What's in Store for 2006?

By James W. Haughy -- Supply Chain Management Review, 12/1/2005

Economic growth in 2006 will follow a pattern very similar to that of 2005. Last year, economic and trade growth began strong, sagged in the spring while inventories were being reduced, recovered in the summer when inventory investment resumed, and then sagged again in the fall from the impact of several devastating hurricanes in the United States.

A strong start is expected again in 2006. But this time it will be fueled by a rebound from the hurricane-related slowdown, delayed inventory building in technology markets, and the first results of recent structural economic reforms in Europe. In the second half of the year, expect the U.S. gross domestic product (GDP) and trade volumes to slow as the sustained rise in energy and credit costs dampens consumer spending and, consequently, investment in capacity expansion.

There will be no significant differences between country growth rates in 2005 and 2006. The United States, China, South Asia, and Eastern Europe will continue to expand at their maximum sustainable pace, which ranges from 3 percent-plus in the United States to 8—9 percent in the developing countries. Western Europe and Japan will both expand at a nearly 2-percent rate, slightly below their sustainable potential. Japan has seen several growth spurts in recent years, usually spurred by pump-priming tax changes. But none of these has persisted long enough to boost the Japanese economy to its full potential. With short-term interest rates at 0.0 percent and a huge fiscal deficit, there's little prospect of a significantly stronger Japanese economy in the next few years. In Latin America, economic growth will sag at under 4 percent-about one-third below the region’s sustainable potential.

Canada, by far the United States’ largest trading partner, has lagged behind the U.S. economy since the last recession. But Canada finally will catch up in 2006, largely because of a 50-percent gain in energy export prices. However, slower growth in the last few years means that there will be considerably more slack in domestic Canadian than in domestic U.S. markets. Mexico, meanwhile, has lagged even further behind the U.S. With the country suffering from the loss of a substantial amount of U.S. contract manufacturing business to cheaper Asian suppliers, very little progress is expected next year.

Upward Creep on Fuel Costs
High fuel costs aggravated the increase in freight rates in 2005, but will add very little to annual average rates in 2006. Even if fuel costs had remained steady in 2005, rates would still have increased about on pace with overall inflation because world production and distribution of goods was expanding faster than production and transportation capacity. Fuel costs will be declining over the course of 2006, but will still average 5—6 percent higher than in 2005.

It’s important to note that price trends differ for various types of fuel, and that they do not all follow the same trend as crude oil prices. The reason: The price impact of a demand/supply imbalance depends heavily on the adequacy of initial inventories for each fuel stock, whether fuels can be substituted for each other, and, post-Katrina, the mix of crude oil and other processing facilities that were lost or damaged. For this reason the price of commercial transportation fuels, such as diesel and jet fuel, increased substantially more than those for gasoline.

Inventories Trending Toward Lean
By the end of this year, inventories were on the lean side of average. In the United States the inventory-to-sales ratio has fallen to a record low and is forecast to further decline slightly, even though aggregate inventory will rise in a strengthening economy.

One cautionary note: It’s not yet clear to what extent the frantic, post-hurricane scrambling for supplies will prompt managers to hold more safety stock. But even if they exhibit a little more caution, that will add more stock during the new inventory-accumulation period that began in mid-2005 and is expected to extend at least through this winter. Accordingly, there is a substantial risk that surplus inventories will again appear in mid-2006. Still, economic forecasts assume that a shift from adding to reducing stocks will be the major factor slowing the pace of economic growth over the course of 2006. Such a shift would also have measurable consequences for lead times and prices.

The cost of short-term loans for holding inventory rose by 3 percent in the United States in the last 18 months and is projected to increase by another 50 to 80 basis points during 2006. The Federal Reserve Board has unmistakably signaled that more inflation-fighting hikes in interest rates are ahead. The rise in inventory-holding costs in 2006 will range from very low to near the historical average, and will not be burdensome enough to prompt many corporate edicts to trim stocks.

Currency and Inflation
No significant new exchange-rate trends are expected in 2006. The U.S. dollar will resume depreciating, probably at an annual pace of about 4 to 5 percent. This comes after a pause in depreciation in 2005, which was caused by concerns about the euro’s value that arose when several countries in the currency union ran larger-than-agreed deficits.

China revalued its currency upward by several percent in mid-2005 and is expected to cautiously continue to revalue in 2006. This will make U.S. manufactured goods more price-competitive with Chinese goods everywhere in the world. Revaluation is unlikely to cause significant country sourcing changes in 2006, but could do so soon afterwards.

Inflation will be slightly higher worldwide in 2006. Credit this to both the rise in energy prices and to tighter supply conditions in a capacity-constrained world economy. U.S. “core” inflation (excluding food and energy) has already crept up from less than 1 percent to 2.5 percent in the last few years and appears likely to rise as high as 3 percent in 2006. At this level, there is substantial risk that higher inflation will be perceived as being indefinite, rather than temporary, in duration.

That would be the Federal Reserve Bank’s worst nightmare. Higher prices for energy and other products would begin creeping into wage rates, setting off a wage-price inflation spiral that would take several years to stop with a restrictive monetary policy that severely slowed demand. We assume that the FRB can manage this problem and will be able to keep inflation below 3 percent. Nevertheless, you can expect to hear the question, “can inflation be stopped?” often next year. This will provide sellers with the cover to become more aggressive in their requests for price increases.

James W. Haughey is Director of Economics for Reed Business Information.

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