Forecast 2007 - Area Development

"Fasten your seat belts and prepare for landing." That cautionary directive, so commonly heard by airline travelers, seems just as appropriate for today's business owners as the economy begins to slacken.

"The expansion of the past few years is maturing somewhat and moderating from its recent elevated activity," says Sophia Koropeckyj at Moody's Economy.com, a research firm based in West Chester, Pa. "In 2007, we expect the Gross Domestic Product (GDP) to slow to a 2.9 percent level." That's just under the level of growth considered normal over the long term. It's also a good deal lower than the 3.5 percent growth anticipated when 2006 results are fully tallied.

The first quarter of 2006 had seen a stronger than expected economy, according to Koropeckyj, but activity quickly waned over the following months as pressure from rising energy prices dampened consumer spending. By November, Susan S. Bies, Ph.D., a member of the Federal Reserve Board of Governors, reported a marked slowing of the GDP to 1.6 percent rate in the third quarter. If 2007 plays out as most economists expect, the economy will experience a soft landing as it moves toward the down side of the business cycle.

Housing Softens
Housing is a major factor in the moderation of the economy. In early November, Bies noted that "the number of single-family and multifamily housing starts has fallen nearly 25 percent since the beginning of the year. Sales of both new and existing homes have dropped sharply since their peak of last summer, and the inventory of unsold homes has soared. At the same time, homes are appreciating more slowly, and in some markets prices are even declining."

Confronted with interest rates that were rising steadily through mid-2006 and with a leveling off of the value of homes, consumers are no longer as anxious to take out second mortgages. As a result, the period of home equity extraction, which fueled a good deal of consumer spending, seems to have come to an end.

The silver lining here is the recent cessation of the Federal Reserve's drive to raise interest rates. "With slower growth and easing gas prices, concerns about inflation (one of the main reasons for raising rates) are abating somewhat," says Koropeckyj. "Now we see the Fed actually lowering rates twice over the next year, down to 5 percent in the first quarter of 2007 and again to 4.75 percent during the second quarter, and after that holding them level."

Revenues Slip
Given the weakening housing market, business confidence has taken on added importance to an economy increasingly dependent on investment and hiring. "The expansion will remain intact only if businesses maintain their expansion plans," says Koropeckyj. "With record profits and pristine balance sheets, it seems likely that they would, but recent business confidence readings call this optimism into question."

Business confidence fell sharply in the summer of 2006, thanks largely to weakening sales growth. "Sales gains, which were strong and stable between early 2004 and early in 2006, have fallen more recently and are currently as soft as they have been since the summer of 2003," says Koropeckyj. "Hiring intentions have also fallen off." Economy.com expects a softening in capital investment, declining from its recent 8 percent annualized rate to 7 percent in 2006 and 4 percent in 2007.

Again, though, interest rate stabilization by the Fed offers some hope. "Manufacturers have been sitting back and watching before they invest too much," says Don Schackne, president of Personnel Management and Administration Associates, a consulting firm in Delaware, Ohio. "The many increases in the prime rate really put a damper on borrowing. But if the Fed begins to lower rates, that will loosen the purse strings."

Energy Costs Mount
A spike in fuel costs in the summer of 2006 took many business owners and economists by surprise. Consumers, hit especially hard by price hikes at the gas pumps, began delaying the purchase of optional goods and services. To add insult to injury, the escalation in gas prices caused shipping and wholesale prices to climb.

Will the pain continue? That question's on most people's minds; in fact, many analysts believe the biggest wild card for 2007 to be the cost of energy. In late 2006, fuel costs began to retreat and Economy.com expects prices to moderate further in 2007. Several factors are playing a role, according to Koropeckyj. These include a diminishment of the political risk premium, an increase in oil inventories, and a moderating growth in demand.

Productivity Moderates
While productivity growth has been a major contributor to corporate profits in recent years, observers see a point of diminishing returns. "With the expansion nearly five years old, firms are finding it more difficult to achieve productivity gains, and productivity growth will slow from its rapid pace of the past few years, to about two percent annually," says Koropeckyj.

The moderation in productivity growth will, in turn, lead to continued job gains through the rest of this year outside of housing-related industries as businesses work to keep up with demand, according to Koropeckyj: "Unit labor cost growth is expected to increase some 3 percent as productivity growth slows and firms increase wages to attract workers in the tighter labor market."

Gains are particularly evident for skilled laborers such as welders and electricians, says Michael Smeltzer, executive director of the Manufacturers' Association of South Central Pennsylvania, a trade group whose members represent primarily smaller manufacturers in a broad range of industries. "We have recently seen instances of 15 percent wage hikes to keep highly skilled workers from leaving for the competition."

Consumers Spend
While most businesses are wary of increases in labor costs, the flip side of the corporate paycheck is a vital part of the economic picture: consumer spending power. The news here remains basically good. "The labor markets are still tight, with unemployment running below 5 percent," says Scott Hoyt, an analyst at Economy.com. "So the bottom line is that total wage and salary income growth will remain supportive of spending, but there will be little prospect of any acceleration."

Maybe unemployment has remained low, but there's been much publicity lately about the persistent problem of stagnant average wages. Despite the gains by some skilled workers, the fact remains that paychecks have not kept pace with corporate profits. While this is a problem that must be addressed, most observers do not feel it is a deal breaker in terms of retail sales. "Stagnant wages do not affect consumer activity as much as the presence of jobs themselves," says George Whalin, president of Retail Management Consultants in San Marcos, Calif. "What dictates whether people buy is whether they have a job and can pay their bills. For most people, those conditions apply."

Raw Materials Costly
If labor costs are largely under control, raw materials in general continue to be a burr under the saddle at many manufacturers. "Metals are driving us nuts," says Smeltzer. "It's not just steel, but nickel and other metals are still priced well above where they have been in the past. But we have been very successful in educating our customers to the reality that in the manufacturing sector we cannot always absorb cost increases."

Despite a recent spike in steel prices due to accelerated global demand, Koropeckyj expects them to stay fairly flat through the end of 2006 and decline a bit next year. The Producer Price Index for steel mill products, which rose 9 percent in 2005, is expected to rise only 2 percent in 2006 and 2007. One reason is a moderation of demand; another is the fact that China has become a net exporter of steel, helping to curb price gains.

Exports Pressured
"Exports are still strong, but are expected to moderate in 2007,' says Koropeckyj. "That has to do with where we are in the business cycle." A weakening of the dollar in 2006 has added additional downward pressure on exports. Koropeckyj expects the dollar to continue to weaken against the Japanese yen and the Chinese yuan in 2007 but remain stable against the euro and the Canadian dollar.

"The Chinese yuan continues to be an issue for us," says Smeltzer. "There have been words of hope that have been spewed by the Chinese government, but we have not seen anything that leads us to believe there is any willingness to deal fairly in the currency market."

Lean and Mean
Manufacturers are positioning their operations for continuing success, in moves that should soften the impact of a downturn in the business cycle. "More manufacturers have embraced the concept of lean manufacturing," says Smeltzer. "They realize that success doesn't rely on one magic bullet, but on a continuing focus on reducing costs."

He points out that steps have been taken to reduce costs in areas such as labor, benefits, and energy: "Much of the effort that manufactures have made to focus on costs has paid off. Since sales have remained steady, businesses are enjoying better profits than a year ago."

Beyond the Horizon
Problems always seem to lurk around the corner, and 2007 will likely be no exception. As the economy approaches a soft landing, many business owners are keeping a wary eye on such matters as the decline of domestic automaking, competition from China, and unpredictable changes in the price of energy and raw materials.

Even so, if a downshift in the business climate promises a bumpy ride for 2007, most analysts advise a response closer to prudence than panic. "The bottom line for 2007 is modest growth," says Hoyt. "It will not be as good as what we have seen in the last few years, but it won't be recession-like either."