BofA Says 1997 Will Be A Difficult Year For Most U.S. Industries.

SAN FRANCISCO--(BUSINESS WIRE)--October 21, 1996--Next year will be difficult for most U.S. industries as they make the transition from an accelerating U.S. economy to one of slower domestic growth, according to Brian W. O'Connell, vice president and senior economist at Bank of America.

Writing in the latest edition of the bank's Economic & Business Outlook, O'Connell points out that most U.S. industries will experience some deceleration in sales growth, as the U.S. economy slows. This will make it difficult for industries to continue to show increasingly higher levels of earnings in 1997. The primary reason is that operating costs in 1997 will rise due to a tightening labor market that has begun to drive up wages, with benefit costs soon to follow. Commodity prices are also expected to firm, O'Connell says in the report.

Management will respond to these changing domestic economic conditions by adopting strategies to increase market share, expanding into foreign markets, and by taking even more aggressive actions to reduce costs. Firms that are slow to adjust will see profit margins squeezed.

On an annualized basis, the U.S. gross domestic product in 1997 is expected to grow at a rate of 2.8 percent compared to a predicted 2.6 percent this year.

The accelerating growth rate of gross domestic product in 1997, however, will obscure the fact that growth, measured on a fourth-quarter-to-fourth-quarter basis, will average just 2.3 percent next year, compared with a 3.3 percent increase in 1996.

The extent and the pattern of the slowdown during 1997 will vary among industries, says O'Connell. For example, consumer-related industries enjoyed robust sales in the first half of 1996, as spending rebounded from a disappointing 1995 Christmas season. However, higher interest rates and consumer debt burdens will slow growth in the coming year.

Residential construction and related industry sales, which have been surprisingly healthy this year, will decline as higher interest rates force home sales and housing starts back in line with demographic fundamentals.

According to O'Connell, even though investment spending growth will decelerate, exports of industrial machinery and high-tech equipment will benefit from stronger foreign markets. He also believes that providers of productivity-enhancing equipment and other business services will also benefit from ongoing corporate restructuring and outsourcing. In addition, materials suppliers -- steel, plastic resins, etc. -- and manufacturers of consumer goods, such as apparel and household textiles, will benefit from buyers' depleted inventories.

However, increasing reliance on imports and stringent inventory controls will limit production gains. Still, even a modest expansion in production will benefit cargo carriers that were battered by inclement weather and weak prices in the first half of 1996, the BofA economist notes in the bank's current Economic & Business Outlook. Airlines -- another transportation industry -- extended its recovery with strong traffic and revenue gains that were boosted by the temporary suspension of the 10 percent excise ticket tax in 1996. Higher operating costs and the reinstatement of the tax will temper the industry's recovery in the coming year. By contrast, aircraft sales are likely to accelerate in 1997.

In prior years, notes O'Connell, businesses have been relentless in reducing their cost structure. The first round of corporate restructuring, downsizing, and cost cutting was driven by necessity to survive the ravages of the 1990-91 recession. As the process continued, industrial America emerged leaner and more efficient. However, further gains may be more difficult to achieve, especially in light of developments in the labor market.

After 5-1/2 years of expansion, the nation's productive resources are beginning to show signs of strain. While price pressures are currently subdued, labor markets are tightening. With the August unemployment rate at 5.1 percent, the lowest since March 1989, labor shortages have begun to appear. In addition, an unemployment rate of 4.1 percent for 25- to 54-year-old workers suggests that the market for skilled labor is even tighter. At these levels, it would not be surprising to see wages accelerate.

In addition to the cyclical forces driving up wage rates, a two-step hike in the minimum wage to $5.15 per hour from $4.25 will aggravate the rise in labor costs. The 50 cent increase, which took effect October 1, will add about 0.8 percent to the growth of hourly compensation in the fourth quarter of 1996.

The increase will primarily strike labor-intensive industries at the low end of the wage spectrum. As a result, the profit margins of retailers and restaurants, especially fast-food chains, will immediately come under pressure.

Wage costs will also rise at low-wage manufacturers, such as apparel and leather producers. While the impacts of a higher minimum wage are relatively isolated, the shortage of skilled workers will drive up wages in most industries.

During the past 12 months, growth in average hourly earnings has accelerated. The employment cost index, a broader measure of total labor compensation costs that includes benefits, is also accelerating.

The wage component of this index has risen 3.4 percent over the past year, while total compensation increased 2.8 percent, says O'Connell. So far, total compensation costs have been held down by the sharp deceleration in the growth of benefits, which rose at an annual rate of only 1.3 percent in the first half of 1996. However, growth in benefit costs is set to accelerate.

Workers' compensation reforms, a significant source of the slowdown in benefit costs, are largely completed. Moreover, with most of the cost savings from shifting employees to managed care plans behind us, the deceleration of health benefit costs is ending. With wages already accelerating and benefits beginning to rise, firms can no longer expect labor costs to contribute to lower operating expenses.

So far, declines in some key commodity prices have disguised the upward creep in labor costs. Farm prices dropped sharply in 1994 and energy prices followed suit in 1995. In the last 12 months, the price of computer memory chips declined 66 percent, while paper prices declined 11 percent, and copper prices fell 20 percent. However, further declines in these key commodities are not expected. In addition, the increase in farm prices, which began in 1995, is expected to continue. Energy prices also rose sharply in 1996, and while prices are expected to moderate later this year, the turmoil in the Persian Gulf could keep prices higher than expected. Management's task of further reducing operating costs will be difficult, as compensation costs continue to climb and commodity prices begin to firm, O'Connell concludes.

CONTACT: Bank of America, San Francisco 

Jack Houseman, 415/622-5324