Forecast 2008: Economy Slows, Housing Woes

Slowing sales. Higher costs. Tighter margins.
Ouch! Those unhappy trends were a three-legged stool of misery for many businesses in the past 12 months. Indeed, 2007 was a period of transition for an entire economy which began to slow after a half-decade of vigorous growth. And there's more to come.

Economy Slows
"We have a considerably weaker near turn outlook than we did a year ago," says Sophia Koropeckyj of Moody's Economy.com, a research firm based in West Chester, Pa. "The economy will be performing below its potential until at least the end of 2008."

Just how far below potential might that be? The answer is reflected in forecasts for the Gross Domestic Product (GDP), the most widely used measure of economic health. Koropeckyj expects GDP growth to come in around 2.0 percent when 2007 numbers are finally tallied. That performance is well below the 2.9 percent recorded for 2006. Not much improvement, if any, is expected in the year ahead when GDP is forecast to grow around 2.3 percent. That's well below the 3.0 percent that economists say is the average rate of long-term growth in a normal economy.

And how about corporate profits? Those are expected to grow some 4 percent when 2007 numbers are finally tallied. That's a significant decline from the healthy 13 percent increase of 2006, a year that brought to an end a five-year string of double-digit increases. As for 2008, Koropeckyj expects 4.7 percent, not much better than 2007.

Housing Woes
What's the problem here? Several villains are playing lead roles: the erosion of the housing market, high fuel and commodity prices, and the continuing struggle by business owners to put a lid on labor and medical costs.

Housing woes, of course, have hit the headlines big time. "The major weights on the economy have been the implosion of subprime mortgages, the downturn in the housing market and the resulting decline in building activity," says Koropeckyj. Look for more ahead. "Problems with the housing market are not going to disappear overnight. They will affect the economy through the end of 2008."

Manufacturers tied to the housing industry have felt a tremendous impact. "Building materials and construction equipment manufacturers have been squeezed between softening demand and higher raw materials and energy costs," says Koropeckyj. "They have been cutting jobs and that is likely to continue."

The decline in the turnover of existing homes is expected to bottom out by early 2008. But the related home construction activity that is so important to the economy is not expected to turn around until well into the year. As for the troubling housing price slide, that's not expected to hit bottom until the end of 2008.

Perhaps the most serious elements of the housing market crisis are the interest rate resets now putting financial pressure on homeowners. These haven't peaked, says Koropeckyj: "There will be more foreclosures, and that could have a serious impact on the economy."

Financially strapped homeowners, of course, shop less. But there's another reason the mortgage meltdown affects business owners: Financial trauma can erode an employee's workplace performance. "All of these repossessions are impacting workers," says Don Schackne, president of Personnel Management and Administration Associates in Delaware, Ohio. "Many of my clients are struggling with how to respond. How much should they try to salvage an employee's problems with corporate money which was not meant for that purpose?"

Energy Prices
High prices for gasoline and heating oil have continued to plague consumers over the past 12 months. The sticky nature of high energy costs took economists by surprise. "The fundamentals would suggest that prices would be falling as moderating demand combines with an increase in supply," says Koropeckyj. "And yet oil prices have remained high."

Speculative activity is one prop for energy prices, according to Koropeckyj. A second is the continuing risk premium from political events. A third is the strong demand from the fast growing Chinese and Indian economies. "Insatiable appetites from China and India have also driven other commodity prices - from copper to steel to aluminum - to record highs," she says. Little improvement is expected in the year ahead.

Labor Costs
One major positive factor is propping up the economy: healthy wages. Economy.com expects a wage growth figure of some 3.5 percent when 2007 figures are in, up from the 3.0 percent of 2006. The figure for 2008 is expected to be 3.2 percent. These wage increases are a result of pressures on employers from the low unemployment rate, which has been hovering around 4.5 percent. It takes more money to find and retain good people.

That, of course, is just the problem. On one hand, robust wage growth is good because more money in consumer pockets stimulates shopping. On the other, business owners feel squeezed between escalating payrolls and customer resistance to price increases in a decelerating economy. "We do not feel confident in our ability to raise pricing," says Michael Smeltzer, director of the Manufacturers' Association of South Central Pennsylvania, a trade group whose members represent primarily smaller manufacturers in a broad range of industries. "That is a major area of concern as we have focused on cost control."

This concern is pretty much nationwide. "Wage growth is rising at a rate faster than inflation, which is rising some 2 or 2 1/2 percent," says Ken Goldstein, an economist at The Conference Board. "That's been the case for a couple of years and is not likely to change in 2008. As a result, business owners foresee a negative impact on profits."

Given the predictions of low unemployment through 2008, upward pressure on labor costs should continue. "The `Help Wanted' signs are out," says Schakne. "We are not hurting for jobs but we're hurting for qualified employees to fill them. In many respects we are right on the edge of the unemployables. Employers are refusing to hire the applicants they are seeing."

More From Less
Efforts to increase productivity, the time-honored cure for escalating labor costs, have pretty much played themselves out over the past three years. "Businesses have outsourced, moved offshore, cut back, jettisoned unprofitable lines, and offered rebates," says Goldstein. "And after all of that, they are still stuck with the unholy trio of wage increases, higher costs for medical benefits, and expensive retirement plans." When 2007 figures are finalized, productivity growth is expected to come in at 1 percent, about even with the performance of the previous year. Not much improvement is anticipated for 2008.

Finally, no element of labor costs has received more attention recently than the perpetually aggravating increase in healthcare coverage. "Healthcare costs are going up in astronomical figures," says Schackne, "and my clients are asking, `How much of this premium can I subsidize?' Employer contributions have gone from 100 percent down to 60 percent in many cases, and employers are saying `I cannot absorb this anymore.'"

Business Confidence
The confluence of such forces has given many business owners second thoughts about the solidity of the nation's economic underpinnings. The Conference Board Measure of CEO Confidence, which had declined to 45 in the second quarter of 2007, edged down to 44 in the third quarter (a reading of more than 50 points reflects more positive than negative responses).

Softening business confidence can be self-fulfilling because of its negative impact on the capital investment decisions and expansion plans that are so critical to a healthy economy. Indeed, economists had expected capital investment to grow at a much stronger pace than the 4.7 percent now anticipated when 2007 numbers are tallied. Such growth has slowed dramatically from the 6.6 percent recorded in 2006. Any rebound over the coming 12 months is expected to be modest at best: Economy.com anticipates a 5.4 percent increase in 2008.

The current decline is troubling but should not be overstated. "Business confidence is more moderate than low," says Goldstein. "The modest decline in late 2007 was not enough to suggest that business investment will fall further from its already slow pace. But it's not likely to kick up any time soon either."

Additionally, the decline of the dollar has brought new vigor to those companies selling overseas. "In 2007, the dollar has been depreciating against every currency," says Koropeckyj. The dollar is not expected to rebound through the end of 2008. Exporters should benefit, according to Koropeckyj. "Supposedly, U.S. manufactured goods will become more attractive overseas, particularly with the major trading partners of Europe and Canada."

Recession Risk
Business owners begin the new year in a risky economic environment. Will the nation fall into recession? Economy.com estimates the risk of such a downturn in 2008 as 1 in 3. That's a reduction from the 40 percent level that the organization maintained between the housing industry debacle of last summer and the Federal Reserve's interest rate cut this past September.

While the Fed may cut rates further, Koropeckyj cautions against expecting too much from monetary policy, as the recession risk is still elevated compared to the last few years. And what else might trigger a recession? According to Koropeckyj, there's little doubt that the most likely culprit would be a downturn in consumer confidence and shopping patterns: "The big wild card is this: Will consumers continue to support the economy?"