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Time to get this show back on the road: Businessmen in America are about to rediscover their animal spirits.
Economist Staff, The Economist
November 14, 2003
Evidence of a turn in the business cycle has been met with almost bewildered disbelief by many American executives. The evidence has been rolling in: profits are rising strongly; investment by non-farm, non-financial corporations has expanded briskly for two quarters in a row; and corporate spending on computers and software is growing as rapidly as it did at the peak of the high-tech boom.
Multi-billion-dollar mergers are back. General Electric is paying £5.7 billion ($9.5 billion) for Amersham, a British life-sciences firm; and Bank of America is purchasing FleetBoston, a rival American bank, for $47 billion. Both deals are aimed at boosting future growth. In addition, an initial public offering (IPO) planned next year for Google, a search-engine firm, could turn into the biggest dotcom flotation ever. Even payrolls have begun to expand again: the economy added 126,000 jobs in October, the sharpest growth in nine months.
Yet many American businessmen, who just a few years ago were breezily predicting an almost eternal growth in profits, still seem strangely unable to rouse themselves from the torpor of recession. Last year, Jack Welch, the former boss of General Electric, warned of too much "hunkering down" in the boardroom, and there is evidence that the hunkering continues. On November 5th, John Chambers, the once-exuberant head of Cisco, a high-tech giant that makes switches to direct traffic around the internet, reported a 76% jump in his firm's profits. But, he said, this inspired in him only an "increasing but very cautious business optimism". Half his friends at the head of other companies tell him that things are looking better, he said. The others are not so sure.
Reasons to Be Cheerless
What is it they are not so sure about? To some extent, they are still trying to recover from the slew of scandals in 2001 and 2002 that weakened the bond of trust between companies and investors. In its wake, prosecutors, regulators and politicians rewrote the rules of behaviour for the chief executive. But the diktats of the Sarbanes-Oxley act, the main vehicle of that process, are now firmly in place in most companies, freeing them to shift from navel-gazing to viewing the outside world.
Others can scarcely believe their financial good fortune, and wonder how long the fiscal and monetary stimulus that has so boosted the economy can last. Steven Galbraith, an analyst at Morgan Stanley, reckons that falling tax rates have been one of the least-appreciated factors behind the rise in corporate profits in recent years. But how long can the burden of corporate taxes continue to fall, ask the doubting Thomases, and how long can interest rates stay so low?
Bill Gross, an influential bond-fund manager, worries that American firms are generating an unusually large share of their profits from financial bets that depend on interest rates remaining low. Although rates have risen sharply since the middle of the year, long-term rates have softened somewhat recently, prompting fears that the business recovery (which should raise demand for capital, and hence push up interest rates) remains unusually subdued.
The interest-rate risk has been reduced to some extent because companies took advantage of favourable market conditions earlier this year to lock in rates for longer terms. In October, the Federal Reserve's figure for outstanding commercial and industrial loans (a proxy for short-term bank borrowing) stood at its lowest level since the summer of 1998. CreditSights, a firm of financial analysts, says it does not think "the numbers necessarily suggest a great deal of borrowing restraint" by companies. They are simply finding funds elsewhere, for longer terms and at more fixed rates.
Some of the biggest firms, however, are still clearly struggling. In late October, Standard & Poor's, a rating agency, downgraded the bonds of DaimlerChrysler. This week, it did the same to Ford Motor, the biggest American issuer of corporate debt, putting its bonds just one notch above "junk" status. Whatever stirrings of animal spirits there may be among America's bosses, they have yet to reach Detroit.
The continuing recession in the manufacturing heartland of the mid-west is dampening spirits more widely. Even an upturn in September left output in the seven states of the region 4% down on a year earlier. Squeezed by the advance of foreign carmakers, the traditional big three of General Motors, Ford and the Chrysler division of DaimlerChrysler have seen their market share slide from 73% in the mid-1990s to barely 60% today. The rise of the foreign brands' factories in the southern states of America is part of a drift south by car manufacturing that is to the disadvantage of Detroit. Today, more than half the car-industry jobs in the Detroit area are white-collar technical and managerial positions. The metal-bashing is heading for the sun, where the unions have less strength.
Three hours drive west of Detroit, however, the view from Boeing's new head office in Chicago is much brighter. Boeing is coping with a halving in the past two years of its commercial-jet business and the disappearance of its market for commercial satellites and the rockets that launch them. Despite these blows, the company's third-quarter profits beat expectations, and its commercial-jet business is preparing to launch its most important new product in ten years. The 7E7 is a 250-seater jet that is supposed to offer operating savings of 20% on current aircraft of a similar size.
Phil Condit, Boeing's boss, says it is the way that information technology has changed business processes that is reaping rewards for manufacturers today. His company's new plane could not have been developed so quickly without the benefit of investment in up-to-date IT, which means that parts for the plane can be produced more accurately right from the start. That eliminates the need for expensive jigs and tools on the assembly floor to hold parts in position while fitters file and trim in order to get everything to match.Uplifting: Non-farm employment and GDP growth
It would be wrong to conclude from the gloom that American businesses will not soon muster again what Keynes called the "spontaneous optimism" that economies need in order to grow. On the available evidence, a remarkably normal business recovery in America is probably under way.
Take Mr Welch's jibe about the timidity of bosses. This appears to miss an important point about the last couple of years of business activity. Although company bosses have not been conquering new markets and industries in the same muscular way that Mr Welch once did, recent management efforts have nevertheless been as vital to sustaining healthy economic growth as all those macho deals of the late 1990s.
Bosses have spent the past few years correcting errors — reversing bad growth strategies, closing businesses, laying off workers and shrinking quickly back to a profitable "core" of activities. Such restructuring creates the conditions for growth to bloom again. Boeing is a case in point. Mr Welch himself began his 20-odd years at the top of GE savagely restructuring a bloated conglomerate — work that gave GE years of subsequent growth and earned Mr Welch the nickname "Neutron" Jack.
The real (and under-celebrated) achievement of American managers over the past decade may not have been the dizzying risks they took in the 1990s, but the speed and courage they have shown putting their mistakes to right. Since January 2000, America's telecoms industry has shed more than 600,000 jobs. Lucent, a manufacturer of telecoms equipment that has had to manage its way through a recession of even greater savagery than telecoms carriers such as AT&T and Sprint, is less than half the company that it used to be: it has shed three-quarters of its workers over the past few years. In the same period, more than 1,000 doomed dotcom firms have gone bust, ridding the world of business plans to sell dog food (and worse) over the internet, but also clearing the field for now-proven business models (eBay, Amazon, Expedia and the like) to grow and thrive.
Whole industries have disappeared with shocking speed — and reappeared in different hands elsewhere. Wholesale energy-trading, for instance, was taken up by Enron as a way to transform a stodgy electric utility into a nimble risk taker. Over the past two years, however, firms such as Mirant and Dynegy have pulled capital and people out of this particular business. But energy trading is now springing up anew, and under different management, among Wall Street's investment banks.
Even those firms which went most badly wrong during the boom have been gutted, stripped bare and redecorated for sale or a relaunch. Within a month or two, WorldCom will emerge out of bankruptcy, rechristened as MCI. With its debts down from around $40 billion to just over $5 billion, and a record $750m fine paid to the Securities and Exchange Commission, the company's return will be as a new, lean competitor for the telecoms industry.
Tyco, whose former boss, Dennis Kozlowski, is currently defending himself in a Manhattan courtroom against charges of "enterprise corruption", is now under new management, which has restored stability to its businesses and some confidence among its shareholders. Tyco's share price has more than doubled over the past 12 months. Enron, on the other hand, may disappear forever as its collection of energy assets and trading contracts are gradually cleaned up and sold to others.
One lesson that the late 1990s did teach America was the powerful effect on corporate behaviour of short-term moves in share prices. Although executives now feel under less market pressure since the discrediting of the Wall Street sell-side analysts who pushed them to have ever-shorter time-horizons, they still hear the market's call. And the current stockmarket rally has pushed the Dow Jones Industrial Average back towards 10,000, where it last stood in May 2002.
As investors' expectations about future profits growth are inflated by rising share prices, a "natural pressure builds", says Jim Andrews of the Boston Consulting Group. In lean times, says Mr Andrews, firms tend to invest fewer of their R&D dollars in new "breakthrough" products or services. Their spending is focused instead on maintaining the competitiveness of existing products. By its nature, restructuring diminishes future opportunities for growth.Bi-cycles: Fixed investment and corporate profits
This makes the current expectations of investors in American shares look all the more unrealistic. Analysts are forecasting that corporate profits will grow by some 11% a year for the next five years. But the long-run performance among S&P 500 firms is only 7% a year. Few of America's top managers, however, yet seem to be in a mood to take on the kind of extra risks which might meet inflated growth expectations, or beat the long-term trend, until they feel confident that restructuring has indeed dealt with all the excesses of the late 1990s. And here the picture is patchy. Industries such as telecoms and business software appear to need still further consolidation. Indicators of capacity utilisation — a measure of how fully businesses are using existing plant and people — suggest that much overcapacity persists.
On the other hand, the rapid growth of investment in computers and software this year — such business IT purchases grew at an annual rate of 18% in the third quarter, following a 19% growth rate in the second quarter — supports those economists who argue that the rapid obsolescence of IT equipment overstates overcapacity. Ageing equipment quickly becomes useless. It is no longer hanging around waiting to be used.
More than two full generations of Moore's law (which says that the number of transistors squeezed on to a computer chip doubles every 18 months) have passed since the tech bubble burst, as have more than three generations of fibre-optics communications technology. Any excess equipment dating back to the past century is likely soon to be unusable too. That should dispose of some of the recorded overcapacity.
Where will growth now come from? What combination of new technology, products and customers will create an enduring increase in profits? Chris Zook, a consultant with Bain & Company, has a good record in anticipating shifts in the business cycle. His last book, "Profit from the Core", was published in 2001, just as companies were forced to set aside dreams of endless growth, and to focus on squeezing profits from their existing core businesses. His next book, to be published in January 2004, is called "Beyond the Core". What, it asks, do you do when you have trimmed and honed your core to the limit?
Mr Zook suggests that risk-taking activities everywhere (not just in America) are more likely than not to fail. He has found, for instance, that just 30% of new product launches, less than 10% of start-ups, about 20% of joint-ventures and 30% of acquisitions create lasting shareholder value. Overall, only one in four investments in growth succeeds. Hope, it seems, triumphs over experience in the investment phase of the business cycle.
To have the best chance of success, says Mr Zook, companies should expand cautiously, into areas that are "adjacent" to their core businesses. One feature he advises executives to look for is "relentless repeatability". "Repeatability in detailed operational processes has been shown over and over to drive productivity improvements," he claims. Mr Zook attributes much of the difference between Nike's success in the 1990s and Reebok's relative failure over the same period to Nike's consistent application of a similar product and formula to different sports, while Reebok took a "hunt and peck" attitude to growth that included the purchase of the Boston Whaler boat company and the Ralph Lauren fashion label.
The high failure rate of America's corporate investment puts a premium on the constant recycling of labour and capital into new bets on the future, lest resources become locked up for too long in unproductive uses. Americans are now recycling their liberated resources into all sorts of different uses. Mark Hurd, the boss of NCR, for example, is betting some of his firm's money on the emergence of a new raft of venture-capital-financed software firms specialising in data analysis.
These start-ups, he says, will build on the investments that big companies have made in his own firm's data-mining technology, which allows them to capture and quiz information about their customers and suppliers. Mr Hurd foresees specialised, tailored software that might allow an airline, say, to administer its frequent-flier programme more intelligently and efficiently, or help a mobile-phone company deal more skilfully with the problem of rapid customer turnover.
Bain, meanwhile, is busily promoting "eHome", a late-1990s-sounding convergence of the television, hi-fi and computer, all linked wirelessly to each other and, via a high-speed broadband connection, to the internet. Such connectedness, reckons Bain, opens up opportunities for firms to bundle packages of equipment, installation and new services (like on-demand music and films) to America's ever-demanding consumers. IBM's consultants are working to introduce telematics technologies to the car industry and new "smart tags" into retailers' supply chains. IBM is also looking for growth from its market lead in providing self-service kiosks to airlines. These use touch-screen technology to reduce queues at airlines' check-in points, and IBM has rolled out a series of prestigious new customers this year, including British Airways, US Airways and United.
Not all new opportunities, however, are high-tech and internet-based. Thanks to an acquisition in 2000, Cemex, a Mexican cement company, is now the biggest producer in America. It thinks wonderful opportunities lie in consolidating small producers and encouraging Americans to make more roads and houses out of (not surprisingly) cement. Barilla, an Italian pasta-maker, sees an opportunity to bring gourmet food products to America, and so renew growth in a market that has traditionally relied heavily on selling the idea of convenience. And no doubt Gillette will one day soon invent the five-bladed razor — heralding it as yet another breakthrough in male grooming. A fine example there of relentless repeatability?
The key to the recovery is the persistence of America's extraordinary dynamism. Labour and capital are quickly recycled and recombined with ever-improving materials, energy and information technologies to advance growth. Politicians, the press and America's corporate footsoldiers naturally tend to celebrate only the expansionary, risk-taking part of the business cycle. And even America's battered bosses seem to find the restructuring phase miserable work. But the real genius of American capitalism may not be its celebrated appetite for risk, but the brutal and uncompromising way in which it deals with the inevitable failures that follow. Despite the obvious signs of an economic upswing, much of American business is still concerned with cleaning up yesterday's mess. Yet with the clean-up well under way, some firms are already dusting down growth strategies once again, and at least a few businessmen are daring to show signs of spontaneous optimism.