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Forecast 2007

As the new year begins, businesses are tightening their belts and bracing for a bumpy ride.

Dec/Jan 07
"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, 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." 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 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."

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