Data on industry and investment cycles point to an economic recovery in 2002. The recovery may be modest, however, because of lagging global business and profit weakness. Be on the lookout for turbulence in currencies, and a deluge of cheap information technology (IT) in U.S. markets. The interplay between China and Japan is a key dynamic, and may be pivotal for the stability of the recovery.

The IT Investment Cycle

U.S. business spending on IT hardware and software runs $400 to $500 billion a year. It is the engine of growth for global electronics and probably for the U.S. economy. As a "buyer of last resort," the only advanced industrial nation willing to run large and persistent trade deficits--the U.S. economy--is a major driver of global growth.

The recession, which the National Bureau of Economic Research dates from March 2001, lengthens the IT investment growth cycle, shown in Table 1. Normally, the cycle averages about 10 quarters between peaks and valleys. But in the early 1990s, a recession caused the cycle to distend to 13-15 quarters-or between three and four years! Replacement demand sets the cadence of this cycle, and in a downturn, businesses try to squeeze more use out of equipment and software.

The Forecast

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The consensus view that the recovery should start by the second quarter of 2002 puts the IT investment cycle on the same timetable as ten years ago. More specifically, our forecast is that sales of computer equipment will rebound in 2002 and 2003. However, because of end-market issues, communications equipment will remain at lower levels. Other electronics market segments should show vigorous growth. Fueled by new game equipment and high-definition television (HDTV), consumer electronics should rock-and-roll in 2002 and 2003. The outlook for the smaller defense and allied surveillance and security electronics segments also is positive.

Essentially, there is good news and some bad news in this recovery.

The Good News

Several factors compel businesses to seriously consider increasing their IT investment from low 2001 levels. Since many companies responded early to the Y2K problem, the average age of computer equipment is now drifting beyond three years; a vintage typically triggering replacement. The crisis and challenge of September 11th underscore the importance of redundancy and backup in corporate IT. Finally, substantially higher clock speed of PCs and workstations for sale in 2002 should drive sales, as users are enticed to try the equipment.

From an engineering and physical maintenance standpoint, there is also a growing need to replace aging switching and routing equipment in the Regional Bell Operating Systems (RBOCs)-companies like Verizon, SBC Communications, Bell South, and Qwest who are direct descendants of the Bell System telephone monopolies.

Low interest rates (both in the U.S. and globally), and accelerated depreciation will benefit investment calculations in IT hardware in 2002.

Contract electronic manufacturing services continued to grow through the recession, although at slower rates. As electronics end markets energize, CMs will be in the market for production and test equipment again, to support continuing acquisitions for 24/7 operations. Perhaps not surprisingly, there has been a burst of outsourcing activity in the aerospace and military avionics market sectors as a result of program expansions for flight navigation, surveillance, imaging and smart weapons technology.

Figure 1 provides grounds for optimism in the situation, illustrating both the underlying trend in dollar volume (blue) and growth (red) of business investment in IT equipment and software. After 2002-II, the figure traces out forecasts of both year-over-year growth and dollar volume.

Remarkably, conservative assumptions show total investment spending on IT quickly rebounds to peak run rates of 2000. Thus, after mid-2002, the red growth line in Figure 1 bounces to around five percent trended growth, about half the annual growth rate of the IT investment trend during the 1990s. Yet this modest growth rate is sufficient to push the dollar volumes of IT spending on equipment and software beyond the peak of the trend flows seen in 2000.

The Bad News

Although indications point to business opportunities pushing up with the tulips this spring, it is clear that in its early stages, the recovery may meet constraints--even challenges. The biggest question is simply what the prospects of a U.S. recovery are in a world that, for all practical purposes, just entered a recession. Softness in U.S. export markets could dampen the vigor of the recovery.

Table 2, for example, suggests depressed conditions in markets outside the U.S. could be a problem for the big names in U.S. computer equipment.

More than 50 percent of the revenues of the largest computer equipment OEMs originate from markets outside the U.S. Pickup in U.S. computer equipment buying will have to be strong to overcome persistent weakness in sales to Asia and Europe.

There also are problems in telecommunications, causing significant downward reductions in projected capital expenditures.

Most telecommunications services have reduced forecasts of capital expenditure for 2002 and beyond. This is true for the RBOCs and their archrivals the CLECs (competitive local exchange carriers). To top it off, many CLECs contributing to the late 1990s surge in telecom investment are no longer in business. In Europe, the old giants like British Telecommunications and Deutsche Telekom struggle with massive debt from their earlier plunges in spectrum auctions. These debt loads constrain their ability to purchase equipment in the near-term.

There are policy failures here. Several European nations appear to be sacrificing rapid deployment of 3G wireless systems in favor of collecting huge payments negotiated in spectrum auctions. In the U.S., there is dalliance and procrastination in conversion and sale of U.S. wireless spectrum by Federal authorities, and indifference to broadband options. But the policy angle is a different story-or maybe policy is what you do when you cannot sell product.

The outlook for the communications segment looks down through 2002 and 2003, with fierce competition among communications equipment firms for market share.

Turbulence in Currency Markets

Someone once said "the one thing certain about the future is that there will be surprises." So what surprises are likely in this emerging recovery? We would argue that the biggest surprise may come in currency valuations.

Sober financial sources have reiterated, time and again, dangers to the U.S. dollar from U.S. trade deficits. The perception is that the dollar is at risk for rapid or, at least, slow devaluation to correct imbalances on the U.S. current account.

However, over 2002 and 2003, the dollar is likely be strong once again, as foreign producers intensify their competition for slices of the U.S. market and as U.S. stocks rebound.

China and Japan

China and Japan will be pivotal in these developments. Indications are that Japan will continue to resist opening its markets and timely resolution of its private financial institution debt. This will cast a shadow on global and especially Asian recovery. The Japanese market, although one of the world's largest in terms of purchasing power, will make scant contribution to increasing global demand for goods and services. Furthermore, the Japanese may be tempted to pursue a weaker and weaker yen, in the hopes they can salvage their traditional trade surplus, achieved mainly in the U.S. market.

But there is a new kid on the block: China. Recently, China absorbed much of the foreign direct investment formerly going to areas outside the advanced industrial regions of Europe, North America, and Japan. Cost and quality factors are a big drawing card, and there is perennial hope that production sited in China can serve a ripening and vast Chinese market. The boom in Chinese semiconductor and board fabs is a case in point. At the same time, the developing Chinese IT capability may mean Europe and other high cost areas fade as manufacturing sites for printed circuit boards.

Expect to see anxious discussion about whether the Chinese will devalue their currency in coming months. In the last Asian currency crisis 1996-1998, China held the line. Today, Chinese devaluation could trigger destructive rounds of devaluation in other Asian currencies, and intensify the financial crisis in Japan.

Perhaps the most important thing is that a rising tide raises all boats and, to mix metaphors, washes some of these phantasms out to sea.