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Midyear update: 2006 looks good, but 2007 is very uncertain

All aspects of plastics manufacturing had a solid first six months: resin shipments, output of plastics products, and the sale of capital goods for the entire plastics supply chain were up solidly. This was in line with the overall economy and in many areas plastics actually outperformed the overall GDP.

The first quarter of 2006 had a sterling 5.3% U.S. GDP growth; second-quarter figures are not available yet but are projected to be just below 4%. The third and fourth quarter will be somewhat lower: We project an average for the year of 3.2% at the very least.

But what about 2007? With NPE behind us, resin and machinery suppliers are attempting to project the growth of the economy for the next 12 months and beyond. Plastics processors face the same challenge and just how they see this economy evolving will dictate future capital spending.

Troubling Signs

U.S. manufacturing is now in the 38th month of continuous expansion. It has been a steady expansion, with a few spectacular growth spurts such as the first quarter of 2006. But it now is clear to many that this rate of expansion will slow, and slow sharply.

In June, the Federal Reserve reported that May industrial expansion fell suddenly, mostly due to weakness in the automotive sector. Output at the nation''s factories, mines and utilities dropped by 0.1% in May after an increase of 0.8% in April. It was the first decline since a 0.1% drop in January.

No, there will not be a recession. But the "ultimate" end user is retrenching. Apart from spending on energy (oil or gas) and paying higher interest rates, overall consumer spending will start to show no growth and will even decline in some areas. Note that energy costs drove up inflation to a very high-by recent standards-0.4% this past May.

In June, numerous reports confirmed the fears of manufacturing executives that vital consumer spending is at risk. Consumer spending accounts for more than 65% of all economic activity and if the consumer decides to seriously cut back, the manufacturing economy will come to a halt.

Core inflation is up and credit-card spending is down, as consumers feel the bite of spiraling interest rates. Housing-a mainstay of the North American manufacturing economy-has started to show some weakness, and the surge of imported manufactured goods only intensifies. The trade deficit hit a historic high of $63.4 billion in April. Even more troubling than the trade deficit is the news that the flow of foreign capital into the United States, foreign funds invested in the States, declined sharply to $46.7 billion. That influx is not enough to compensate for the record trade deficit and probably will force capital costs up along with actual interest rates.

Oil prices are stagnating at about $71/bbl and are forcing the consumer to divert funds to fuel cars and power air conditioners now, and run heating systems this winter. Plastic processors likewise are hit with ever-higher energy spending: To operate plants, pay high resin prices, and transport products they will have to cut back on expansion plans. Price increases to boost profitability are just not in the cards. Typical is one blown-film processor in northern New Jersey who has been able to boost prices merely 2.1% over the past 14 months: "Our actual costs have gone up by over five percent," that processor confided.

So what is the outlook now?

At the very least it is uncertain for 2007. Right now, plastics processors have plenty of orders in their books to sustain production increases for the next six or seven months. But it will be August or September before we will have the first indications of how orders for all types of goods will look for the first quarter of 2007. We predict a reduction in new orders for capital equipment.

Orders for new capital equipment-extruders, blowmolding machines, injection machines, and such auxiliary equipment as pelletizers and plant automation devices-will surge some in July and August but then decline. "We are done with new orders for the year," an Evansville, IN-based molder of automotive parts (mostly for Asian transplants) said. "We are not sure where this economy is going and we have put capital spending on hold." This one comment is typical for what we hear from others in blowmolding or extrusion, and in markets as diverse as packaging (film, bottles) and electrical products (small molded items or coated wires).

Whence China?

If the Chinese economy tumbles or goes into a temporary crisis, the impact will be felt worldwide. Chinese plastics products manufacturers will sharply drop prices of exported products just to stay in business, which would put enormous pressure on plastics processors in Canada, the United States, and Mexico, who would be unable to stomach more extreme low prices.

On the surface, China looks as though it is booming. But warning signs are plentiful and many speculate that China''s banking system (troubled by more than $450 billion-at least what is known-in bad loans) may go into a crisis mode.

Note that in June, China reported that industrial production increased in May more rapidly than at any time in the past two years. Output rose 17.9% compared to May 2005. Exports in May rose by 25.1% while domestic retail sales grew by 14.2%. Every effort by the Chinese government to slow the economy has failed.

The People''s Bank of China (PBC), China''s central bank, is in a full-blown crisis mode. They are warning against increases in lending. How successful they will be is uncertain: China''s money supply in May grew 19.1% year-on-year. And of the annual lending target to manufacturers specified for 2006, Chinese banks have already lent more than two-thirds.

Summary

The combined output of all plastics processing in Q1 this year increased 4.21% from that of the previous quarter, while orders to processors overall increased by 4.76% on average. That rate of orders improvement surpassed such rates of all quarters since Q2 2003, for example, and continued a steady upward trend. However, as the domestic economy cools following the sharp acceleration in GDP growth during the first four months of this year-real GDP increased 5.3%, driven by strong consumer spending, the fastest growth rate since the third quarter of 2003-expect growth in orders to slow by 0.10% to 0.16%.

Petroleum-based energy costs have soared at a 61.5% annual rate since January, deterring sales of SUVs and light trucks, thereby reducing demand for related injection molded parts. Moreover, those costs have elevated feedstock prices. Real disposable personal income has been hurt by high gas prices; concurrently, as the Federal Reserve has raised interest rates to counter inflation-and mortgages have therefore become more expensive-the housing market has faltered and home equity is declining. But the strong consumer spending that lifted the GDP was borrowed on gains in home equity through re-mortgaging and that cow can no longer be milked. Anticipate a decline in the 2007 economy but a tolerable decline.

Agostino von Hassell ([email protected]), and Ed Connelly ([email protected]), of the Repton Group LLC (New York).

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