2006 ECONOMIC OUTLOOK

July 5, 2006 05:44 AM

If momentum serves as a predictor for what 2006 has in store for the economy, the forecast is rather rosy. “Broadly stated, 2005 was a good one,” says Carl Tannenbaum, chief economist for LaSalle Bank. Tannenbaum points out that gross domestic product (GDP) growth for the last three years has consistently remained above the benchmark of 3%, which according to most economists is considered a solid number. And most recently, despite rising record energy prices and the initial drag on the economy caused by hurricane disruptions, rising consumer and business spending spurred the economy to grow at a whopping 4.3% annual rate for the third quarter of 2005 — the best pace the economy has seen in more than a year. “We are entering 2006 with a reasonable amount of momentum,” Tannebaum says, noting that other positive economic signs include the United States adding 2 million jobs in the past year, unemployment being down to 5%, solid home sales, companies again adding new office space and sending employees on business travel and even the telling tale of the middle seats on airlines once again full.

The factor that most likely will give the economy in 2006 the biggest boost is the rebuilding of the Gulf Coast from the devastation caused by this year’s hurricanes. “I can give you 120 billion reasons why we will not have a recession,” Tannenbaum explains, referring to the money the government and the insurance companies will contribute to the rebuilding of the Gulf. He says this will increase sales for heavy equipment and materials, driving the economy throughout 2006. As for the shorter term, Tannenbaum expects the fourth quarter growth rate to be above 3%.

Other areas that will either enhance or at least not drag on next year’s economy include the housing sector and corporate profits. Recently economists have characterized the housing market as due for a soft landing as opposed to a bubble that is about to burst.

“We most likely will see a modest correction in the housing market as things cool off,” Tannenbaum says, explaining that as the market starts to slow down it will provide a healthy correction and that a crash is unlikely. Mike Englund, chief economist with Action Economics, agrees. “We will see a rather solid housing market next year,” he says.

Robert Neal, associate professor of finance at the Kelley School of Business at Indiana University, also says the housing market should remain strong next year, pointing to the rebuilding in Louisiana and Mississippi as one of the main drivers.

While economists agree on predictions for next year’s housing market, forecasts for corporate profits are more mixed. “We predict that corporate profit growth will be at about 8 to 10% next year,” Neal says. He explains that the costs of health care, pensions and energy may keep profits from not reaching the high levels experienced in recent years.

On the other hand, Diane Swonk, chief economist with Mesirow Financial, forecasts higher corporate profits, pegging growth for 2006 at 13.9%. And Englund agrees 2006 will be another strong year for corporate profits, predicting that companies will bring in strong numbers at the beginning of the year that will keep year end numbers high. Some industries, Englund explains, will experience a “bottleneck” in unprecedented and unfilled orders, including aerospace, materials and the trucking industry. “For instance, we will see huge increases in heavy equipment sales before the trucking industry instigates its new regulations that will change the heavy trucking industry,” he says. In addition, Englund adds that corporate profits may get a boost as a result of the dollar moderating.

NO BIG SURPRISES

As for interest rates in 2006, predictions run the gamut, but the consensus appears to be that short-term interest rates will land between 4.75% to 5% in 2006. (See chart “Meeting minutes tell all?” below). For instance, Swonk forecasted in November that Fed fund rates would reach 4.75% in 2006. Tannenbaum expects interest rates to reach 5% by the middle of next year. Regardless of where rates end up many economists agree inflation will be on the Fed’s mind.

“The risk of inflation will increase somewhat next year. I expect the core inflation [measurement] next year to be at 2.4%, up from 2.2% this year,” Tannenbaum says. Swonk comments, “I expect the Fed’s concern about inflation to carry over into the [Ben] Bernanke administration.” Bernanke is expected to take over Feb. 1 or possibly sooner if his nomination process is expedited.

Some economists, however, believe the Fed will pause its tightening track sooner than later. “We believe the Fed will pause in February,” says Englund, explaining the Fed’s rate hikes will stop at 4.5% as opposed to 5%.

Indiana University’s Business Outlook panel, which Neal is a member of, forecasts the federal funds rate will raise to at least 4.5%, with the prime rate expected to rise to 7.5% and the mortgage rates to reach near 7%.

LOOSE WALLETS?

Consumer spending, which accounts for two thirds of the total economy, will be another major factor for how well the economy performs next year. Tannenbaum explains that strong bonus numbers likely will advance consumer spending at the beginning of the year, but his confidence in the consumer is not what it has been in years past. “We do not have the same energy to rely on from the consumer standpoint that we had in the last four years,” he says.

Swonk explains consumer spending has taken a bit of a back seat to record company cash flows and relatively low interest rates. She explains four major factors that will determine the pace of next year’s economy include how much businesses are willing to part with their cash, government spending, Federal Reserve interest rate hikes and how strong consumer spending ends up. In October, U.S. consumer spending rose 0.2%, which drove the savings rate into negative territory of -0.7%, making October the fifth straight month the savings rate has been negative.

Englund sees this ongoing negative savings rate as evidence that consumers are not losing confidence. He explains, “Next year may end up to be the best year yet as far as optimism from consumers and consumer spending.” He believes this to be true as a result of the pause that is expected in rising interest rates as well as the ongoing accumulation of wealth in the United States.

2006 CHALLENGES

But what might hold back consumer spending, strong corporate profits and a solid housing market? Simple. Energy prices.

“The next six months we will be challenged by the cost of natural gas. This will tax consumers and businesses,” Tannenbaum says. However, he explains this economic negative will be counterbalanced by the positive boost that the rebuilding of the Gulf will offer the economy. Economists once again when handing out 2006 forecasts include the ever common caveat, “unless, of course, energy prices skyrocket.” Swonk says, “Not surprisingly, the wild card for 2006 is what happens to energy prices.” However, her prediction is that prices will stabilize, but adds that like always weather will play a large role on where prices end up, which of course can not easily be predicted.

Another challenge 2006 brings is the adjustment that Wall Street and the world, for that matter, will endure with Federal Reserve Chairman Alan Greenspan leaving office. The biggest change according to Tannenbaum and many other economists will come in the area of communication. “Bernanke is fond of being very explicit, very clear about interest rate policies,” Tannenbaum says. Neal agrees. “The new Federal Reserve chairman will likely be more transparent,” he says, adding that if inflation is higher than Bernanke is comfortable with when he takes over as Fed chairman, he may take a more aggressive stance.

Swonk explains the net result of a new Federal Reserve chairman will not provide that much of a difference. However, she says, “The biggest change is the somewhat of an uncertainty and risk premium that will come back into the bond market.” Swonk adds, “Greenspan’s style is completely different than Bernanke and it will take some time for Wall Street to get used to this.” While Greenspan is someone who was comfortable with his photo on the cover of Time magazine, Swonk characterized Bernanke as the type that “walks quietly with a big stick.” And another change, Swonk explains is that under the Bernanke administration the nation will see more diversity of opinion coming from the Federal Reserve, something that has worked well for other nations’ central banks. “The Federal Reserve will become recognized more for the institution instead of being focused on the leadership,” Swonk says.

THE CHINA FACTOR

For a true U.S. economic outlook, economists need to look across the globe, and China and India are most important these days. China’s future today is as important to the United States’ economy as the regular laundry list of factors such as interest rates, housing, corporate profits and unemployment. Tannenbaum is from the camp that believes in the long run we will benefit greatly from China’s growth. He explains that while U.S. companies complain about China taking away from their business, instead we should be looking at the benefits the relationship with China has to offer the United States.

“Our relationship with China allows us to keep inflation down, interest rates are held down and products are cheaper for us. We need to be patient,” Tannenbaum says, “In the long run China is going to continue to be a very important trade partner for the United States.” Englund says the three way trade phenomenon between the United States, China and India is growing in importance all the time. “We need to be aware of how the United States integrates into this powerful growth engine,”

Englund says. But Englund reminds us that while we read about China’s and India’s explosive growth, the United States also is experiencing unprecedented expansion. “We add a new Australia each year,” Englund says, explaining that the United States throughout the last couple of years has added $700 to $800 billion to its economy. “Next year, in nominal terms, we are set up for the biggest addition yet. We will add $900 billion to the economy next year. This is a huge increase,” he adds.

Carla M. Bauch is a freelance writer in Chicago.

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