EconSouth (Fourth Quarter 2002)


COVER STORY


Outlook Mixed for Southeast and Nation in 2003

The U.S. economy remains on the road to recovery. Signs look promising for 2003, but the effects of the 2001–02 recession will continue to be felt in many industries.

Cover Story

The year 2002 has seen the U.S. economy recovering from the recession that began in March 2001, but the country’s economic engine is not yet firing on all cylinders as 2003 begins. The economic recovery observed during 2002 was slower than typical of post–World War II business cycles in the United States: The usual measures of economic health, such as employment and spending growth, have been mixed, and financial markets reflect a perception of increased risk. Heightened uncertainty about global economic growth and potential geopolitical events add to the economic head winds faced by the United States. While the economic outlook for 2003 appears positive overall, growth will likely be more modest than it typically is at this stage of the business cycle, reflecting some distinct characteristics of the 2001–02 recession.

How was the 2001–02 recession different?
A decline in consumer spending is usually a defining characteristic of a recession. Yet in 2001 inflation-adjusted consumer spending on goods and services increased, albeit more slowly than in any of the previous five years. So where was the recession focused?

The 2001 recession centered on business investment — capital spending on equipment and structures as well as inventory investment. During the 1990s a growing proportion of business investment was in the form of new technologies (for example, personal computing equipment and software) as opposed to spending on existing technologies. Not only was technology available that did not exist a decade earlier, but also the price of this technology declined rapidly. Both investments by technology firms and purchases of technology by other firms were motivated by profit opportunities — investment projects that aimed to increase cash flows by much more than the cost of the investment.

Unfortunately, cash flows failed to match expectations. By the middle of 2000, business profits in some sectors of the economy, such as the telecommunications industry, stagnated, and nonfinancial business investment was weakening. By the fourth quarter of 2000, business investment began to contract. What had been a stable and persistent rate of growth in real investment spending turned to rapid decline in the second quarter of 2001, when investment growth fell at a double-digit rate (see chart 1).

The reduction in real investment spending was widespread. The rapid expansion of capacity in the manufacturing sector during the late 1990s was not matched by growth in final sales. Rather than maintaining production increases and risking the accumulation of unsold inventories, firms responded by reducing inventories of finished products. In essence, all forms of investment spending were reduced as firms struggled to maintain and, in some cases, regain profitability. In each quarter of 2001, nonfarm inventories contracted by progressively larger amounts, ending the year with a contraction of nearly $100 billion at an annual rate in the fourth quarter. But because consumer spending continued to increase throughout the recession, the liquidation of business inventories occurred more quickly than in a typical downturn (see chart 2).

CHART 1
Business Fixed Investment
Chart 1
Note: Shaded bars indicate recessions.
Source: Bureau of Economic Analysis, National Income and Product Accounts

Slow recovery likely to continue for nation in 2003
Some short-run sources provided momentum to the economy in 2002. For example, once manufacturers recognized that consumers were not reducing their spending, companies had an incentive to increase production. But analysts are still concerned about the outlook: As the impetus generated by inventory adjustment diminishes, what will be the source of final demand growth during 2003?

In a typical recovery from a recession, there is considerable pent-up demand on the part of consumers who have postponed purchases during the recession. Slower inventory liquidation typically evolves into increased production in order to satisfy the growth in consumption. As businesses expand production, they will also increase their payrolls, reinforcing the recovery in household incomes and final demand growth.

In the recovery from the 2001–02 recession, the response of consumers appears to be more muted than normal, however. A variety of factors support this view. For one thing, little pent-up demand from consumers exists because real spending on both housing investment and consumer durables grew throughout the recession as interest rates fell. In addition, while most households’ balance sheets have already benefited from the improved cash flow generated by refinancing mortgage debt at lower interest rates during the downturn, stock market equity values remain well below pre-recession levels. Finally, though labor markets stabilized in 2002, they have not resumed solid growth. On the production side, considerable underutilized capacity can be seen. If final demand does not grow strongly in the short term and uncertainties remain heightened, then businesses may delay investment and hiring plans.

The U.S. economy’s dynamism often surprises analysts, so it is possible that growth could exceed expectations. Most analysts anticipate real gross domestic product will grow in the range of 2.5 to 3.5 percent for next year, comparable to the growth rate in 2002. Business investment is unlikely to be robust in 2003, but investment spending should not be a significant drag on growth either. A delayed and muted recovery in employment is consistent with the slow recovery in business investment, but a slow recovery that incorporates appropriate adjustments in response to the recession, as well as the related underutilized capacity, may also provide for a more sustainable expansion.

CHART 2
Change in Real Private Inventories
Chart 2
Note: Shaded bars indicate recessions.
Source: Bureau of Economic Analysis, National Income and Product Accounts

The Southeastern economy during the recession
In past recessions, the Southeast tended to be less affected by a downturn than the nation as a whole was — in large part because many areas in the region had a relatively high concentration of nondurable manufacturing industries. Demand for nondurable items like food and clothing is usually less cyclical than the demand for durable goods, such as industrial equipment.

The region’s dependence on most types of nondurable manufacturing has declined steadily in recent years. In 1990 the share of Southeastern manufacturing employment in nondurable manufacturing was about 20 percent higher than the share in nondurable manufacturing for the rest of the nation. By 2001 that difference had declined to around 10 percent.

Roughly speaking, the change in composition reflects the closing of apparel plants on the one hand and the expansion of the automobile assembly industry into the Southeast on the other. During the last few years, many companies — such as Burlington Industries, Fruit of the Loom and others — closed operations in the Southeast, and some relocated in countries with lower labor costs. At the same time, foreign auto producers such as Nissan, Honda, Mercedes-Benz and Toyota moved into the region in order to avoid the high transportation costs of bringing vehicles from overseas. These two trends did not offset each other, however. In fact, overall manufacturing employment between March 2000 and March 2001, prior to the recession, fell by about 4 percent in the Southeast (compared with a 2 percent decline for the nation as a whole), and the closure of a large number of apparel plants was a primary contributor to this net decline.

The recession that began in March 2001 also had a significant and direct effect on the Southeast’s manufacturing sector as well. Manufacturing employment in the region declined by approximately 5 percent between March 2001 and September 2002, and the decline during this recession was about 1 percentage point greater than during the 1990–91 recession.

During most of 2002, however, manufacturing employment was relatively stable. The region’s automobile industry has weathered the economic downturn so far and has been able to maintain or, in some cases, expand payrolls. This strength, combined with the stabilization of the nondurable manufacturing sector, meant that the decline in overall manufacturing employment in the Southeast since the onset of the recession has been less severe than in the rest of the country; for the nation as a whole manufacturing payrolls fell by almost 8 percent between March 2001 and September 2002.

Stable employment levels probably set the stage for a modest recovery in manufacturing in 2003. For one thing, increased military spending by the federal government has been a boon for some manufacturers. Higher oil prices could stimulate domestic production in the Gulf of Mexico, and this development could help producers of oil field equipment. The manufacturing sector as a whole, however, is unlikely to recoup 2002’s employment losses over the coming year. Lumber and building-supply demand, as well as furniture and carpet production, may slow along with slower residential housing markets. According to analysts, further layoffs are expected in the apparel industry as companies shut down or move operations offshore to remain competitive.

One risk factor for the recovery will be the automobile industry’s performance. If demand for new vehicles declines significantly, then automobile producers will probably pare back production and employment levels. On a positive note, because the Southeast’s newer auto plants tend to be among the most efficient in the industry, production may shift to these lower-cost facilities, and local producers may be less affected by a slowdown in demand.

Cover Story Callout

Business spending and employment suffer
The recession has also had a large effect on other sectors of the Southeast’s economy — especially those directly tied to business spending. When business spending declined last year, the providers of business services cut back spending as well.

Between September 2001 and September 2002, transportation service employment in the Southeast declined about 4 percent (10 percent nationally). Most of the decline occurred between November 2001 and January 2002 as airlines were forced to trim staffing levels in response to sharply reduced business and leisure travel.

The hotel sector reduced staffing levels by as much as 10 percent, especially in cities serving primarily business travelers, in response to lower business spending on conventions and business trips. With a considerable amount of hotel/motel space completed over the past few years, operators will probably continue to struggle with low occupancy rates in 2003.

Employment in the communication services industry in the region declined by almost 5 percent over the period (7 percent nationally) in response to the excess supply of telecommunication infrastructure. The computer and data-processing sector in high-concentration areas like Atlanta also shed some 12 percent of its workforce (2 percent nationally).

Retail and hospitality sectors still subdued
The retail sector has not been immune to the recession either. In the Southeast, wholesale and retail employment declined almost 1 percent between September 2001 and September 2002 (and 1 percent nationally), with most of the decline following a disappointing fourth quarter in 2001. Retail sales during 2002 have remained generally lackluster in the Southeast, and discount retailers have continued to outperform many traditional retail outlets. Although analysts do not expect a retrenchment in the retail sector, growth in 2003 will potentially remain subdued overall.

The Southeast’s tourism and hospitality sector has reeled from the psychological effects of the Sept. 11, 2001, terrorist attacks and the sluggishness of the economy in 2002. Though visitor counts have improved from post–9/11 lows, they have remained below those of 2000. In 2002, some theme parks delayed opening new attractions, cut back on hours or temporarily shuttered underused facilities to manage costs and remain profitable. However, casinos, primarily those along the Mississippi Gulf Coast, remained quite strong over the year — most likely because these casinos are predominately drive-to destinations. The cruise industry also posted relatively strong bookings in 2002 as some consumers chose to avoid vacations involving air travel. As with retail spending more generally, the outlook for the tourism and hospitality industry in 2003 remains guarded.

Cover Story Callout

Residential construction stays strong
Construction activity in the Southeast during 2002 continued to display the split that was emerging during 2001 — the residential sector expanded while the commercial sector declined. Most sources reported that home sales and building activity in the third quarter of 2002 were near robust year-earlier levels. Reports from Florida markets were especially upbeat, with starter and midpriced homes in strongest demand. Inventory levels have been held largely in check, with the exception of high-end homes, particularly in Atlanta, Nashville and Tampa. In 2003, construction and home sales should continue to be focused in the starter to midpriced segment, with housing markets continuing to perform at solid levels overall. The biggest risk to the housing market would be a sharp decline in housing affordability.

Overall, construction employment in the Southeast declined approximately 2 percent for the year ending September 2002 (2 percent nationally), with most of the decline concentrated in the commercial sector in larger metropolitan areas. With vacancy rates approaching 20 percent in some cities, and with considerable amounts of sublease office space likely to re-enter the market in 2003, the prospects for a quick resurgence in commercial construction appear dim. Generous concessions and lower rental rates are increasingly common. New development in 2002 was restricted mainly to government and health care facilities, and this trend may continue in 2003.

Industrial and warehouse markets also have not fared well during the downturn. Industrial and warehouse vacancy rates have risen sharply over the past two years and rates were above the U.S. average in Atlanta, Nashville, Jacksonville and Orlando during the third quarter of 2002. Nonetheless, with the Southeast continuing to grow in importance as a distribution center, improvements in industrial and warehouse markets may precede advances in the region’s office markets.

Retail markets have been a mixed bag in 2002. New construction continued, albeit at a slower pace than seen in the last few years. Retail construction continued to benefit from strong residential housing growth as shopping centers, mainly anchored by grocery stores, expanded into newly populated areas. Existing retail space, however, will likely continue to struggle in many markets because of slower retail spending overall and fierce competition among retailers.

Apartment markets across the Southeast experienced a difficult year in 2002. Low mortgage rates increased the pace at which renters became homeowners. As a result, apartment occupancies sagged in 2002, and landlords increased the use of incentives to attract tenants. Despite the softness in apartment markets, multifamily construction in the Southeast strengthened during 2002. The number of multifamily permits (units) issued during the 12 months ending September 2002 increased by around 13 percent in the Southeast compared with a 16 percent expansion nationwide. This pace is not likely to be sustained into 2003.

Health services and banking sectors on solid ground
Not all service industries are displaying weakness. Health services, for instance, continued to expand at a brisk pace in 2002. Health care consumption now constitutes approximately 13 percent of all expenditures in the United States, and, based on demographic changes, this share is likely to increase over the next decade. In the Southeast, employment in the health services industry grew by almost 3 percent between September 2001 and September 2002 (the same as in the nation), and the shortage of qualified medical staff remains acute in most areas.

Another industry doing reasonably well in the Southeast has been the banking industry. Banks’ good performances have been driven primarily by solid deposit growth and relatively low levels of problem assets. But banking activity during 2002 remained heavily concentrated in the consumer sector. Low mortgage interest rates continued to spur a flurry of mortgage refinancing. Similarly, medium-term consumer financing for automobile purchases displayed robust demand during most of 2002. Commercial and industrial lending was sluggish, however, probably as a result of lower demand by businesses and somewhat tighter standards imposed by banks. The banking industry’s performance in 2003 will continue to depend on the health of deposit growth and asset performance.

Editor’s note: Throughout this issue, Southeast refers to the six states that, in whole or in part, make up the Sixth Federal Reserve District: Alabama, Florida, Georgia, Louisiana, Mississippi and Tennessee. John Robertson, Ellis Tallman, David Avery, Whitney Mancuso, Navnita Sarma and Gustavo Uceda of the Atlanta Fed research department contributed to this article.

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