Why Some Businesses May Feel Cheated This Year

Corporate America in 1995 could end up feeling like the Penn State football team. Companies are doing everything right, but they still might miss out on the big prize.

Businesses have worked hard to cut costs and boost productivity, which has enhanced their competitiveness abroad and bolstered their profitability. But just like the Nittany Lions, who went undefeated but lost the national championship to the Nebraska Cornhuskers, companies this year may find that their efforts to improve sales and profits will go unrewarded.

The spoiler is shaping up to be the Federal Reserve. To keep inflation down, the Fed will continue to raise interest rates in order to slow the economy. Higher borrowing costs will hit the goods-producing side of the economy--notably manufacturers and builders--especially hard. That's not tough to figure: Durable goods, from turbines to cars to furniture as well as construction projects, are usually bought on credit.

Goods producers have been a pretty substantial force in this expansion. During the year ended in the third quarter, the output of the goods and construction sectors accounted for some 80% of the gain in real gross domestic product. Now, though, there are signs that housing is slowing and that factory output may cool off a bit. The slack in those sectors this year will help push overall GDP down to the Fed's target of sustainable but noninflationary growth.

Last year's shift in monetary policy will also take some cash out of the pockets of consumers and corporations. Consumers can expect to see rising finance charges on everything from mortgages to auto leases to credit-card bills. And adjustable-rate mortgages will be refigured higher, sapping more money out of the monthly budget.

THE FED-ENGINEERED slowdown will hold back revenues and earnings. Corporate America enjoyed a banner year for profits in 1994, but that is unlikely to be repeated in 1995. Indeed, the 1995 economy is shaping up to be a bleached copy of 1994: less growth, smaller job gains, and slightly higher inflation.

Industrial activity already showed some fatigue in December, according to the National Association of Purchasing Management, even though prices of industrial materials continued to rise (chart). The NAPM's index fell to 57.8% last month from 61.2% in November. While the overall index is still high, the purchasers reported declines in their production and employment indexes at yearend.

The overall new-orders index also fell in December, but export bookings rose. That suggests that the slowdown in demand is concentrated at home. Most likely, the buildup in inventories at retailers during the holiday season has caused stores to hold off on reordering. The strength in export orders means that manufacturing will slow, but not sink, in coming months.

FOR INFLATION WATCHERS at the central bank and in the financial markets, the most alarming facet of the NAPM report was the unrelenting rise in prices. The NAPM price index jumped from 77.9% in November to 83% in December--the highest reading in almost 15 years.

Also disturbing was the rise in the supplier-deliveries index, to 64.9% from 64.4%. That means businesses are waiting longer for their suppliers to ship out orders. In fact, delivery performance is at its poorest in six years. That suggests production bottlenecks are forming, which could enable manufacturers to lift prices.

But whether these price hikes stick--and whether they can be pushed forward in the supply chain--will depend on demand. By all indications, the Fed will continue to raise interest rates to slow domestic spending. Home builders are already feeling the pinch, though construction has held up surprisingly well given the rate hikes of 1994.

Warm weather helped lift construction in November. Spending on building projects increased 0.7%, the fourth consecutive gain. But even though home building rose only 0.5% in the month, outlays for business construction jumped 4.8%, as a pickup in nonresidential spending continues to buoy the building sector (chart).

That's also the indication of the latest data on construction contracts. The F.W. Dodge Div. of McGraw-Hill Inc. reports that contracts for nonresidential buildings were up 10.9% in November, with retail projects up 19%. Contracts for residential building dropped for the third consecutive month in November. They fell 2.2% in November and are down 14.6% from their peak of November, 1993. Total contracts rose 2.8% in November.

The drop in residential contracts reflects weaker housing demand. Sales of new single-family homes fell 2.5% in November, to an annual rate of 693,000. The temperate weather lifted sales in the Northeast and Midwest, but buying plunged 16.1% in the much larger Western market. Also, the supply of built but unsold homes expanded in November.

Industrial and office projects will take up some of the slack caused by housing. The ongoing boom in capital spending and the increase in industrial operating rates are lifting business construction. Also, the economic expansion helped soak up the large amounts of vacant office and retail space that cluttered the commercial real estate picture in the early 1990s.

For 1995, nonresidential construction should continue to do well. Of course, weather plays a greater role in construction than in any other part of the economy, and higher interest rates may table some commercial projects. But the need to expand factories, build retail space, and upgrade office facilities should keep the building sector afloat.

OTHER BUSINESSES SHARE an upbeat view of 1995. Corporate executives are feeling extremely confident about the prospects for this year, reports the U.S. Chamber of Commerce. Its index of business confidence bounced up to 65.2% in December from 57.2% in October (chart). The bimonthly index is just 41/2 years old, but the current reading is the highest in this expansion.

What's lifting the spirits in the corner office? The Republican victory for one thing. The Chamber reports that 79.5% of the respondents felt that recent election results will improve the business climate. In addition, more than half expect increased sales in the first half of 1995, and 46.3% figured that the economy would keep growing.

Even projected job growth showed a bit of strength: The percentage expecting some new hiring rose to 27.6% in December from 24.2% in October. However, the vast majority of businesses--65.2%--foresaw no change in their payrolls over the next six months.

In fact, businesses will still keep a keen eye on their labor costs this year. That's what helped them to such a profitable year in 1994. This year, companies are sure to stick with their winning strategy. But trying to gain ground against the Fed's stingy defense will be a whole new ball game.

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