Magazine article Economic Trends

Money and Financial Markets

Magazine article Economic Trends

Money and Financial Markets

Article excerpt


Despite the Federal Open Market Committee's aggressive three-percentage-point reduction in the intended funds rate since January, hopes for an incipient resurgence in economic activity appear to be slipping. Mixed signals from incoming data, which fail to confirm a broad rebound in economic activity, are fostering greater uncertainty about the timing of the expected upturn. While consumer and housing sectors have held up surprisingly well and inventories have been worked down, financial markets have been listless over the summer months.

The uncertain outlook is most evident in the stock market. Because equity markets are forward looking, stock prices typically anticipate upturns, moving in advance of an accelerating economy. In April, stock prices rose substantially, appearing to support the optimistic view that the economy would accelerate during the second half of the year. When subsequent indicators failed to confirm this view, the stock market rally stalled and equity prices retraced much of their advance. Despite the decline in stock prices, the price/earnings ratio still remains above its average rate since 1990.

A fundamental drag on the stock market has been the persistently negative news on corporate earnings. Operating earnings at S&P 500 companies turned out weaker than expected in the second quarter--down one-third from their levels in the same quarter last year. The expected path of operating earnings in 2001 and 2002 has been revised down substantially over the summer months. Nevertheless, a sharp rebound is projected for 2002 earnings.

One explanation for this optimism about 2002 may derive from an expected rebound in investment in new technologies.

The primary source of weakness in the economy is the sharp deceleration in business fixed investment. Demand for capital equipment slowed substantially as firms faced the prospect of diminishing profits. Because earnings are a major source of financing for capital expenditures, their weakness is reflected in a persistently high financing gap--the difference between investment and internally generated funds. Although investment has declined more than profits, the need for external funds remains strong. Corporations have responded by cutting back on cash-financed mergers and equity repurchases, but these measures have not fully offset the effects of diminished profits. …

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