Amidst some concerns, modest growth ahead
Economists and investment managers are more bullish, manufacturing and housing managers are more bearish
By Tom Stundza -- Purchasing, 2/3/2005 2:00:00 AM
Gazing into the crystal ball for 2005, economists at various Wall Street brokerage and investment houses agree: Although the stock market and economy will continue to prosper, it will be a somewhat uninspiring 2005. In fact, Robert Doll, president and chief investment officer at Merrill Lynch Investment Managers in New York, is calling for economic growth to slow, interest rates and commodity prices to rise, and earnings to miss expectations.
"We think it will be a 'muddling through' sort of year," he says, suggesting that real gross domestic product (GDP) growth in the U.S. should slow to less than 3.5% because consumer spending will soften and capital spending will take a hit from high energy costs, rising interest rates and lower productivity. Most other economists are looking at 3.6% in GDP growth, but Doll's a bit bearish. Reason: He thinks consumer spending will rise between 2.7% and 3% this year from a 3.7% pace in 2004, citing an end to fiscal and monetary stimulus. The global economy is also projected to slow down, he adds, with Europe lagging and China continuing to lead the pack—so world GDP growth is expected to be around 7%.
However, PURCHASING magazine's index of manufacturing activity in January is at its lowest average since the summer of 2003. A key reason is that the late-2004 pickup in factory demand was supported by orders for new commercial aircraft that are erratic and by orders for computers that are seasonal. Excluding transportation, factory orders have been flat. And, orders for machinery, a better gauge of metalworking activity, actually fell by 5%. Doll of Merrill Lynch expects business spending to climb 5% to 8% vs. more than 10% last year. However, some other economists and more than a few manufacturing insiders have mixed opinions about the future—and are concerned about the latest factory orders data.
Doll believes that inflation will continue to creep up in 2005, due to a weaker dollar, high oil prices and rising labor costs. As a result, he suggests the Federal Reserve will "show no sign of slowing its campaign of measured one-quarter-point rate hikes." The funds rate should end ar 2005 at 3.5%, up from the current 2.25% rate, while the 10-year note likely will end the year at 5%. In 2004, Doll accurately predicted that U.S. growth would hit 4% for the first time in five years and that the Fed would double the fed funds rate.
With so many forces working against the economy in 2005, Doll said corporate profits growth will probably slow to between 5% and 8%, down from the 19% growth seen over the past two years. That, in turn, forms his view that the stock market could struggle this year—and that stocks may not attain their historical average returns of 2.9%. Still, he does expect stocks to outperform both bonds and cash this year and notes that many companies could raise their dividends and buy back stock, given the strength of corporate balance sheets. Since U.S. corporations have a record amount of cash on hand right now—an estimated $1 trillion plus—he also sees increased merger and acquisition activity. However, Doll expects the yawning trade and budget deficits to improve in 2005 for the first time in 10 years, as the dollar declines and tax receipts go up.
Finally, Doll forecasts that commodity prices will perform well again this year, with oil prices averaging more than $40 a barrel, due to continued geopolitical risks and a lack of spare capacity within OPEC.
Other views also bullish
Benjamin Pace, chief investment officer of Deutsche Bank Private Wealth Management in New York, differs only slightly from Doll. Pace expects U.S. economic growth to lose some momentum around midyear and corporate earnings growth to taper from double digits to about 8%, partly because companies cannot continue cutting their costs as aggressively as they have been doing.
Pace notes that commodities have not been very popular investments until recently; now, many analysts believe that there will be strong economic growth in many parts of the world, and this will lead to high demand for industrial commodities used to build infrastructure. Among them: industrial metals, steel, aluminum and cement. "We're in the middle of a secular price advance in commodities," says Pace. As for oil, it will come down from its current price of about $45 a barrel, to $35 or $37, which he says is still quite high.
Mickey D. Levy, chief economist at Bank of America, believes the overall economy is fundamentally sound, "with strong productivity gains reflecting flexible and efficient production processes and labor markets, stable unit labor costs and low inflation, and highly efficient capital markets and a well-capitalized banking system." To Levy, "the largest risks for 2005 are a sustained sharp rise in oil and energy prices and higher core inflation that would push up interest rates significantly."
The frustration about oil prices is that they are potentially very important to economic performance but virtually impossible to predict, says New York-based Levy. "Assessing whether 2004's sharp price rise was the result of rising global demand or speculation based on concerns about supply disruptions involves uncertainties." That's why the bank's economist says he "would reduce" the bank's economic and profits projections "if oil prices were to rise significantly"
In the same vein, Lynn Reaser, chief economist of Bank of America Capital Management in St. Louis, foresees "a good but not spectacular year" for the economy and the stock market. She says that although industrial manufacturing saw tentative signs of a recovery in 2004, economic uncertainty is likely to become the norm.
That's why she and numerous other corporate economists and financial officers and purchasing officers are less optimistic about expansion in the manufacturing sector than they are for the U.S. economy overall. Only 44% of the economic and business gurus polled by Bank of America expect the manufacturing sector to expand as much as GDP. And that's not much lower than the 47% of the purchasing officers polled by PURCHASING magazine.
And that may be why changes in the business landscape may accelerate this year. "We're clearly at a turning point in merger and acquisition activity," says Bob Filek, a partner in the PricewaterhouseCoopers' transaction services group in New York. "Companies will be more active across the board. They have a lot of cash, and there's a lot of debt financing available."
Filek sees expansion being driven by corporate emphasis on core competencies, the continued creation of very lean and flexible structures, and a corporate focus on key customers and technologies. "In a slowing business cycle, corporations use acquisitions to drive value and to boost otherwise flat growth."
But, according to Filek, there is a wild card in deal-making—the impact of rising commodity prices. "In the current global environment, there's a lot of uncertainty regarding the sources of supply and demand for key commodities. In addition, he says, "we've never faced a situation where China is the third-largest exporter as well as one of the world's biggest consumers of physical commodities.
"It could get really interesting if we suddenly start to have more rapid inflation or limited supplies of core commodities," says Filek. "That could spur the defensive use of acquisitions to secure raw materials" and buyers could experience supply problems, he adds, "because if there are real shortages or allocations of critical commodities, then even lower-tier vendors may find themselves in real demand" by the merger-and-acquisition players.
Housing slowdown
Home sales, new-home construction and mortgage activity will all slow in 2005, according to a trio of economists addressing the International Builders Show in Orlando, Fla., in January. But, they also suggest housing will stay strong by historic standards, with sales likely to ease to perhaps the second-best year on record.
David Seiders, chief economist for the National Association of Home Builders (NAHB), believes both housing and the economy face "stiffer challenges" in 2005 than they did in 2004, particularly the higher course of interest rates as the Federal Reserve continues to boost its Fed Funds target rate. "There is going to be an ongoing increase in short-term rates throughout the year. Our forecast has the Fed Funds rate rising from 2.25% today to 3.75% at the end of the year. It is inevitable that we will see long-term rates, including mortgages, increase," Seiders says.
The NAHB 2005 forecast calls for new-home sales to fall to 1.14 million units from 1.19 million units in 2004. Existing-home sales will also decline from about 6.6 million units to 6.4 million units. Housing starts will drop back to 1.88 million units from 1.95 million units in 2004.
Fannie Mae's chief economist, David Berson, is a little more optimistic, based on his feeling that even though short-term rates will jump in 2005, 30-year mortgage rates are likely to remain relatively cheap, rising only to 6.25% at the end of the year from 5.75% today. "We've had record home sales the last four years. Will 2005 be 'one for the thumb,' a fifth ring? It could be," Berson said. "But the higher rates themselves should take some oomph out of the housing market."
As Seiders points out, one reason for caution on the forecasts is that last year's projects undershot the mark. At the beginning of 2004, most economists were predicting home sales would drop as mortgage rates rose. Instead they will likely set records when final numbers are tallied. Berson also thinks mortgage originations will decline in 2005 as home sales fall about 7% and refinancing continues to back off. He sees $2.1 trillion in originations this year versus $2.8 trillion in 2004. Home prices should continue to grow in 2005, but much less than the nearly 10% they are expected to have jumped in 2004, he says. Gains this year are more likely to be in the range of 3.5%.
Freddie Mac's chief economist, Frank Nothaft, also sees the national average on the 30-year mortgage at 6.25% by the end of 2005. Short-term rates will rise more, he says, but lenders pushing adjustable-rate mortgages will likely offer bigger initial interest-rate discounts on those products as the Fed pushes rates higher. While adjustable-rate mortgages will not be quite so popular in 2005, with their market share falling to 30% from 37% today, demand for interest-only loans will grow, Nothaft says.
Price pressures on steel parts
Steel use grew by just 7% last year in the U.S., recovering only about half of the 12% decline of 2003. And there is serious debate among economists whether the metalworking expansion will sprint ahead or plod along.
Looking ahead, economist Craig Alexander at TD Group Financial Services in Toronto believes that the commodity cycle is at, or nearing, a peak. "Global economic growth is poised to slow from close to 5% last year to below 4% in 2005. That still implies robust demand for raw materials," he says, "but the extent of the moderation in demand may be greater than markets currently expect and that may lead to a change in market sentiment towards commodity prices."
As a result, Alexander believes that commodity prices are likely to trend lower in the coming months. Still, there has been—and continues to be—pressure from corporate finance directors to reduce cost by lowering inventories of steel and other raw materials. Also, the auto industry is a major consumer of sheet steel but auto assembly has been down for two quarters because inventories of unsold cars, trucks and sports utility vehicles have been very high.
Now, the auto parts makers believe they will remain under pressure from rising raw materials costs and North American light vehicle production cuts in 2005—and some are projecting weaker earnings outlooks than Wall Street had expected. Suppliers were pressured in late 2004 by North American production cuts by Ford Motor Co. and General Motors, and both automakers plan to cut output by 8% in the first quarter as well. "Payback time is here, a lot of the volume is going to be going down, and that's why you see a lot of auto suppliers lowering earnings" estimates, says analyst Rosa Welton at Mesirow Financial Investment Management in Chicago.
She says the auto parts companies expect that North American light vehicle production cuts and steel and other metals costs that are higher than a year earlier will continue to pressure early 2005 results. "There's really not a whole lot these auto parts suppliers can do to mitigate the impact of steel prices," Welton adds. "These auto suppliers, for the most part, don't have a lot of pricing power, so they can't pass through a lot of these steel costs." So, even if steel prices do slip in coming weeks because inventories in the U.S. are nearly double the figure recorded at this time last year, the pricetags still are higher now than a year ago.
Independent analysts such as MEPS (International) of the United Kingdom are forecasting a continued slow decrease in transaction values over the next twelve months in the North American sheet steel market. "We have reports that discounts are being given on published scrap surcharges in the US. Canadian supply is now plentiful from both local and overseas sources," says economist and market analyst Peter Fish, writing from Sheffield, England. "All the above factors reinforce our belief that the price situation will continue to move downward in the coming months."
But not all economists/analysts agree. Michael Gambardella, at JP Morgan Chase & Co.'s metals and mining group, says the revised forecast suggests that spot-steel sheet prices "could move higher in the first half of 2005." He notes that "while steel imports continue to rise, strong U.S. demand, high freight rates, and a weak dollar mitigate the risk of lower-priced imports."
As for nonferrous base metals, Gambardella says "prices will remain high heading into the first half of 2005 but aluminum, copper and nickel will gradually decline in the second half because of moderating demand growth and increased capacity pressure pricing." However, the anticipated strong steel production cycle should prop zinc pricing, he says. Zinc is used to coat galvanized steel sheet.
Resins shortages an issue
Demand for plastic resins, a $51 billion business in the U.S., grew 8.3% in the first 10 months of 2004, the American Plastics Council estimates. New cars contain about 280 pounds of plastic, double the amount in 1988. Chemical makers are raising prices as their raw material costs surge and as growing demand exhausts spare production capacity.
Domestic production of plastic resins in 2004 rose to 89% of industry capacity from 85% in 2003, the Arlington, Virginia-based American Chemistry Council (ACC) said. Capacity use will climb to 91% this year and 92% in 2006, the council says.
However, supplies are so tight that there are limits on how much resin customers can buy. Resin supply is tight because producers shut plants and reduced spending when demand weakened in recent years. The last polyethylene plant built in the U.S. opened in Baytown, Texas, in 2002. Nova is planning to help build a polyethylene plant in Mexico by 2010, the only one proposed for North America. That growing imbalance between supply and demand also has been spurred in part by increased purchases by China. Producers also are raising prices to keep pace with higher costs for oil and gas, which are broken down into the chemicals used to make plastics.
Detroit-based General Motors, the world's largest carmaker, is trimming costs by using more recycled plastics under the hood, behind the instrument panel, and inside the wheel wells of full-sized trucks such as the Silverado. "We are challenging our suppliers to find good solutions using recycled materials,'' says a GM spokesman.
That's partly because buyers universally expect that U.S. and Canadian chemical makers will continue to raise plastic prices in 2005. The spot price of polypropylene, used in carpet fibers, snack packaging and car parts, rose 80% in a year, and polystyrene, used in plastic utensils, cups and CD cases, jumped 74%. Both resins have surpassed peak 1980s prices, according to the Chemical Market Association in Houston. Profit margins at resin makers have yet to peak because costs for gas and oil are three to four times higher than in the late 1980s, says Howard Rappaport, plastics director for the Chemical Market Association.
U.S. automakers are using more plastic than a decade ago, replacing steel with light, easily shaped polymers in everything from door panels to bumpers, says Jim Kolb, vice president of automotive programs at the ACC. Automakers are expected to expand their use of plastic to at least 325 pounds per vehicle in 10 years, compared with 70 pounds in 1970.
From dent-resistant doors in General Motors' Saturn cars to seat cushioning and instrument panels, plastics are the material of choice. Germany's BASF convinced General Motors to use a one-piece plastic frame for the third-row seat of the GMC Envoy sport utility vehicle, replacing a metal version that had 15 parts, required 10 additional assembly steps and weighed 50% more, reports Jay Baker, BASF's vice president of engineering plastics in North America.
The company expects to increase U.S. sales of plastic car parts as much as 4% annually by reducing carmakers' manufacturing costs and improving vehicle fuel efficiency. But, Baker adds that even as sales gain, higher costs have narrowed profit margins. "We've all had to struggle in 2004, and we're going to continue to struggle in 2005; it's a lot less profitable than it used to be.''
Forecasts of key indicators
(annual, % change)
| ACTUAL FORECAST | '01 | '02 | '03 | '04 | '05 |
| SOURCE: BLUE CHIP ECONOMIC INDICATORS, NATIONAL ASSOCIATION OF BUSINESS ECONOMISTS |
|||||
| Gross domestic product | 0.3 | 2.5 | 3.0 | 4.4 | 3.6 |
| GDP price index | 2.4 | 1.7 | 1.8 | 2.1 | 2.0 |
| Gross domestic purchases | 0.4 | 3.0 | 3.3 | 3.6 | 3.3 |
| Consumer spending | 2.5 | 3.1 | 3.3 | 3.6 | 3.3 |
| Residential starts | 1.9 | 6.9 | 8.2 | 4.9 | -6.2 |
| Nonresidential investment | -5.2 | -5.7 | 2.8 | 10.2 | 8.5 |
| Industrial production | -3.4 | -0.6 | 0.2 | 4.5 | 4.2 |
| Motor vehicle sales | -1.7 | -2.3 | 8.2 | -1.2 | 1.8 |
| Off-road vehicle sales | 9.1 | 0.1 | 20.6 | 9.7 | 3.5 |
| Unemployment rate | 4.7 | 5.8 | 6.0 | 5.5 | 5.3 |
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