Plastics companies face ‘strong headwinds’ in 2023

Turning points in business and economic cycles do not always coincide with changes in the calendar year, but for my first column in 2023 I will suggest that the U.S. economy is currently at a significant turning point.

I must start with a caveat. This does not mean the economic environment will now start to improve. To the contrary, I am quite confident the economic environment will experience strong headwinds during the next few months. The good news is that the recent spate of interest rate hikes by the Fed are starting to have their desired effect of lowering the rate of inflation in the United States.

As of the December reading, the headline figure for the Consumer Price Index came in lower on a month-to-month basis for the second consecutive month. By now we all know there are multiple ways of measuring, slicing, dicing, adjusting and interpreting the data on inflation. And we have also learned that two months' worth of good news is not a guarantee of a sustained, long-term trend, so there is still a danger of a return to the upside. And we have further learned that the year-over-year rate of inflation is still too high. Now that I think about it, we have learned a lot about inflation in the past year.

But all long-term trends start off as short-term trends, and like I said, I believe the economy is currently at a significant turning point. I am not sure how long the data will continue to register month-over-month declines, but the trajectory in the data on the prices paid for goods will flatten out this year, and for many types of goods, the trend will actually be noticeably lower (aka deflation).

The prices paid for services will not trend lower this year. Prices for services are strongly affected either by trends in the cost of housing, or the costs associated with wages and benefits. The rate of increase in these costs will likely decelerate, but they will probably not decline this year.

For manufacturers in the plastics industry, this means the prices paid for materials and other products may decline when compared with last year. It also means the prices they receive for the products they make may decline as well. The ability to pass costs through will be much more difficult than it was a year ago. The costs stemming from wages and benefits will not decline.

When you put it all together, it works out like this: The rate of change in total revenues for plastics companies will decelerate at a faster pace than the rate of change in total costs. In other words, profit margins will be compressed. That is what I mean by strong headwinds in the economic environment.

The rate of inflation in the overall economy will steadily progress toward the target level of 2 percent per year as 2023 progresses, but we will have to endure a period of short-term pain before we return to a sustainable level of strong economic fitness. Profits for all industry segments will decline, and it is highly likely some segments of the plastics industry may even go into a period of recession.

The residential construction sector is already in a recession. The trend in total housing starts in the U.S. is a bellwether leading indicator for many industries, including plastics, and the starts data hit a cyclical peak in the spring of last year. Since then, the data has trended downward, and the downtrend is gaining momentum. In 2022, the total number of houses started declined by an estimated 3 percent when compared with 2021. In 2023, my forecast calls for the annual total to drop another 10-15 percent.

Yet despite this downward trend in new construction activity, the data that measures employment levels in the construction sector continues to rise. This is because there was a strong backlog of houses under construction that still need to be finished, and there has been a chronic shortage of skilled construction workers dating back to the housing crisis in 2008.

The acute labor market imbalance in the construction sector is a good example of why the prices paid for housing services, and also to costs associated with wages and benefits, will be slower to decline. Good help has been hard to come by in recent years, and many companies are willing to ride out a mild downturn in an effort to hang on to their productive employees.

The demand for labor pushed wages higher, and this is a major factor causing the recent spike in inflation. The economy entered a wage/price spiral, which the Fed has had to douse with an aggressive strategy of monetary tightening. The unwelcome news is that higher wages will keep prices higher for longer, and this will in turn keep the Fed's interest rates higher for longer than many people expect.

The good news is these higher wages may keep the economy from tipping into a deeper and more prolonged recession than we would otherwise get if companies started to shed employees aggressively, as they have done in the past. I expect the data on construction workers will soon start to decline. This is what should happen when activity levels drop. This will be an indication that the market is starting to normalize, and it will lay the foundation for a more sustainable, noninflationary recovery starting in 2024. That is when I expect the Fed to start lowering their interest rate to a neutral level.

I do not want to understate the pain that comes with the loss of jobs. But the Fed has been aggressively trying to destroy demand, and that means people are going to lose jobs eventually. I hope the suffering will be minimal, and I am certain it will be much less than it would have been if inflation had been allowed to get out of control.

So for this year, I will pay close attention to the residential construction data, especially the employment figures. I will also closely monitor the employment figures for the overall economy, and the manufacturing sector. This data will provide the strongest clues about the length and depth of the pending deceleration/recession in the economy.

The rate of inflation in the overall economy will steadily progress toward the target level of 2 percent per year as 2023 progresses, but we will have to endure a period of short-term pain before we return to a sustainable level of strong economic fitness.