well below the 2000 level.
And thats even as the number of cars sold in the United States has stayed remarkably constant (at 16.8 million in 2002 vs. 17.1 million in 2001) and revenues have actually climbed (to $186 billion in 2002 from $177 billion in 2001). General Motors has managed to produce just about as many cars and as much revenue with fewer workers. Considering that car production has run near historic highs recently, thanks to massive financial incentives to buyers, it seems unlikely that the jobs that have disappeared will come back with better times.
This kind of restructuring in a manufacturing business is in many ways just a continuation of the massive restructuring that U.S. industries went through in the 1980s -- if at a somewhat slower pace. That last restructuring of the U.S. economy radically reduced the number of workers in the manufacturing sector, for example. Now the sector accounts for about 17 million workers and about 16% of gross domestic product.
And it was largely successful in beating back the competitive threat posed by efficient Japanese manufacturers. General Motors is now one of the leanest carmakers in the world, with variable costs for labor, parts, outsourced production and the like adding up to 62% of revenue. That puts the company ahead of Ford Motor (F, news, msgs) at 68% and not far behind the Japanese leaders Toyota Motor (TOYOF, news, msgs) and Honda Motor (HNDAF, news, msgs).
Renewed cost battle
But its now clear that the fight has to begin all over again. And this is why Im willing to generalize from specific examples like the travel industry and General Motors to the economy as a whole.
The same cost battle that U.S. companies struggled to win against the Japanese in the 1980s now has to be fought all over again with a new group of competitors in China, Malaysia, Poland and India. At the end of 2002, General Motors and its Chinese partners launched the Wuling Sunshine, a compact van that sells for about $5,000. General Motors says that at that price, the car is just barely profitable. Think about the cost structure that lets General Motors make any money at all on a $5,000 van and youll understand why the company has been in talks, which still may go nowhere, to acquire a stake in Chinese truck maker Qingling Motors.
This renewed cost battle isnt just being fought in the automobile industry, either. It extends to the chipmakers and the companies that assemble computer gear, as well as to the companies that contract out their manufacturing to these factories. It includes retailers and financial-service companies that locate new call centers in English-speaking Bangladesh and India.
Take a look at the cost pressure at a company like Cisco Systems (CSCO, news, msgs) and the way Cisco is wringing pennies out of every stage of its supply system. Ciscos revenues have essentially been flat for the last four quarters. But over that period, Cisco has been able to grow earnings anyway by cutting costs (by about 10% according to my calculations) through the extraction of lower prices from suppliers.
A second battle front
But the cost battle is also going to be fought on a second front this time -- thanks to the aging of the U.S. and the worlds workforce. Lets go back to General Motors and its battles with costs. GM pays its unionized workforce only slightly more per hour than Toyota and Honda pay the workers at their U.S. factories. But the pension and health-care benefits that GM pays come to about $24 an hour, twice what the Japanese companies pay their U.S. workers.
This type of cost structure puts General Motors at a huge competitive disadvantage. Investment firm Sanford C. Bernstein figures that retirement benefits cost General Motors an extra $1,300 a car vs. a Japanese car built in a non-union plant in the United States.
Producers in the new generation of low-cost manufacturing nations dont pay benefits anywhere near those paid by even the non-union Japanese auto plants in the United States. With workforces much, much younger than those in the United States, companies in these countries would be facing lower payments to retirees even if they paid U.S.-style benefits. Which they dont. Retirement and health-care benefits are meager, if they exist at all.
This part of the restructuring battle, then, will be fought over retirement benefits and health care costs. In this fight, its not only U.S. companies that are at a disadvantage, but also those in any country with an aging population and an even barely adequate company-financed retirement and health care system.
And companies dont have to face foreign competitors to feel these cost pressures. Any established company with an older work force and a traditional benefits system faces the same kind of brutal cost competition from newer companies with younger work forces that dont yet face much in the way of retirement costs. The domestic airline industry is an example of this. JetBlue Airways (JBLU, news, msgs) has just such a fixed-cost advantage -- to go along with its variable cost edge -- over older competitors such as Delta Air Lines (DAL, news, msgs) and US Airways Group (UAWGQ, news, msgs).
Put in this context, the efforts by companies such as US Airways to use the bankruptcy courts to reduce pension liabilities and the calls by management at Delta and Northwest to renegotiate retirement benefits with their workers arent just one-shot responses to a slump in air travel caused by the uncertainties of potential war and terrorism. Theyre early acts in a wider restructuring of U.S. business that will play out for years.
Continued layoffs
Does that sound depressing? Well, it certainly wont be pleasant. Layoffs will continue. Pressure to give back wages or benefits will increase. (It looks like the jargon this time will call it cost sharing.) Some companies will fold.
And I certainly wish I could be more hopeful about our government finding innovative ways to minimize the pain for individuals and their families. The safety net in this country has frayed very thin (under administrations of both parties) and in its current form, I doubt that its up to the task of taking up the additional load. If most U.S. companies react to the challenge of this round of cost-cutting by eliminating their pension plans or radically cutting the benefits they pay, then I think we will have a retirement crisis in this country that will make anything imagined by the media so far seem like a pleasant day in the park.
But the alternative is even grimmer. Without a restructuring, the U.S. economy drifts into the stagnation that comes from being the high-cost producer in a world of constantly falling prices. If you want to see what that looks like, you dont have to look much further than Japan. That country looks set to get caught in a truly horrible trap that combines stagnant economic growth with the soaring costs of a rapidly aging population.
On the record, the United States is the only one of the more established industrialized economies that seems to have the flexibility to restructure to meet this challenge. Our brand of capitalism, whatever its many flaws, is especially good at letting the forces of creative destruction sweep away the old so that the new can be born.
Once the economy emerges from that restructuring, it should be more efficient, more competitive and more profitable than it is now. At least thats the lesson of the past.
Next column: How to build a stock portfolio for these times.
New developments on past columns
When your star stock stumbles
A number of readers e-mailed me saying that passing off American International Groups (AIG, news, msgs) $24 billion exposure to airplane leases with a single sentence just wasnt adequate. (Heres that single sentence, by the way: Wall Street is keeping its eyes focused on the companys airplane leasing business as the most likely source of trouble.) AIG's management apparently agrees with those readers, since the company offered more detail than ever before on those leases and the companys exposure to the troubled airline industry when it reported earnings on Feb. 13. All 83 aircraft on order for 2003 at IFLC, the companys leasing subsidiary, are pre-leased, the company said, and only four of those are leased to U.S. domestic airlines. The company has 500 more aircraft on order through 2008 -- much of that new capacity is leased for 2004-2005. Further, the company said that terms of existing leases arent changing -- that is no one is renegotiating prices -- and that the average term of a lease is eight years. All planes coming off lease recently have been re-leased or sold, and none of those sales was for a price below book value. Re-leases have been at lower rates, but the effect of this has been offset by lower interest rates, management said. Any time a company has this big an exposure to an industry thats in as much trouble as the airline industry, the situation bears watching. But so far AIG seems to have the damage under control.
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET. Selected CNBC stories can be found in the TV Reports index.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: American International Group. He does not own short positions in any stock mentioned in this column.
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