Risky business in 2006? Could be
The housing market and rising rates are worrisome, but manufacturing, growth overseas may help.
By Chris Isidore, CNNMoney.com senior writer

NEW YORK (CNNMoney.com) - The bond market's signal of slower economic growth ahead sent shivers through financial markets this week and raised questions about the strength of the current expansion.

That sign came when long-term interest rates fell below short-term rates in the Treasury bond market on Tuesday and Wednesday -- a so-called inverted yield curve that has traditionally meant slower growth, or even recession, ahead.

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The economy grew at a solid 4.1 percent annual rate in the third quarter, after expanding 3.8 percent in the first quarter and 3.3 percent in the second quarter. Full-year growth of about 3.7 percent seems to be in reach.

While most economists aren't forecasting a recession many are predicting a slowdown next year, with growth of about 2.5 to 3.3 percent -- and that was before the signal from the Treasury market. (For more on the yield curve, click here).

"We have a pretty good idea (that growth will slow) for the first half and maybe through the summer," said Anirvan Banerji, director of research at the Economic Cycle Research Institute. "Beyond that, we ought to be honest and admit that it gets fuzzy."

Here's a look at a number of factors to watch to see if the economy stumbles or stays strong in 2006.

Shocks to the system

The United States proved surprisingly hearty this year, as record $70 a barrel oil, higher interest rates and the most expensive hurricane season in history all failed to spoil the party.

What kind of shocks will 2006 hold? No one knows for sure. But Banerji says there's more reason to worry about the jolts ahead than the ones from this year.

"A lot of people have assumed the economy has become so structurally resilient it won't be a problem if there are more shocks in 2006," he said. "But the resilience is not likely to be as high in 2006, especially in second half of the year.

"The difference has to do with where we are in business cycle," he said. "Things are likely to get more wobbly, and that makes the economy more vulnerable. Pretty much any shock could be a problem."

What's out there to worry about?

The Federal Reserve pushing interest rates too high, for one thing. Fed policy-makers have raised rates 13 straight times in a bid to keep inflation at bay, but some analysts worry that the central bank might overdo it, crimping economic growth.

Analysts say another distinct possibility is a bankruptcy filing by General Motors (Research), though the automaker denies it. That could have ripple effects far beyond the company's employees and stock and bondholders.

A problem with hedge funds, which have grown dramatically since the collapse of Long Term Capital Management in 1998, is another fear.

And there are concerns that the slowdown in the housing market could mean trouble for the broader economy.

Housing market slowdown

While many experts say fears of a housing market bubble bursting are overblown, nearly all real estate economists say housing is likely to slow in 2006, which could dent economic growth.

White hot sales of new homes have led to a boom in hiring by construction firms, real estate agents and mortgage finance companies in recent years, so a housing retreat could mean slower job growth in 2006.

UCLA's Anderson Forecast projects that 500,000 construction jobs and 300,000 finance jobs could be lost even if the housing market slows without collapsing, due to a reduction in home building.

But beyond a drop in construction, a leveling off in home price appreciation coupled with higher mortgage rates could shut off an important source of cash for homeowners who have used their homes like ATMs in recent years, said Carl Steidtmann, chief economist with Deloitte Research.

"The housing market has had a huge wealth effect," he said. "That wealth effect is not going to be nearly as strong. That will give consumers a sense of not being as flush. That is where you'll feel it the most."

The sting from energy

While gasoline prices have returned to pre-Katrina levels, the impact of higher energy costs isn't over, Steidtmann said, due to home heating bills now starting to arrive in mailboxes. Natural gas, an important fuel for businesses and electric generators, isn't likely to retreat soon because of limited availability of overseas imports.

And while oil is well below the post-Katrina highs, last summer showed how unexpected weather or political upheaval overseas can quickly cause another oil price spike.

Jason Schenker, economist at Wachovia Corp., said the jury is still out on whether higher energy prices will seep into the cost of other goods and services, though they haven't so far.

Schenker said another factor that could drive prices higher is rising labor costs, if the economy keeps adding about 200,000 jobs a month. Some employers, particularly in health care and manufacturing, are reporting a shortage of the skilled workers they need, and are projecting higher costs in 2006.

Of course Schenker said the relatively strong job market is one factor leading Wachovia to project solid economic growth of 3 to 3.3 percent for 2006. And he and other economists say there are a number of things that should help in that regard.

Stronger overseas growth

While U.S. consumer purchases may show some weakness in 2006, other nations' economies are showing new signs of strength.

But rather than threatening the U.S., that should help American exporters and lessen the pressure on some countries, particularly China, about shipping goods here that could cost of U.S. jobs.

"The Japanese economy for the first time in 15 years is getting up off the mat," said Deloitte's Steidtmann. "They've gotten their banking system back in shape. Europe will probably muddle along, but China's growth will still be quite strong."

Surprisingly, even with the problems at GM and Ford, manufacturing heads into next year in pretty good shape, economists said, largely due to the rebounds overseas.

Manufacturing rebound

Right now manufacturing is poised to grow at a faster pace than the service sector in 2006, said Banerji of the Economic Cycle Research Institute.

"It's not very usual for that to happen, but contrary to popular perceptions, not everything moves in synch," he said.

Manufacturing, despite being battered in recent decades, is still an important source of good paying jobs and wealth creation, accounting for about 11 percent of U.S. jobs overall.

And even if the housing market slows, some economists say federal assistance and insurance proceeds for rebuilding the Gulf Coast, along with increases in highway and infrastructure recently approved by Congress, will keep construction employment strong.


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