Economic Signposts for 2006

What's ahead? Here's the collective wisdom of 54 economists on indicators ranging from growth and profits to oil prices and interest rates

BusinessWeek's annual economic outlook survey for 2006 shows continued strength, unless the housing market falls apart or oil markets head back toward the stratosphere. With tables on key indicators -- including growth, corporate profits, unemployment, inflation, oil prices, Federal Reserve policy, and market interest rates -- BW's survey of 54 top economists shows where the economy is likely headed next year. The good news: These economists see more of what businesses and consumers enjoyed in 2005 as the economy enters its fifth year of expansion.

ECONOMIC GROWTH

Economists expect the economy to slow a notch in 2006, primarily reflecting a cooling off in housing and a slower pace of consumer spending. Nevertheless, 3.3% growth is sufficient to create jobs and incomes at a healthy clip. The biggest uncertainties: the degree of slowdown in housing and the direction of energy prices.

What the forecasters are saying:

Maury Harris, UBS Securities:
"A soft landing for economic growth is expected for 2006 as earlier interest rate rises lead to somewhat weaker housing but no outright crash in home prices. Two upside wild cards are greater-than-average productivity growth and faster-than-currently estimated household formation. An unanticipated broad-based decline in home prices is maybe the single most important downside risk."

Michael Englund, Action Economics:
"Rapid growth in the aircraft, energy, construction, transportation, heavy-truck, and trade sectors will drive a robust economy. This broad-based strength should prevent any significant correction in the housing market, though growth should slow, and rapid profit growth should limit any losses in the stock market from rising."

David Wyss, Standard & Poor's:
"Rebuilding from Katrina should balance the slowdown in consumer spending. Lower oil prices will help somewhat, but higher interest rates will be a drag, as will the continued widening of the trade gap."

CORPORATE PROFITS

Profit growth is expected to slow from its surprisingly strong performance in 2005. The solid 2005 gains in the face of higher costs for energy and labor suggest some increase in pricing power, especially given exceptionally high profit margins. In 2006, look for earnings to post gains in the mid to high single digits. That's not bad for the fifth year of an economic expansion.

What the forecasters are saying:

James Paulsen, Wells Capital Management:
"Better pricing trends will keep corporate profits better than expected but also greatly heighten inflation fears next year."

Kenneth Mayland, ClearView Economics, LLC:
" 'Pricing power' is stronger than it has been in more than a decade, but this is mostly true in the lower half of the supply chain. At the top, price pressures will largely be offset by productivity increases and perhaps some profit margin reductions."

Michael Moran, Daiwa Securities America:
"Firms will attempt to pass through cost increases, and they will probably have some success. Some of the cost pressure will be absorbed in profit margins, but core inflation is likely to drift higher in 2006."

UNEMPLOYMENT

If the forecasters are right about the economy's growth rate, then a 3.3% pace will be sufficient to generate jobs at a rate that will stabilize joblessness at 4.9% through yearend 2006. The key question is, just how close is the economy to "full" employment, the point at which wage growth begins to accelerate? Labor shortages are already showing up in some areas. The Federal Reserve's interest rate decisions will give special consideration to how labor-market conditions might affect inflation.

What the forecasters are saying:

Vincent Boberski, RBC Capital Markets:
"Most important to consumers will be the health of the labor market, and the economy looks set to create more jobs, not less."

Lynn Michaelis, Weyerhaeuser:
"The improving employment situation will clearly boost the spending power for some households. However, with the savings rate negative, higher interest rates and a slowdown in home-price gains will be reflected in a more modest consumer spending year in 2006 than in 2005."

John Ryding, Bear Stearns:
"We believe that hiring and income growth are the most important drivers of consumer spending. We expect that income growth will remain strong enough to support solid consumer spending in 2006. Consumer spending has been remarkably resilient to negative shocks."

INFLATION

With energy prices expected to level off or decline, overall inflation is set to fall in 2006 from its expected 3.8% rate in 2005. The more important pattern, however, will be core inflation. Forecasters expect core prices to be pushed up by the impact of higher energy costs that are passed through into prices broadly as well as a pickup in unit-labor costs. Federal Reserve policymakers will watch core inflation closely.

What the forecasters are saying:

Nariman Behravesh, Global Insight:
"We expect core inflation to edge higher, as firms do seem more able to pass on increased costs for energy and other materials than earlier in the cycle. That will motivate further Fed hikes to at least 4.75%. But a slowing economy and intense competition should keep a lid on inflation."

Ethan Harris, Lehman Brothers:
"We expect a low pass-through to general inflation. The economy still has some slack capacity, and the global competitive threat should limit the wage and price pickup."

Ed McKelvey, Goldman Sachs:
"Core inflation is currently in the upper bounds of the Fed's comfort zone -- thus, we expect the Fed to continue tightening through mid-2006. Pricing power has improved over the last two or three years, but it is still fairly limited."

CRUDE OIL

The forecasters are betting that oil prices will end 2006 somewhat lower than the level at yearend 2005. High oil prices in recent years have been primarily a demand-led phenomenon, and world growth in 2006 is likely to be equal to, or perhaps a shade faster, than it was 2005. However, slower growth among several big oil consumers in Asia, notably China, India, and some other emerging-market nations should help to temper oil demand.

What the forecasters are saying:

Mark Zandi, Moody's Economy.com:
"Rising and now falling energy prices do impact consumer spending, but only modestly, given that the dollars involved are small compared to wages and salaries and home-equity extraction."

Vincent Boberski, RBC Capital Markets:
"Natural gas and heating-oil prices are likely to give a nasty surprise this winter, but people so far have dealt surprisingly well with high gasoline prices."

Stuart Hoffman, PNC Financial Services Group:
"One key assumption underlying my sanguine global economic outlook is that crude-oil prices will fluctuate within a $45- to $70-per-barrel range, but average close to $55 per barrel in 2006, down slightly from $57 per barrel in 2005."

INTEREST RATES

The forecasters generally expect the Federal Reserve to stop hiking its target interest rate by the spring of 2006, with the federal funds rate topping out at 4.75%. What could rock the boat? If the economy is stronger than expected, if inflation in nonenergy items picks up substantially, or if tight labor markets threaten to heat up wage growth, then the rate could hit 5% or more. The markets expect little change in the way monetary policy is conducted as incoming Fed Chairman Ben Bernanke takes over the helm from the departing Alan Greenspan.

What the forecasters are saying:

Kevin Logan, Dresdner Kleinwort Wasserstein:
"The Fed will react to mounting cost pressures by raising the fed funds rate to about 4.75%. Pricing power has rebounded in the last two years from the lows reached in 2002/2003, but it's not much stronger than it was in the late 1990s."

Mickey Levy, Bank of America:
"Fed credibility has kept inflationary expectations under good control. Pricing power has temporarily increased in the wake of the hurricanes but still remains rather weak. The Fed will watch labor markets carefully for signs of pressure, which could generate upside interest rate risk."

David Resler, Nomura Securities International:
"The Fed remains overly sensitive to the inflation effects of higher energy prices and seems almost indifferent to the associated downside-growth risks. It is following the same reaction pattern of summer, 1990 and fall, 2000 when energy-supply shocks threatened both growth and inflation. In both instances, the economy slipped into recession."

INTEREST RATES

The bond market has been at odds with the Federal Reserve's desire to lift interest rates for a year and a half. Long-term rates have generally stayed down, as the Fed has pushed up short rates. The extent to which long rates rise in 2006 will have the biggest impact on the degree of any housing slowdown. If the forecasters are correct, and the 10-year note peaks at about 5% in 2006, then mortgage rates are not likely to rise above 6.5% or so. At that level, housing activity will cool gradually, and the risk of an outright collapse will be decreased.

What the forecasters are saying:
James Meil, Eaton:
"2006 will slow as higher interest rates restrain discretionary expenditures and a flat yield curve slows credit extension."

Gene Huang, FedEx:
"The pace of change in financing costs and energy costs will affect consumer spending in durable goods, including both auto and housing. The risks are slightly tilted toward the downside."

John Pope, Investment Economics
"Given that much has been borrowed against lines of credit and home equity, the infamous duo of increasing interest rates and falling home prices could materialize to depress the consumer. Conditions are ripe for this given that the household debt service-to-income ratio is the highest on record. Further, prompted by the regulators at the Office of the Comptroller of the Currency, the credit-card industry is doubling the minimum required monthly payment from the existing 2% of the outstanding balance to 4%."

Hedging Against Inflation

By Joseph Weber

Think that whiff of inflation in the air may get stronger in the new year? With the effects of the fall’s hurricanes receding and energy oil prices dropping, along with continued vigilance by the Fed, most prognosticators don’t see a big uptick through 2006. That doesn’t mean you should let down your guard on the traditional inflation hedges, such as gold and commodities. After all, a year ago, forecasters underestimated how bad inflation would be in 2005.

Commodities

Format: Futures, limited partnerships, mutual funds

WHAT HAPPENED IN 2005 Rapid growth in the developing world, especially China and India, has sharply driven up the prices for copper, platinum, and other metals. The Goldman Sachs Commodities Spot Index was up nearly 42% for the year to date, as of Dec. 9.

OUTLOOK FOR 2006 Double-digit rises are expected to continue. “Investors should have hard assets in their portfolio,” says New York planner Kathleen Piaggesi. Natural-resources funds offer the broadest plays, whether they buy commodities contracts or stocks in producers, and allow for a quick exit if prices overshoot demand.

Currencies

Format: Cash, futures, mutual funds

WHAT HAPPENED IN 2005 The surprise of the year. Despite higher inflation in the U.S. and record budget and trade deficits, the greenback rose against the euro and the yen. That means the euro is down about 13% against the dollar and the yen 15%. The Chinese government finally relented and revalued the yuan against the dollar, but only by a little bit—about 5%.

OUTLOOK FOR 2006 The dollar is expected to resume its long-term slide, making other currencies, particularly the euro, appealing. The Swiss franc is a good bet if you believe gold prices will climb, since the Swiss hold lots of the metal.

Energy

Format: Energy company stocks, limited partnerships, futures

WHAT HAPPENED IN 2005 Oil soared to new heights and then retreated a bit, with commonly watched West Texas Intermediate crude oil climbing from an average of about $47 a barrel in January to an average of $65.59 in September. It has since slipped to about $60 a barrel now, according to the U.S. Government’s Energy Information Administration.

OUTLOOK FOR 2006 Similarly sharp short-term climbs seem unlikely, barring supply disruptions. Still, pressure on oil won’t abate soon, as demand continues to rise. Global growth will keep driving oil prices, so selected stocks might be worth bets.

Gold

Format: Physical gold, exchange-traded funds, commodity futures

WHAT HAPPENED IN 2005 The precious yellow metal shot up from $428 in January, to $536 an ounce in December amid worries over soaring trade deficits, inflation, energy price hikes, and fears that Social Security would crumble.

OUTLOOK FOR 2006 Skepticism abounds over the sustainability of current prices, the highest in two decades. Given the runup, a pullback is a strong possibility—and some advisers say it may be smart to make purchases if gold falls below $450. Still, don’t bank on the $800-an-ounce record set 25 years ago, and keep in mind that prices fell below $300 during the 1990s.

Inflation-Indexed Securities

Format: U.S. Treasury Inflation-Indexed Securities, Series I Savings Bonds, mutual funds

WHAT HAPPENED IN 2005 The rise in inflation led to higher returns. Those bonds that reset their rates in the fall got a boost from the Hurricane Katrina-induced spurt of inflation. Ten-year TIPS returned 4.5%, and the I Bonds, 6.73%.

OUTLOOK FOR 2006 With inflation expected to moderate, yields should be lower. The real yield—what you earn over the inflation adjustment—is less than 2%, and that’s not expected to change. As inflation moderates, adjustments to I bonds will likely lower the yield. Still, the point of these securities is not to make a killing but to earn a real return on your capital.

Real Estate

Format: Residential and commercial properties, real estate investment trusts

WHAT HAPPENED IN 2005 The housing bubble didn’t burst, but it’s definitely losing air. With prices far outrunning income growth in many markets, what else could you expect? Rising mortgage rates are cutting away at affordability, too, something even creative financing can’t paper over.

OUTLOOK FOR 2006 Commercial real estate looks to be a better bet than residential, since businesses will continue to grow and their office needs must be met. One smart way to diversify risk is through real estate operating companies, or REOCs.