Economically speaking, 2000 was another great year in the United States. Economic growth and increases in productivity remained solid. The construction industry remained very healthy. The year's biggest negative was stock market volatility - especially the losses sustained on the tech-weighted Nasdaq securities exchange.

But how is the economic landscape shaping up for the coming year? To assemble an economic forecast for 2001, I consulted with David Orr, senior vice president and chief economist for First Union Capital Markets Corp. in Charlotte, N.C. He provided substantial input for this article as well as the accompanying charts.

This forecast is divided into three parts. The first provides a broad overview of the economy, including an examination of trends in economic growth, inflation and interest rates. This sets the stage for the second part, a discussion of specific trends in the construction industry. The third part provides a discussion and suggests trends for the stock market in 2001.

Figure 1

The macro outlook

It's time to sober up. Economic nirvana is over - at least for a while. In fact, a number of doomsayers are predicting a recession for 2001. I do not foresee a recession, and most members of the construction industry have yet to experience anything that would suggest a slowdown from the past couple of years.

Compared to the past few years, however, there currently is greater risk of a decrease in consumer spending, an increase in unemployment and a cooling of the construction market. If consumer spending does decrease and unemployment increases, the U.S. Federal Reserve Board (Fed) would likely reduce short-term interest rates and stimulate economic growth to prevent a recession.

Economic growth during 2000, which continued at an exceptionally strong clip, will probably come in at 5% for the year (see fig. 1). But the rate of growth is starting to decline, returning to more normal levels of 2.5% to 3%. This moderate slowdown will require a temporary adjustment period during which, for example, we may see a decline in vehicle production and housing starts.

Durable goods orders are already slowing and the price of lumber is plunging. Clearly, the economy is working through an overhang in durable goods inventory, as evidenced by the recent proliferation of automotive rebate programs. During the early autumn of 2000, 183,000 jobs were lost in manufacturing. Furthermore, there has not been a net increase in construction jobs during the past six months. When the final numbers are calculated, I anticipate a 3.3% annualized real economic growth rate in the fourth quarter of 2000, followed by 3.6% and 3% growth rates for 2001 and 2002, respectively.

Business owners should avoid the temptation to bask in the glow of the past two years. Rather, they should take their cues from the profit and loss statements of 1996 and 1997 - the two years that preceded the frenzied growth of 1998 through 2000. In other words, business plans for 2001 should anticipate the more moderate kind of growth experienced during 1996 and 1997 rather than the expansion rates of the past two years.

Longer term, the outlook is optimistic. Ongoing investments in technology and employees, as well as enhanced global competition, have contributed to increased U.S. productivity. These long-term structural changes set the stage for sustained periods of real economic growth (perhaps at a 4% annual level) with moderate inflation. This is very good news.

Figure 2

Inflation and interest rates

The very strong economic growth that characterized 2000 resulted in decreasing unemployment which, in turn, exerted upward pressure on labor costs. But increased labor costs have been partially offset by unusually high gains in productivity. The rate of productivity increases will likely start to abate, however.

Furthermore, the low cost of oil (which within the span of recent memory was about $10 a barrel) that helped hold inflation in check is now only a memory. When the calculations are complete, inflation as measured by the Consumer Price Index (CPI) for 2000 is projected at about 3.3%. The numbers also are likely to show that inflation rose to 4% over the winter. This contrasts with an inflation rate of 1.6% and 2.2% for 1998 and 1999, respectively (see fig. 2). The annual rate should slow to about 2.7% as the economy cools during the latter part of 2001.

Interest rates are driven largely by the actual and anticipated rates of inflation. A primary goal of the Fed is to hold inflation in check, which it accomplishes by increasing short-term interest rates when higher rates of inflation are anticipated. For example, we witnessed the Fed increase short-term interest rates several times during 2000 as a means of cooling the economy and thereby reducing inflationary pressures.

Figure 3
Significant short-term interest rate increases are not expected during 2001. In the event that unemployment starts to rise, on the other hand, the Fed may lower short-term rates (see fig. 3).

Bond traders, not the Fed, exert primary control over long-term interest rates (such as those on the 10-year Treasury Notes that serve as a basis for mortgage interest rates). When bond traders perceive higher inflation, they bid upward bond interest rates.

During 2000, budget surpluses allowed the U.S. Treasury to reduce the amount of Federal debt outstanding. This helped keep long-term rates from increasing significantly. And in light of the lofty projections of future surpluses, some bond traders were willing to accept lower interest rates on Treasury Bonds because they anticipated a possible shortage of them in the future. Now, with enhanced prospects of increased government spending and/or tax rate reductions, the likelihood of huge surpluses is evaporating - and so is concern about shortages of Treasury Bonds.

Finally, faced with extreme stock-price volatility in 2000, traders took a "flight to quality" by purchasing government-guaranteed Treasury Notes and Bonds. That had the effect of moderating longer-term interest rates. Looking to 2001, I expect to see mortgage rates in the range of 7.75% to 8%, which would be a moderate increase from the recent lower rates of 7.625%.

Figure 4

The residential housing market

New home construction increased significantly over the past few years. During 1998, new housing starts reached 1.66 million units and remained virtually unchanged through 1999. This level of new home starts is significantly above the level that can be supported by new family formations, which is the underlying driving force in new home construction.

The rate of new housing starts began to decrease during the end of 2000 to an annual rate of about 1.5 million units. Looking ahead, I expect starts to decrease to an annual rate of about 1.45 million units during the first half of 2001. By most historical standards, however, 1.45 million housing starts would be considered quite strong. Similarly, I expect existing home sales to drop from the current 5 million units to a more sustainable 4.5 million level.

The level of new home construction may increase slightly, to perhaps 1.5 million during the next few years, as the recent wave of immigrants purchase homes. Furthermore, the population of 25-35 year olds (the primary first-time homebuyers) will start to increase in about five years. This should provide another small boost to housing starts. Finally, the first wave of the large population of extremely affluent baby boomers, who can afford to live wherever they wish in retirement, will turn 55 in 2001. Therefore, I anticipate increasing demand for property in the traditional retirement states as well as in shore areas.

The anticipated decrease in housing starts to 1.45 million units is in keeping with the rate of family formations. The 1998-1999 surge in housing starts resulted from several factors. First, there was the surge in stock market prices. People felt wealthy and built new homes. But stock market gains were largely reversed in 2000, so the wealth effect may now be more muted.

Figure 5
Second, the 1997 tax law changes that permit a $500,000 exclusion in home sales capital gains as frequently as every two years spurred a spike in construction. Third, mortgage rates plunged, dropping from 9% in the fall of 1997 to 6.5% in the fall of 1998. Now rates are higher, and another precipitous drop is very unlikely.

Finally, job growth was extremely strong during the past two years. This spurred new home sales. With very low unemployment rates, job growth will slacken. Readers should be cautioned not to expect the level of expansion seen in 1998 and 1999. (See figs. 4 and 5.)

Figure 6

Nonresidential construction

Although residential construction is expected to decline during 2001, non-residential construction is expected to grow. Nationally, office vacancy rates are low - averaging about 6.5%. Office construction grew 8% during 2000 and should continue to grow during 2001.

The weakest sector in nonresidential construction is industrial facilities, which were down about 25% compared to 1999 and are expected to decrease further during 2001. The decrease is a reflection of worldwide overcapacity in production facilities and energy costs that are eroding profits. Also, significant growth in retail facilities is not anticipated.

The forecast for school construction remains very solid. As states continue to enjoy budget surpluses, and the Federal government exhibits increasing interest in education, school construction and retrofitting should remain solid for the next five to 10 years.

The hotel and motel sector remains overbuilt, particularly among the mid-price range units situated along interstates. Currently, construction in this sector is expected to decline. In contrast, upscale downtown hotels are reporting higher occupancy rates and construction of these facilities should continue (see fig. 6).

Stock market outlook

During the five-year period from 1995 through 1999, the S&P 500 index (a weighted average of the nation's 500 largest companies) increased nearly 29% annually, which can only be characterized as spectacular growth. Things turned south in 2000 - especially for many high-tech Nasdaq stocks.

In retrospect, 1999 may be viewed as a pivotal year. While many major market indices increased appreciably due to the heavy weighting of very large capitalization companies in those indices, the typical stock in a universe of approximately 7,000 U.S. stocks listed on the various exchanges decreased about 15%. Actually, from mid-1998 to the start of 2000, about two-thirds of all stocks were caught in the clutches of a bear market. But this reality was masked by the increasing prices of large-cap companies. During 2000, many of the small- and mid-cap stocks increased in value while many of the large-cap stocks took a beating.

What lies ahead? Stock prices are driven largely by current and anticipated profits, changes in interest rates (lower interest rates generally lead to higher stock prices), the level of investor exuberance, and the flow of money into the stock markets. With the slowing rate of economic growth and higher employment and energy costs, the chances for significant earnings increases during 2001 are slim.

Furthermore, interest rates are not expected to fall very much during the coming year. Investor exuberance has waned since the Nasdaq took a dive, and many investors are unnerved.

On the positive side, billions of dollars continue to flow into the stock markets each month largely through contributions to individual retirement accounts (IRAs), 401(k) and other retirement plans. For many investors, the stock market is the only game in town and this ongoing inflow of funds will tend to buoy the market - or at least keep it from sinking rapidly.

For 2001, I expect profits to grow only about 5%, compared to 10% last year. Therefore, the stock market will probably turn in a flat performance in 2001, with the broad market measures likely increasing or decreasing by about 5%. Investors will need to adjust their earnings expectations accordingly.

Most readers are in the market for the long run - often with 30-, 40- or 50-year retirement planning horizons. History indicates that those who invest regularly and resist the temptation to "time the markets" will come out ahead. So, I don't recommend jumping ship. However, investors should diversify their stock portfolios to include small- and mid-cap as well as large-cap companies. Also, selective investment in international stocks - with perhaps 20% in small- and mid-cap companies and 20% in international stocks - should be considered. This year's favorite is likely to be next year's ugly duckling. Diversify, diversify, diversify!