United States: Business Conditions: Record Low

The Morgan Stanley Business Conditions Index hit an all-time low in early January, declining three points to 28%. Our canvass of industry analysts has never been tested in a recession, of course, because we started the survey and the index in June 2002. But a comparison over that period with other business indicators corroborates the evident weakness in business conditions consistent with at least a mild recession.

The questions now are how deep and how long the recession will be. Fed Chairman Ben Bernanke this week signalled heightened concerns about the outlook, and we now expect the Fed to cut the funds rate by 50 bp at the January 29/30 FOMC meeting rather than 25 basis points as we were previously expecting. But given the lags in monetary policy, that won’t affect the economy for some time.

Unfortunately, the way we read our survey results, the bottom of the downturn, let alone recovery, is not yet on the horizon. Our business conditions expectations index fell 10 points to an historical low of 25%, while advance bookings are contracting. Hiring plans remained weak, with only 26% of the groups planning to increase payrolls over the next three months. In contrast, plans to increase capital spending over the next three months jumped 25 points to a near-record high of 61%. We think this surprise is anomalous. Survey results also suggest a worse growth-cum-inflation mix that feels like stagflation. The pricing conditions index increased eight points to 71%, last reached in December 2005.

The breadth of this downturn tells the story: Business conditions deteriorated over the past month for a staggering 50% of groups and improved for an inconsequential 3%. Conditions deteriorated for nearly all sectors, but remained unchanged in healthcare and utilities. Expectations for business conditions over the next six months are notably worse. Fully 68% of analysts expect conditions to deteriorate, up from 59% last month. Weakness is expected in all sectors.

While Wall Street is beginning to accept the reality of a recession or at the very least an economic slowdown, Street earnings forecasts have remained stubbornly high. S&P 500 consensus earnings estimates for 2008 have increased compared to last month from 14.0% to 15.3%, while 2007 estimates were revised down slightly to 1.9% from 3.7%. The good news is that our own analysts are taking recession risks more seriously than a month ago and folding the scenario into their estimates. Compared to early December, 2008 earnings estimates have come down to 10.9% from 13.5%. There is evidence, moreover, that other Street analysts may be following suit. Bill Smith from our US equity strategy team notes downgrades in the consensus FY2 earnings revision factor in some non-financial groups including industrials, telecom, and tech within the past month.

Downward revision estimates still have a long way to go. According to our analysts, 37% expect margins to expand in 2008 at companies under their coverage, compared to consensus Street expectations of 80%. As we noted last month, to get to 10.9% earnings growth, analysts continue to expect extremely high revenue growth which isn’t likely given our economic outlook. In fact, 68% of analysts still believe there are downside risks to earnings estimates, virtually unchanged from last month. Of these, 58% believe the risk is from worse domestic results, 15% from worse domestic and foreign growth, 15% from margin compression, and 11% from worse than expected growth abroad. Only 32% of analysts see upside risks to earnings estimates. Also, fewer analysts than before believe the dollar has helped earnings: 37% believe the dollar has contributed to bottom line results, down from 48% in early December.

Credit availability continues to be a concern. Our credit conditions index, which looks at the ability to get financing compared to three months ago, remained unchanged at a weak 28% in January. Over the past month, lending standards continued to tighten. This month is the fifth month that roughly half of the groups which fall into the ‘borrower’ category (~80% of sample) have faced sequentially tighter lending standards. Of the lenders, three-fourths have tightened standards, up significantly from 33% in December.

There is no doubt that the MSBCI is deep in recession territory. Now we wait to see whether there are any signals of a bottom. A sustained upturn in the headline index can’t happen until analysts start reporting that conditions are at least not getting worse. Getting better lies off in the future.

SPECIAL ELECTION QUESTIONS. With the 2008 presidential election process in full swing, we asked analysts two special questions about the elections and business. The results were predictable. First, we asked analysts whether the uncertainty over the election outcome is causing companies under their coverage to delay hiring and/or capital spending plans. Only 11% of the groups are delaying spending, including managed care, household and personal care products, and aerospace and defense. In addition, 82% of analysts believe that companies under their coverage perceive that the environment for their businesses would be more favorable with a Republican Administration.

By Shital Patel and Richard Berner New York
Morgan Stanley
January 11, 2008