The Earnings Challenge
A big roadblock to a strong recovery.

Mr. Malpass is the Chief International Economist for Bear Stearns.
February 7, 2002, 8:00 a.m.

First, there's weak nominal growth. The fourth quarter GDP data showed a decline in nominal GDP of 0.1% (real GDP revision showed a positive gain of 0.2%). Nominal GDP is a key driver for corporate earnings, which are measured in nominal terms. For 2002, nominal GDP projects to be only 2.3% above 2001, which was 3.3% above 2000. And overall, the 2001-2002 period will be the slowest U.S. two-year nominal growth performance since 1945-1946.

Second, the global environment remains weak, and the earnings of multinationals will continue to feel the pressure.

Third, recent data shows a weak outlook for labor. The January Chicago Purchasing Managers report showed a 23 reading for the interest in hiring — the lowest since World War II. The February 1 jobs report showed continuing reductions in both jobs and hours worked. You can expect the unemployment rate to rise into the third quarter of 2002, reaching 6.4%.

Fourth, the pricing environment is weak. Recent data on deflation showed a continuing challenge for corporate profitability. The fourth-quarter GDP deflator was -0.3%, the first negative quarterly reading since 1952 (though it was distorted some by September 11 effects.)

Fortunately, the U.S. economy is showing dynamism in confronting these challenges. America's animal spirits — the confidence to draw on the balance sheet and future income in order to conduct current activity — may be enough to win the near-term growth battle.

On balance, the economy has indeed shifted from contraction to recovery. While there are enough negative signals to keep the contraction vs. growth debate alive, there are also a few positive signals: the strength of final sales in the fourth quarter (which drew inventories down to very low levels), the resilience of the U.S. housing sector through the recession, and the rapid pace of adjustment going on in the economy.

Still, corporate earnings are key to watch. They will remain under pressure due to the likely weakness of nominal growth, both U.S. and global. Unlike previous declines in corporate earnings, this profit recession is
characterized by both a recession and a deflation. As a result, the drop of profits has been deeper — and has
lasted longer — than the average of the seven previous "profit recessions."

Economic profits peaked in the third quarter of 2000 at $895 billion (seasonally adjusted annual rate). They fell 22% to $697 billion by last year's third quarter (the last period for which we have data). This compares with an average drop of profits of about 10% from the peak over the first four quarters of the recession.

So, if economic profits rise to an expected 6.6% during 2002, this would leave profits still 17%
below the the third-quarter 2000 peak level at the end of this year. In an average recession, profits would have surpassed the previous peak by that time.

Through the third quarter of 2001, American businesses had already lost $88 billion more than in the average profit recession. The cumulative loss in profits compared to a normal recession will reach nearly $241 billion, with a continuation of the sub-par performance into 2003.

That's not the pretty profits picture we need for a robust recovery.