Economic engine trouble

The economy has been slowing for months - but suddenly the gas gauge looks lower than most anyone had figured.

Until last week, the tech sector - that great engine of the country's economic boom - had hit some rough patches in the road, but investors still held out hope that the next big thing would send the economy zooming along on another wave of productivity and prosperity. And consumers, many still flush from stock market gains, had continued to spend at a healthy - though more modest - clip.

But in the days after Thanksgiving, typically one of the heaviest shopping stints of the year, the world seemed like a very different place.

The malls were still crowded but not as much as store managers had expected. "It's dead here," complained one clerk at the Polo Ralph Lauren store in the Stanford Shopping Center in Palo Alto, Calif., the Sunday after the turkey feast.

Here, there and everywhere. During the week, a slew of retailers announced that their November sales had grown at a lackluster pace - a few even saw a decline - compared with last year. The stock market was a mess, with the Nasdaq dipping below half its March peak. And underscoring the mood was a string of disappointing economic reports, most notably new figures that put the growth in the nation's gross domestic product at its slowest in four years. None of this is helped by the unresolved presidential election that has cast a restive uncertainty over the entire country.

Adding to the gloom, Gateway, the only company in the beleaguered PC industry that was still predicting strong growth in sales, changed its tune. It revealed that sales during Thanksgiving weekend had plummeted 30 percent from a year earlier and that the next few quarters probably wouldn't look much better.

All of a sudden, the "R" word is on everyone's lips. While unlikely, a recession has become imaginable. "It is definitely on everyone's radar screen right now," says Ed Yardeni, chief investment strategist at Deutsche Bank Securities.

Few economists believe that the longest economic expansion in U.S. history is going to slam into reverse. However, the mere fact that economists are worrying about the possibility of a recession is a stark indication of how things have changed during the past few months. Some investors are questioning whether Fed Chairman Alan Greenspan, the architect of the slowdown, overdid it. The dot-com shakeout and the grounding of technology companies that began in the spring have now filtered throughout the economy - and it doesn't look pretty. The much-hoped-for "soft landing" isn't turning out to be as easy a descent as many had expected.

"The odds are for a soft landing," says Laura D'Andrea Tyson, a former top economic adviser to President Clinton and now dean of the University of California at Berkeley's Haas School of Business. "But I would say the odds of a hard landing have considerably increased."

The causes of the shift have been in place for months. The Federal Reserve, eager to prevent inflationary overheating, raised interest rates six times in an 11-month period, ending in May. The cost of borrowing money had gone up, both for individuals and companies, triggering the slowdown.

The economy also has been buffeted by other factors. The strong dollar has hurt many U.S. manufacturers, making it harder for them to sell their products overseas. Add to that the dramatic hike in oil prices, which raises the costs of producing just about everything, and you have the makings of a slowdown.

And underlying all of this downshifting is the sputtering engine of technology. For a few years, many economists believed that growth was propelled by an increase in productivity, unleashed by computers and the Internet. And there was a widespread belief that the potential for even greater productivity was just around the corner. Investors bought in, launching the stock market into the stratosphere and, in turn, generating unprecedented prosperity for millions of Americans. The economy at large seemed headed for what extreme new-economy boosters believed would be perpetual prosperity - known as the "long boom."

Such optimism is gone.

During the past week, troubling signs of a deepening slowdown piled up like dirty dishes in the kitchen sink.

The number of people filing for first-time jobless claims hit 358,000 on Thanksgiving week, the highest level in more than two years. Also, in a surprise to economists, personal incomes fell 0.2 percent in October, down from a slight gain in September.

Most important, the Commerce Department revised its estimate for economic growth in the third quarter to 2.4 percent from 2.7 percent. The number is dramatically below the 5.7 percent economic growth in the third quarter of last year and represents the smallest increase in four years.

Wall Street economists immediately began to revisit their predictions for growth next year. "The economy is as slow as it's been since 1995, and there is a risk of something even slower," says J.P. Morgan senior economist Robert Mellman. "The forces that created a boom last winter - the boom in the Nasdaq, the boom in high-tech spending - are unwinding now." J.P. Morgan had predicted 2.5 percent growth for the first half of next year, but it might lower that estimate in light of last week's news.

Details in the GDP report fueled Mellman's concerns. The report revealed that companies are slowing their investments in capital goods, from new computers to undersea cables, that help drive growth higher in the long run. From July to September, companies spent the annual equivalent of $1.44 trillion on so-called fixed investments, an increase of 7.8 percent from the previous quarter. Capital spending had been increasing at 10 percent to 20 percent per quarter for the past few years.

The battered Nasdaq also slashed the net worth of millions of Americans. The companies that comprise The Standard 100 index, for instance, lost more than $2.3 trillion in combined value from March 9 to Nov. 30.

Growth in the retail sector, which accounts for roughly two-thirds of the GDP, slowed even more than expected in November, raising fears that Christmas shoppers might not provide the relief that businesses need. Just last week, U.S. retailers reported that November sales at stores open for at least one year - a key measure of performance - rose a modest 3.2 percent. That's lower than last year's gain of 4.1 percent, and lower than analysts expected as recently as this summer.

Want more proof that consumers are worried? Try the Conference Board's monthly index of Consumer Confidence, which fell in November for the second-straight month, hitting its lowest level since October 1999.

The slowdown has affected specialty retailers and high-end apparel makers particularly hard. Among the most troubled is the Gap: Its November sales dropped 1 percent, compared with a 1 percent rise in November 1999. Ann Taylor suffered a decline of nearly 3 percent; last year, the company posted a 4 percent gain. Analysts say some of these retailers have been caught in classic boom and bust cycles. "They've overbuilt quite a bit," says Mark Sellers, an analyst at Morningstar. "Too many stores, too much square footage." Sellers adds that the Gap already had announced plans to slow down its expansion in 2001.

And then Wednesday, Gateway warned that sales of its PCs would be flat next year. The culprit, executives said, was not internal problems, but slowing consumer demand. The news that sales had plummeted during Thanksgiving weekend, a traditionally important milestone for PC makers, was a startling departure for the company. As recently as October, Gateway predicted a cheery holiday, with fourth-quarter sales expected to beat last year's by more than 20 percent. Instead, the company tempered its projected growth for next year, saying growth in PC sales is likely to flatten in 2001.

Gateway's gloomy outlook followed equally discouraging news in recent months from high-tech stalwarts such as Dell and Intel, both of which cite d slowing PC sales in their earnings reports. The sentiment has gotten so bad that Hewlett-Packard, as if in crisis mode, rushed out a press release the day after Gateway's bad news, assuring investors that it would not lower its growth projections. HP had just gone through the mud a couple of weeks earlier with its own disappointing earnings. The industry's funk is likely to spread, not just to the wider tech sector, but to the U.S. economy as a whole. For more than a decade, the PC has been the turbine powering the tech boom. What could make matters worse is the downturn that could lead to defaults on debt in another pillar of the new economy - telecommunications.

To be sure, there's a big difference between a sharp slowdown in growth and an all-out recession, which is a term economists generally agree means two consecutive quarters of reduction in economic activity. And some economists do find a measure of optimism in other areas. Despite the latest rise in jobless claims, for instance, the labor market remains the best it has been in decades: Incomes are still rising and, while consumer spending is slowing from the frothy rates of years past, it has not yet decreased. "Consumer spending will likely keep us out of a recession going into next year, but only with the aid of the Fed lowering rates next year," Yardeni says.

Although specialty stores are suffering, discount stores such as Kmart and Wal-Mart continue to perform respectably, and some witnessed accelerated growth in November. Many businesses are using deep discounts to try to make up for unfavorable conditions. That already has hurt troubled e-retailers, which last year had a lock on discounts, but it also will cut into the retailers' profits, eroding prospects for renewed growth. "Unfortunately, at this point, the Christmas season is not as profitable as it used to be," says Walter Loeb, publisher of the Loeb Retail Letter.

Not everyone is decrying the slowdown. Many economists believe that economic growth is sustainable at a rate of 2.5 percent to 3 percent - half what the economy has been chugging along at for the past year. And if retail sales-growth rates fall in line with those numbers, all the better, note some observers. Michael Swanson, a Wells Fargo economist, says that "would be a reason for cheer."

That's more or less the soft landing Greenspan is bargaining for. However, there's still a risk that the slowdown can spin into a downward spiral. As consumers see signs of a slowdown, they spend less, giving companies less revenue, sending stock prices down, making credit more expensive, forcing companies to tighten their belts - and scaring consumers even more. And if that pattern sets in, even a rate cut by Greenspan might not be enough to get the economy humming again.

"Expectations are a powerful force of behavior," says Haas' Tyson. "If they become more adverse, that increases the odds that you get into a recessionary situation."

Mark Boslet, Jennifer Couzin, Mark Mowrey, Aaron Pressman and Anya Schiffrin contributed to this report.

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