And For The Economy's Next Act...
What a year. In 1997, the U.S. economy reveled in strong 3.7% growth, mild 2% inflation, 4.6% unemployment, low interest rates, fat profits, and a seemingly unstoppable stock market. Such trends are the stuff that economic dreams are made of.
But now it's time to look at 1998, and based on BUSINESS WEEK's annual survey of 50 top economists, the outlook is filled with more than the usual uncertainties. For example, how much will the Asian crisis affect growth, the trade deficit, and profits? Can stronger markets in Europe take up some of the slack? Will tight U.S. labor markets push up labor costs? Will it be inflation or deflation? Here's what the experts think.
First of all, one way or another, U.S. economic growth is going to slow from its rambunctious 1997 pace. The slowdown may come simply from an unwinding of the unsustainable cyclical strength that had built up in 1997. Or it may be the result of an Asian-led drag on foreign demand. Or--if growth remains stubbornly robust--the Federal Reserve may lose patience and hike interest rates. And don't forget the possibility of a confidence-shattering stock market correction amid worries over profits (chart). But barring any new financial shocks, a recession is not on the radar screen. All forecasters expect the slowdown to be a soft landing, resulting in an eight-year expansion, the longest period of peacetime prosperity since World War II.
World growth in 1998 will also ease back. The Asian region generally will crater, of course, taking some of Latin America with it--especially Brazil, where Asian fallout has rained down heavily. Elsewhere, economic prospects are bright. Canada and Mexico, which together buy more U.S. exports than all of Asia, are each set to post solid growth. Moreover, the pace in Western Europe, which chips in 20% of U.S. export purchases, is projected to pick up a bit.
BUSINESS WEEK expects the U.S. economy to grow 2.4% next year, measured by fourth-quarter to fourth-quarter growth in real gross domestic product. That is a shade above the 2.3% average of the 50 forecasters (table), and it mainly reflects our belief that the slowdown will arrive later rather than sooner, given the economy's powerful momentum heading into 1998. We expect consumer inflation to edge up only to about 2.5%, as a pickup in service prices offsets a continued decline in goods inflation. And after the unemployment rate declines slightly from November's 24-year low of 4.6%, we look for joblessness to rise to 4.8% by yearend, amid slower growth.
The big unknown, however, is Asia. "The Asian meltdown and its effect on U.S. trade, inflation, and profits is the most significant issue for the U.S. economy in 1998," says Allen Sinai of Primark Decision Economics Inc. and 1997's best forecaster. Most others agree. Of the expected 1.4-percentage-point slowdown in 1998 growth from 1997, the economists believe, on average, that Asian woes will account for half a percentage point of that cooler pace. And with the events still fluid, most believe that the risks favor a bigger jolt. "To date, the banking casualties have been confined to Asia, but I would hazard a guess that some global banks also will face nonperforming-loan problems before this crisis is over," says Nancy Kimelman of Technical Data.
TRADE TRAUMA? The growth impact in the U.S. will be felt mainly through a widening trade deficit, which was already expected to rise even before the Asian flu began to spread. "Given that the U.S. sends close to 30% of its exports to all Asian countries, it stands to reason that exports will weaken, given the 30% to 60% currency devaluations already experienced in some of these countries," says Anthony Chan of Banc One Investment Advisors. Moreover, since Asian goods will be even cheaper in dollars, look for U.S. imports to grow somewhat faster as well.
Based on the econometric model of Macroeconomic Advisers, the currency effect alone will cut 0.4 percentage points from U.S. economic growth over the next two years, while weaker Asian demand will subtract about twice that amount. Add it all up, and the U.S. trade deficit is expected to widen sharply in 1998, providing the biggest single hit to the year's growth rate. But while export growth will be slower as a result of the Asian effect, it should remain healthy. The bigger problem will be a flood of cheaper Asian goods, when imports already account for a record 31% of domestic demand for nonoil goods.
However, not all Asian fallout will be negative. A further strengthening in the trade-weighted dollar, mainly against Asian currencies, will place further downward pressure on U.S. inflation, chiefly through goods prices. As a result, consumers will enjoy continued low interest rates and further gains in real wages in 1998. Also, cheaper commodity prices around the world will lower production costs for many businesses. However, all economists reject an outright decline in overall prices. "We see no U.S. deflation," says Joseph Liro of CIBC Oppenheimer Corp., "as domestic demand is strong and service-sector inflation will accelerate, offsetting any decline in goods prices."
In addition to Asia, profits are another especially worrisome issue for 1998. BUSINESS WEEK also surveyed economists on their earnings outlooks, and, on average, operating earnings per share for the companies in the Standard & Poor's 500-stock index are expected to grow only 6% in 1998, about half the projected results for 1997. The problem may well go beyond the earnings hit to U.S. multinationals that do business in Asia. "Wage increases are starting to exceed the possible productivity gains," says Edward E. Yardeni of Deutsche Morgan Grenfell Inc.
LEAPING LABOR. At yearend 1997, average hourly earnings were rising slightly more than 4% from a year ago, and with labor markets likely to tighten further in early 1998, wage growth will continue to accelerate. That's especially true for pay in the service sector, which employs three-fourths of all private-sector workers and where labor demand is generally immune to foreign competition. Service wages at yearend were growing at a 4.5% clip. "Margins will be under pressure in 1998," says Howard Keen of Conrail Inc. "We are less confident that offsetting productivity gains can be achieved."
Service industries may have more luck lifting prices in an attempt to pass along their higher labor costs to consumers, but price resistance by households will likely remain stiff. And given the disinflationary winds blowing out of Asia, on top of intense global and domestic competition, the bottom lines of many goods producers could get hung out to dry. Yardeni says that many stock analysts expect at least 10% earnings growth in 1998, so if the economists are right, investors will be in for some serious earnings disappointments.
More important, the improved inflation outlook will help to forestall the need for a tightening of monetary policy by the Federal Reserve. But any policy decision will not be easy. A majority of economists believes that the Fed will either keep policy on hold in 1998 or actually cut interest rates. "A Fed tightening would frustrate efforts to bail out the Asian economies, since it would only mop up the additional liquidity that the International Monetary Fund and various central banks are trying to provide," argues Gary Ciminero of Independent Economic Advisory. However, 25% of the forecasters still look for a tightening. "Domestic concerns over a strong economy, a tighter labor market, and accelerating labor costs will overwhelm international concerns," says Mark Zandi of Regional Financial Associates.
Despite the drag on growth from Asia, the U.S. economy's momentum in 1997 will carry over into early 1998. Consumers accounted for two-thirds of economic growth in 1997, and household fundamentals actually were stronger at the end of 1997 than they were at the beginning. Those include employment growth, confidence, lower long-term interest rates, and stock prices. Demand for housing and big-ticket items is set to remain sturdy, especially with fixed mortgage rates currently headed toward 7%. Moreover, as long as demand holds firm, capital spending will also stay robust, but business outlays, especially for more traditional machinery and buildings, are likely to suffer as the year wears on, reflecting slower growth and weaker profits.
Also, the U.S. export machine, while shifting down a notch, will remain strong. Exporters have greatly enhanced their competitiveness in recent years. So despite the dollar's strength, real exports of goods and services are expected to rise 15% in 1997, even faster than in 1996. During the past year and a half, exporters have been cutting prices in dollar terms in order to remain competitive. A threat for 1998 could be rising labor costs, which could limit some of those aggressive pricing decisions.
Outside of Asia, the outlook for the other 70% of U.S. export markets is upbeat. That's especially true for Europe, which is finally beginning to make the shift from export-led growth to stronger domestic demand. In fact, slower global growth in 1998 will crimp European exports, but domestic spending growth is expected to be firmer and broader. Support will come from the lagged effects of very stimulative interest rates, a slight pickup in real wages as labor markets improve at least grudgingly, and the lack of fiscal restraint that has hampered growth in recent years. Already, European growth in the middle quarters of 1997 has been generally in the 3% zone. Exports are still dominating, but capital spending by businesses on equipment and inventories is showing signs of life in response to strong corporate profits.
JAPAN FACTOR. The news is not so optimistic for the world's second-largest economy, Japan. The sharp slowdown in growth within emerging Asia will likely clobber Japan, which is highly exposed to the crisis since nearly 45% of its exports go to other Asian nations. Most economists believe that the real threat to the U.S. from the Asian turmoil is not from trade flows but from the possible breakdown of Japanese financial stability and the aftershocks on U.S. financial markets. "With domestic economic growth stagnating due to a tight fiscal policy, the financial system has cracked, and public funds are now required to rescue the system," says Richard Jerram of ING Barings Ltd. A key worry is a possible Japanese recession that would push stock and property prices down even further and swell the nonperforming loans of banks even more.
But aside from any Asian doomsday scenario, the U.S. economy heads into 1998 easily in the best shape it has been in since the 1960s. To be sure, the coming year will present much greater challenges for businesses and investors than 1997. But past cost-cutting and investments in high-tech equipment have given the economy the enhanced efficiency and competitiveness it needs to weather most global storms--including this one.