The Economy: Drawing A Bead On The Future

We put four key economic questions to 58 experts for a sneak peek at the year to come

Smart investors always ask plenty of questions. Getting the rightanswers is the hard part, especially answers about the future of the economy--and the windshifts that can make or break your portfolio. BusinessWeek offers some help on what we think are the four key questions that will play the biggest roles in shaping the investment climate in 2007.

We gathered 58 experts and their best estimates for our annual outlook survey. The overview looks like this: On average, the economists see an investor-friendly economy, with growth cooling to 2.6% from the end of 2006 to the end of 2007. That's a notch slower than the 3.1% pace expected for 2006, but they project a slight pickup in the pace as the year progresses. The slowdown will cause the unemployment rate to drift up--though not by much--from 4.5% to 4.8%. The slump in home construction is expected to end by midyear, yet by the end of the year, home prices are still projected to dip nationally by an average of 1.7%.

The best news for investors is that cooler growth would allow core inflation, which excludes energy and food, to moderate. The consumer price index is projected to rise 2.5%, while the core CPI is pegged to go down a notch, to 2.4%. A tamer look for inflation will give the Federal Reserve leeway to trim its target interest rate to just below 5%, from 5.25% at the end of 2006. Fed policy easing will restore a flatter yield curve, with the return on a 10-year Treasury note also expected to drift up by the end of the year to just under 5%. Profits will continue to grow but at a slower single-digit pace, compared with high double-digits in 2006.

Overall, not a bad outlook. Of course, no consensus forecast is ever a sure thing. So let's take a look at those nagging questions.

1 Will the housing recession sink the economy?

Not likely. Although no housing downturn of this magnitude has ever occurred outside of an economy-wide recession, this housing slump is unique. The market simply fell under its own weight of speculation, overbuilding, and soaring prices, all without the usual push from punishingly high mortgage rates, tight credit, or rising unemployment. As a result, the housing recession has remained confined to the housing sector.

That said, the economy would have grown more than a percentage point faster without the direct effects of cutbacks in home construction in both the third and fourth quarters of 2006. And the drag will continue into early 2007. "Home sales are bottoming out in the fourth quarter, but the inventory overhang is quite heavy and residential construction will fall further," says David F. Seiders of the National Association of Home Builders. However, Seiders and other economists believe the drag will ease in the first half, and builders will begin breaking ground again by late spring.

It is the indirect effects, centered on falling home prices, that generate the worries. Most all economists expect ripples in the rest of the economy, especially in consumer spending, will be unavoidable. Slower spending in 2006 is already forcing businesses to adjust their inventories, which is showing up as new weakness in manufacturing--and the need to cut production will extend into early 2007.

These second-round effects should be manageable. "The wealth effect of housing equity on consumer spending will be felt, but not by more than 0.5% off consumer spending growth," says David A. Lereah of the National Association of Realtors. Growth in jobs and incomes, along with stock market gains, will cushion the drop in home equity.

2 Is the Fed's next move a rate cut or a hike?

Two-thirds of the economists expect a rate cut at some point, while only nine of our 58 panelists look for further hikes. But don't expect any Fed action until well into the year. The odds of an eventual Fed easing increased in late 2006 as evidence of continued slow growth emerged. "It would be crazy for the Fed to further imperil the expansion by raising rates in the teeth of an inventory and housing correction," says David Kelly at Putnam Investments. As the housing slump, the factory slowdown, and moderation in consumer spending filter through the economy, pressures on inflation are sure to ease. "Why should interest rates rise if there is more slack and inflation becomes less of a problem?" asks Jan Hatzius at Goldman Sachs Group Inc. (GS )

So far, core inflation, which excludes energy and food, has shown few signs of backing down. The Fed's preferred measure stood at 2.4% in October, above its informal 1% to 2% comfort zone. What separates the handful of hikers from the cutters is their expectation that the economy will not slow enough to allow the inflation rate to drift lower. "We expect consumer spending to remain strong and believe that overall growth will pick up as the drag from housing and autos fades," says Dean Maki, at Barclays Capital (BCS ).

In fact, Fed officials have continued to talk tough about the pressures on prices, especially those from rising labor costs generated by tight labor markets. However, the job markets and inflation always respond to an economic slowdown with a lag. "The Fed's current focus on inflation risks should fade once some slack opens up in the domestic economy," says Kevin Logan at Dresdner Kleinwort Ltd. Indeed, most economists expect the jobless rate to begin edging up by early 2007.

3 Will the profit boom turn to bust?

A profit slowdown is inevitable, as top-line revenue growth slows and profit margins narrow. Profit growth will most likely slide down to single digits, but don't expect a crash. "All the restructuring and cost-saving over the past 20 years is paying off for Corporate America," says David Berson at Fannie Mae (FNM ). Corporate profitability in the third quarter of 2006, measured as profits per unit of real GDP, was the highest in four decades.

Productivity has not fallen off as sharply as it has in past business cycles, and labor costs are not burdensome. In fact, unit labor costs may even be overstated, says Stephen Gallagher at Société Générale. He notes that labor compensation is increasingly tied to profit performance, a trend that eases the traditional margin squeeze. "Profitability usually peaks several years before the economy goes into a recession," says Dana Johnson at Comerica Bank. (CMA ) That means there is a lot of room for profit growth to slow before the economy is in danger.

Profits will support healthy, if slower, growth in business investment in new equipment and facilities. With margins still high and firms sitting on huge cash reserves, "capital spending should still be one of the brighter spots," says Nariman Behravesh at Global Insight Inc.

4 How will the global outlook play into U.S. prospects?

Expect two key trends, both good for the U.S. economy: The dollar will slide lower, helping to boost exports and profits returned to the U.S. from overseas operations. And the trade deficit will finally begin to stabilize, albeit at a still-high level and with further widening in the gap with China.

"The rebalancing of the global trade position has begun," says Robert Shrouds at DuPont. (DD )Economies in Europe, Japan, and throughout Asia are strengthening as U.S. growth is slowing. What's different now is that economies overseas are growing from within, fueled more by strong domestic demand and less by exports, especially to the U.S. "We're no longer the buyer of last resort, and the rest of the world appears to be decoupling from U.S. growth," says Diane C. Swonk at Mesirow Financial Holdings Inc. That uncoupling will give the global upturn legs, and assure that the current boom in U.S. exports can be sustained, especially as the dollar heads lower.

The downward forces acting on the greenback will persist due to better growth prospects abroad and narrower differences in interest rates, as overseas central banks continue to tighten policy while the Fed is on hold. The European Central Bank is still raising rates, and the Bank of Japan is about to begin.These trends favor foreign investments relative to those in the U.S. Plus, "China has embarked on a gradual process of re-weighting its foreign exchange reserves in favor of the Japanese yen, the euro, and other nondollar currencies," says Donald Straszheim at Roth Capital Partners. That increases the Chinese yuan's value vs. the dollar, but lowers it in areas where China wants to sell its goods.

Could the dollar crash? "A crisis ought to be avoided as long as growth and interest-rate differentials are not too punishing," says Joshua Shapiro at MFR Inc. The biggest risk to the dollar would be a U.S. recession, but if the economists on our panel have the right answers to the these key questions, that's nothing for investors to fear.

By James C. Cooper

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