We may not have a double-dip recession, but the economy isn't out of the woods yet, believes Alan Levenson, chief economist at T. Rowe Price of Baltimore.

A double-dip recession occurs when the economy fails to keep growing during the early stages of recovery after a recession. In the last recession, Levenson said, business kept inventories too high and overspent on plant and equipment. But the economist does not see that happening this time.

Last year's inventory liquidation was the sharpest on record, Levenson said. Inventory-to-sales ratios generally remain at, or just above, all-time lows before the economy picks up.

In addition, businesses cut back sharply on plant and equipment purchases, particularly in technology goods. The current rate of new business investment is at a three-year low, and the net growth in capacity is near a post-World War II low. Thus, further cutbacks should be limited, Levenson said.

A further ray of hope is the fact that business profitability has improved sharply, and that profit margins should continue to expand due to how greatly businesses have slashed both investment spending and jobs, he added. Productivity, which is growing at 4%, also is helping to boost profits.

"In contrast, the jobless recovery' of the early-1990s was associated with an extended period of low and stagnant profit margins," Levenson said.

Monetary policy and federal fiscal policy of a 1.75% fed funds rates. are injecting significant stimulus into the economy, as well, Levenson noted. Federal government spending increases and income tax cuts also are stimulating aggregate demand, and consumers are saving money because they have refinanced homes.

However, there still is a trade imbalance. The U.S. current account deficit hit 5% of GDP in the second quarter of this year. Oil prices are another wild card. A possible war with Iraq could push the price of oil above $30 a barrel, Levenson said.

Further, consumer debt levels are high, and a continuation of the bear market could hurt economic expansion.

"The stock market's sharp retreat from mid-May to mid-July has emerged as a new shock to the economy," Levenson said. "It threatens the momentum that had been under way."

Nevertheless, Levenson believes the consumer will keep the economy moving forward, due to the fact that consumer spending is growing at a 3.9% annual rate this year and disposable income is growing at 7.9%. Investors are benefiting from last year's tax cuts. Rising inflation-adjusted hourly wages, and recent modest job gains bode well for the economy, and household net worth is still at an historical high, he said.

"Corporate equities comprise just over 40% of household financial assets, and financial assets, in general, play a far smaller role than income in determining the path of consumer spending," he says. "Households' exposure to equities has declined in recent years - not just because share prices are declining. The household sector appears to have been a net seller of equities since the middle of 1996."

But Levenson sees a cutback in business hiring and capital spending as the greatest threat to the economy.

"Corporations seeking to free themselves of the taint of infectious greed' might choose to hoard cash to signal financial health and honesty," he said. "Alternatively, fears that equity market weakness will reduce demand for goods and services [could] dilute expansion plans."

"The business sector is now closer to some rock-bottom level of capital stock and personnel. [Any lower and] business may not be sustained," he said. "The momentum of recovery [should be] more fully developed [for] this spring than a year ago. We're inclined to give cyclical recovery the benefit of the doubt. It may proceed slowly, but it is likely to be sustained, with no recession relapse."

What about next year?

Levenson sees the economy growing 3% to 3.5% in 2003. Intermediate-term interest rates should rise 100 basis points over the next year. Inflation should run between 2% and 2.5%, and corporate profits should increase 10%. The Fed will likely maintain a 1.75% Fed Funds rate through the first quarter; then it will increase, he said.

On the stock side, Levenson said T. Rowe Price managers believe that the big difference in valuations between growth and value stocks will narrow. Undervalued stocks have outperformed growth stocks over the past five years. But the valuations of many large companies are how attractive in relation to future earnings, he said.

Longer term, companies that produce consistently superior growth in earnings and dividends will inevitably reward investors.

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