A key element of the 2008 economic outlook is the expectation that capital goods production will slow, winding down after four years of solid growth. In its policy statement last week the Federal Reserve cited "some softening" in business spending, a warning that followed unusually weak showings for capital goods data in the October durable goods report. In its semi-annual report the Institute For Supply Management said the nation's companies, brimming with productive capacity, are likely to spend less on capital expansion in 2008.

Business spending may be about to turn a corner but there are still plenty of signs that growth is continuing. The graphs that follow offer a variety of readings on the sector and, in sum, may point more to resilience than to weakness for next year's industrial economy.

Let's start off with the ISM's monthly report on manufacturing where leadtimes for capital expenditure commitments have taken off. Manufacturers first reported a giant 15-day spike in leadtimes during September, to 125 days for a level last seen during the Y2K stampede. It was the feverish business investment of the 1990s that bloated productive capacity relative to demand, setting up the economy and especially the capital goods sector for several years of trouble.

Capital leadtimes in ISM's October and November reports are showing their heaviest three-month run since 1999. Notice the graph's shape, sliding down through the late 90s and picking up through this decade. This 'V' pattern, reflecting the depth of the drawback and steepness of recovery, will be repeated in variation in other graphs.

Strong exports are what may make the difference in 2008 between flat conditions for capital goods and rising conditions. Accelerating infrastructure development in China and India, as well as Latin America, is adding important markets for U.S. capital goods producers, markets that will help offset slowness in domestic demand. This was the theme of General Electric's quarterly outlook last week, one that looks for continued healthy sales growth of 10 percent. The graph below tracks exports and imports of capital goods which are evenly balanced and share the same vertical scale on the right of the graph. Note that the darker blue line, exports, is spiking higher as the year winds down, hard evidence of strong global demand.

But demand from emerging industrial economies is not the only factor behind capital goods exports which are also getting a big boost from the weak dollar. The graph above tracks the broadest measure of the dollar and shows an 'A' shape, a contrast to the 'V' shape and a reminder that business is best in the U.S. capital goods sector when the dollar has weakened. The nation's exporters, a group led by capital goods producers, have been stressing the importance of a competitive dollar in their 2008 outlooks. The weak dollar has added several percentage points to the top lines of exporters this year, and a major risk for the 2008 outlook is whether this gain evaporates or, worse, if the effect reverses.

The relative strength of capital goods exports to imports is seen in prices. The graph above tracks prices of capital goods exports (darker blue) against prices of capital goods imports (lighter blue). U.S. capital goods producers are getting more for their products overseas while foreign capital goods producers are getting no more for their products here.

The graph below looks at finished capital equipment in the producer price report, showing a steady and mild year-on-year rate of between 1.5 and 2.5 percent. Note prices showed their peak in early 2005 reflecting a pitch of capacity expansion during the meat of the current economic expansion. Price results in sum are mixed, showing price strength for exports but price softness for imports and for prices overall.

Capital goods are often discussed within the context of nonresidential construction, strength in which has helped to offset the slump underway in the residential sector. The graph below tracks construction spending between the two sectors and confirms the need for the non-residential side to take up slack. Whether it does or not could prove to be one of the biggest factors in the 2008 economy. Companies are generally on guard for the non-residential sector, seeing little to no growth next year.

The contrasting paths of the non-residential and residential markets are reflected in employment where a shift to the non-residential side is increasingly underway. The graph below compares two employment categories of the construction sector, showing trends similar to trends in output.

The employment fallout from the 2001 recession was severe in the capital goods sector. Companies through all sectors had over expanded, leading to acute over expansion in the capital goods sector. Employment readings are generally not broken down by their relation to consumer or capital goods, but there are two sectors, fabricated metals and machinery, that offer a concentrated look at the capital goods side.

The graph below is a reminder of what's most at stake should the capital goods sector begin to slow. Jobs for both fabricated metals and machinery have been very stable through the last five years, showing an ongoing trend of marginal growth. Actual growth in output of course has been much higher over this period, boosted by high productivity rates for labor and improvement in company processes. Lagging levels of domestic employment also reflect the impact of offshore production. But providing a cushion for domestic labor may be the weakening dollar which is increasing offshore costs and perhaps increasing the chances that companies will decide to pull back their offshore operations first.

October's durable goods report really shook up the outlook for the capital goods sector. Most categories posted sizable drops raising questions whether nonresidential fixed investment will continue to add to quarterly GDP growth. But of all the data on the capital goods sector, it is data in the durable goods report that show the least strength. Shipments of nondefense capital goods excluding-aircraft (light blue line in graph below) are a favorite guide for the capital goods sector.

Note that the current dollar level, near $62 billion a month, is still under the 2001 peak of $64 billion. And these numbers are not adjusted for inflation meaning that the level in adjusted dollars is even further behind. It's not just this category of the durable goods report that shows this deep, asymmetrical 'V' but also other capital goods categories. In contrast the dark blue line, which is the Federal Reserve's business equipment index, shows a much flatter 'V' shape at a what is now a much higher level of output. Certainly some capital goods producers, especially on the electronics side, are just now returning to Y2K levels, but the bulk of companies have long since topped their earlier peaks.

We close with the graph above on nonresidential fixed investment which closely matches the path of the Fed's business equipment index. The graph shows the strong trajectory of the capital goods sector over the past four years, at an adjusted annual rate of $1.5 trillion in the third quarter and representing nearly 11 percent of total GDP. This series overtook the Y2K peak in mid-2005 though the proportion to total GDP is still less than the nearly 13 percent high hit in third quarter 2000.

Bottom line

Whether nonresidential fixed investment will continue to advance at a steady rate could very well prove to be the deciding factor for the economy, where troubles in the housing and credit markets are posing the risk of recession. The dollar could prove the wildcard for the greater economy, as a strengthening in the currency could hurt exports of capital goods. A weekly capital goods report I compile for Market News International continues to show strong rates of growth. The report is based on company news which I think in general is more upbeat on the capital goods sector than are policy makers or Wall Street economists. There are a variety of measurements for the capital goods sector and not all are pointing the same way, something to watch for in 2008. Next key data will be durable goods for November, to be posted Thursday December 27.