INCHING INTO RECOVERY It may not seem likely now, but growth will quicken into a recognizable expansion by mid-1992.
By Vivian Brownstein CHIEF ECONOMIST Vivian Brownstein STAFF ECONOMIST Joseph Spiers RESEARCH ASSOCIATES Lenore Schiff and Lorraine Carson FORTUNE's forecast is produced by this magazine's economists using our own economic model.

(FORTUNE Magazine) – DESPITE the present gloom, the next 18 months will finish decidedly better than they start out. Growth in the first half of 1992, though barely discernible to most people, will nevertheless be an improvement over the economy's no-growth performance in the last quarter of 1991. As the tempo quickens later in the new year -- and it will -- businesses and consumers will finally feel that a recovery worthy of the name is under way. FORTUNE expects real GDP to move ahead at less than a 2% annual rate during the first and second quarters, helped a bit by the Federal Reserve's full- point cut in the discount rate. For the following 12 months, growth should average 3%. We factor in a relatively small federal stimulus package that should emerge from the current political maneuvering. Unemployment will notch down during the 18 months but will still hover at about 6% in mid-1993. The outlook for inflation is mixed. It will pick up from the recent low rate, but nothing points to a worrisome acceleration. The GDP deflator, the broadest measure of inflation, should average about 4% during the year and a half. Beyond mid-year, the economy will be moving ahead faster than its long-term potential. Even that will seem mediocre. In the past a quick-start recovery has made up for much of the output lost during a downturn. Without such a surge, some of the pain left by this recession -- and the year and a half of subnormal growth that preceded it -- will linger. So will the corporate restructuring that adds to the anxiety of workers and managers. Business leaders remain convinced that the recession never ended, regardless of what economists say. Based on the usual statistical data, business cycle expert Geoffrey Moore -- who serves on the committee that officially dates expansions and contractions -- has concluded that the trough most likely occurred last May. But nearly seven out of ten FORTUNE 500 CEOs responding to our latest poll of their views think the country is still in a serious downturn (see page 53). Small business is equally glum. Economist William Dunkelberg of the National Federation of Independent Business sums up the mood that the 550,000 members expressed in his latest survey: ''We're headed nowhere, and we are moving there at a very slow pace.'' Gallows humor and scare talk reflect a simple fact of life for too many companies: Business is still dismal, seven months into what they had expected would be a period of steady expansion. Why has the recovery been so dauntingly elusive? In part, blame an excess of early optimism. Business apparently counted on a humongous upsurge in sales at - the end of the Gulf war. How else to explain its shopping spree abroad? In the third quarter, imports of cars, engines, and other auto parts increased by a hefty 17%. Businesses also imported 10% more VCRs, camcorders, clothing, and other consumer goods than in the spring quarter. Then total consumer spending for all goods rose less than imports alone. The resulting disappointment undoubtedly added lemon to the already sour business mood. The import bulge also accounted for much of the shortfall in economic growth from the 3.5% annual rate FORTUNE had forecast for the second half of 1991. Imports cut GDP growth by half during the summer. Jobs and incomes are fundamental to what has been happening in the economy and to the outlook for the next 18 months. Despite the low confidence indexes reported by the Conference Board and others, consumers aren't hibernating in their caves contemplating their debt burdens. The point bears stressing: Their spirits are down, not broken. They don't seem to be holding on to their money because they are afraid of becoming unemployed or for any other reason. The growth of household debt has slowed -- some people are paying theirs down or off. But savings as a percent of disposable incomes is hovering around the 5% it has averaged since 1985. In short, consumers are spending about as much of their incomes as before the recession. The problem is that those earnings haven't grown. Real disposable income has been unchanged for the past two quarters. That's why sales have been weak, never mind the psychology. Employment and incomes have been clobbered twice over. First, blame those imports for much of the recent weakness -- Americans didn't work the hours and earn the wages to produce them. But what makes this period unlike other recession-recovery transitions is business's hell-bent determination to reduce payrolls. Jobs are disappearing, many forever, and fewer new ones are becoming available. Call it restructuring, call it downsizing, call it work speedup or any other name. The result is the same. The great U.S. job-creating engine has run into the brick wall of cost cutting. Corporate downsizing began well before the almost decade-long expansion of the 1980s ground to a halt. The recession multiplied the numbers of companies that felt the need to pare people. Worse, it dealt a death blow to the notion of job security -- it is now socially correct to lay people off. Even at companies such as IBM and AT&T, which for decades had received lifetime commitments from employees and made the same in return, the compact has frayed. Especially among big companies, the layoffs are likely to continue well into the future. Even so, a strong case can be made that the idling job engine will begin to gather some momentum in the months ahead, with or without extra help from Washington. Exports will continue to expand, and other areas of the economy that were falling are beginning to turn already. Business investment in computers and other capital equipment has been growing for months. The most recent Commerce Department survey of spending plans for 1992 shows a 5.4% increase, suggesting that companies haven't been deterred from modernizing and perhaps expanding their facilities. It also indicates at least moderate gains ahead for manufacturing employment. The same is true for residential construction. Despite the dip in November, housing starts are well ahead of their recession lows, and outlays for homebuilding are increasing. The lowest mortgage rates in a decade and a half will give a further boost in the months ahead. Starts have begun to increase, creating new construction jobs, and will climb 18% to a 1.3 million annual rate by mid-1993. Low mortgage rates will give the economy and employment a prod beyond housing. An avalanche of refinancings in recent months is starting to put spending money into the hands of consumers -- without adding to the federal deficit. This will spill into higher retail sales and eventually more employment. Self-healing will nevertheless be slow -- probably too slow to satisfy either Congress or President Bush. And, indeed, a clear sign of concern and leadership from Washington could help lift spirits and confidence, both for consumers and for business. Much depends, however, on whether the medicine prescribed follows the precept guiding physicians -- ''first, do no harm.'' Unfortunately, measures that might really boost productivity, saving, and investment for the future are either too costly to initiate now or don't have the quick-start potential mandated by election year politics. Given the discount rate cut and the general reluctance to undermine the budget agreement, the size of likely tax reductions will be small enough to do minimal damage. Without guessing the exact form the cuts will take, FORTUNE assumes that consumers will receive a $15 billion to $20 billion break on taxes, possibly including larger reductions for middle- and lower-income $ taxpayers and some increase in taxes on the ''rich.'' We assume business will also get some tax relief, $5 billion to $10 billion. The total will add up to a $25 billion package. The cuts will be labeled ''temporary,'' though with the relatively slow recovery we expect, the payback time will likely be postponed beyond the next 18 months. Given the small size -- $25 billion amounts to only 0.4% of today's $6 trillion GDP, vs. the 1.5% more typical of federal stimulus efforts in the past -- the package will make little material difference to the path of the economy and should not spook the bond market. Yet we do believe that by lightening the business and consumer mood, it will speed the recovery a touch. With his dramatic December discount rate cut, Fed Chairman Alan Greenspan suggested strongly that he is still no fan of fiscal manipulations. Lower short-term rates will do a bit more good than harm, though even that medicine has its drawbacks. Interest income earned on personal accounts, which dropped by $21 billion during the first three quarters of 1991, will sink even further as bank rates on money market deposits and CDs drop again. But a decline in home-equity loan rates is equivalent to giving those borrowers an immediate increase in take-home pay. Similarly, the drop in the bank prime rate will help business borrowers. Inflation won't be so high later in the year that the Fed feels the need to clamp down again, but it will be high enough that board members won't go off fishing. Overall GDP inflation will be about 4% a year, with little speedup in sight. Consumer prices will hit a 4.5% to 5% rate, but they won't be running away either, even though businesses will push for price increases after years of declining margins. Better productivity will help companies offset wage and pay increases. FORTUNE is assuming that the pickup in business activity, together with a tight rein on head counts, will lead to a productivity gain of 1.4% during 1992, the best in four years. Nonfinancial corporations should realize gains of about 20% in after-tax profits, even with prices rising only moderately. Barring some foolishness from Washington, the economy will weather this period of slow growth -- and should in the end be the better for it. That's not much comfort for the people who are out of work now or who will have to settle for lower-paying, perhaps less-satisfying jobs. Nor is it saying that better policies could not have prevented the excesses of the Eighties, some of ( which still remain to be paid for. Given where it starts, though, 1992 doesn't look too bad.

-- INTEREST RATES: A gentle uptrend. Since peaking early in 1989, short-term rates have dropped five percentage points and may slip some more as a result of the Fed's move. Long-term rates fell 1 1/2 to two points over the same period. Neither will regain much ground by the middle of 1993. Short rates will rise one to 1 1/2 points. One might not expect long rates to rise, too, because of the wide spread between the two. At the recent rate of 8.5%, corporate bond yields would be less than four points above the consumer inflation rate we expect -- that's little more than the normal return investors get. But investors are skeptical of claims that inflation is now whipped and have been demanding higher-than-normal returns over inflation. Since they are likely to remain wary, bond yields, and perhaps mortgage rates, will rise a bit. Economic growth after midyear in nominal GDP (real growth plus overall inflation) will mount to 7.5% a year, above the 2.5% to 6.5% 1992 provisional target range the Fed set in July for M2, the broad money supply. When GDP grows faster than money supply, short rates usually go up too. The Fed most likely will not raise its target. Its recent practice has been to lower the ranges or hold them steady. Since M2 grew at the bottom of the range in 1991, the Fed has room to push growth toward the upper end before doing anything else. Greater credit needs will also exert upward pressure on rates. Treasury borrowing will increase in 1992 and then hold about steady in early 1993. Business will seek more money to finance expanding outlays for inventories, plant, and equipment. Consumers will increase their borrowing to buy more homes and goods.

-- WAGES, PRICES, AND PROFITS: A delayed rise. Gains in hourly compensation have held steady at about a 4% annual rate, 1% above the increase in living costs over the past year. As the economy improves, business will give raises of 4.5% or so -- but with consumer prices possibly rising a touch faster, compensation could trail inflation. Since productivity will also speed up, unit labor costs won't climb, meaning that companies can use price increases to nourish their emaciated earnings. Profits of nonfinancial companies will soon expand again, but they won't surpass previous highs before 1993. Consumer prices rose only 3% during 1991, largely because oil prices were retreating. They will climb 4.5% to 5% during 1992 and maintain that pace during the first half of 1993. Inflation, as reckoned on the broad GDP deflator, ran at 3.5% in 1991 and will climb at just over a 4% rate in 1992 and early 1993.

-- CONSUMER SPENDING: Slow off the mark. The nervous consumer will not jump- start the recovery soon. But he will have enough money in hand by the second half of 1992 to push spending up at a 3% rate. That's sluggish growth for a recovery, because real income gains will still be lackluster. Auto sales won't pick up fast enough to please the industry, but they will still account for the biggest increase in consumer spending. The slump of the past two years has built a lot of pent-up demand. Sales of cars and light trucks should rise from a depressed annual rate of 12 million units in 1991's fourth quarter to about 15 million in the first half of 1993. Given their modest income growth, consumers will pay for those vehicles by forgoing other purchases.

-- CAPITAL SPENDING: Gains for equipment. With office, retail, and lodging space epically superabundant, spending on that kind of construction will continue to fall. Electric utilities and manufacturers will add modestly, so the result will be flat construction spending. Business investment in equipment held up relatively well during the past year, and as cost-conscious companies strive for greater efficiency, they will continue to boost outlays -- especially for computers. Manufacturers will increasingly modernize their production equipment as well. Aircraft spending will rise as the backlog is worked down. All told, equipment investment will grow at a 6% annual rate through mid-1993.

-- FOREIGN TRADE: The bright spot. Merchandise export volume increased at a 9% rate in the first ten months of 1991 -- modest only in comparison to the double-digit gains of the late 1980s. Sales of American equipment, aircraft, and other products will keep growing, though at a slower rate. Except for a surge of imports last summer, the deficit on trade in goods and services continues to shrink. Increased trade surpluses in transportation and other services will help keep it on a downward path. The 1991 current account deficit, including investment income and other transfers, was reduced by contributions from Gulf war allies. Without that special inflow of funds, the current account imbalance will widen again next year, but to only about half the $92 billion shortfall of 1990.

-- GOVERNMENTS: Strapped. The reported federal deficit in fiscal 1992 will leap $120 billion or so, reaching $380 billion to $390 billion. That's not as bad as it appears. Some $50 billion will come from the loss of foreign payments for the Gulf war, and another $40 billion from larger estimated bank and S&L bailouts. But the $25 billion tax cut we expect, coupled with slow growth of taxable incomes, will overwhelm further cuts in defense spending. The deficit will shrink a bit in fiscal 1993, to around $320 billion -- still a monumental sum. Most of the improvement will come from a projected $60 billion cutback in bailout money. In state and local governments the unthinkable is happening: Real outlays, excluding construction, will decline for the first time in a decade. But governments borrowed a record amount in 1991 to finance school buildings and other infrastructure, and they will spend heavily on these projects.


-- Real GDP will grow 1.5% in 1992, vs. a drop of nearly 1% the past year. -- Unemployment will average 6.5% in 1992. -- Consumer prices will rise 4% again in the next 12 months.

CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: Exports, capital spending, and inventory building will lift industrial production. The boost to incomes will revive consumer spending. Low mortgage rates will spur homebuilding. GROWTH GDP COMPONENTS INFLATION