WITH all the back-and-forth in the markets and the ongoing debate about the strength of the US economic recovery, we thought it would be useful to make a series of broad observations about the economy and the implications for the markets.
We will start with five notes about the US economy and the stock market.
1. Economic data generally continues to be better than expected, which suggests that we are emerging from the longest and deepest recession of the post-WWII period. We believe there is even a possibility of an upside surprise to 3Q GDP growth.
2. While GDP historically has risen sharply following recessions (the average gain for the first three quarters is 6.7%), we do not believe that will be the case this time. Due to continued weakness in the credit markets and ongoing deleveraging, we are expecting GDP growth to be about half of that average over the next three or four quarters.
3. The US corporate sector has done an exceptional job in managing through the economic downturn. Thanks to a combination of reduced labour costs and technological improvements, productivity has increased by almost 2% over the last 12 months, an unprecedented rate for a recessionary environment.
4. There has been widespread concern that depressed consumer spending will hold back overall economic growth. While we share this concern, we would also point out that early stages of economic advances are almost never led by the consumer sector, but by improvements in inventories and capital expenditures.
5. From a markets perspective, investors have now endured two sharp bear markets over the last 10 years. It is reasonable to ask what sort of impact that will have on investor psychology and behaviour, and it is certainly possible that this will prevent some investors from wanting to return to higher-risk assets.
With this backdrop, we can point to both a bullish and a bearish case for the US economy. On the positive side, we would cite widespread stimulus and exceptionally low interest rates around the world, which have improved the global money supply and have helped the global economy to regain its footing, particularly in the emerging-markets sector. Additionally, global trade levels have picked up. In the corporate arena, productivity has improved and corporate profits have also begun to recover. The US housing sector has begun to bottom. On the labour-market front, jobs are still being lost, but the pace has slackened noticeably. Finally, we would point to continued low inflation, some improvements in credit markets and higher equity prices.
The bearish case for the US economy starts with the acknowledgement that the banking system remains troubled and is still not back to functioning at normal levels. Credit-related issues remain, and we expect the deleveraging cycle to continue for several more years. Additionally, the consumer sector remains under pressure and the savings rate continues to rise. The high unemployment level is also a source of concern, and we do not believe that the unemployment rate has yet peaked. Also, a rapid ly expanding federal budget deficit is a risk, as are deteriorating state and local budgets and the probability of higher tax rates for individuals and, potentially, businesses.
On balance, we continue to believe that we are emerging from the recession and are entering a period of positive, but subpar, growth levels. From an equity-market perspective, such an environment might actually be better than a period of rapid recovery, since periods of exceptionally high economic growth trigger inflationary pressures. Equities typically do quite well when the economy is experiencing a combination of robust stimulus measures, low inflation and low, but positive, growth rates.
Looking ahead, we acknowledge that markets have come a long way in a short period of time, which could make stocks vulnerable to some sort of corrective action. As we have seen over the past couple of months, investors are highly attuned to the tone of economic data and policymakers’ decisions, and a shift in either could represent a potential risk. Nevertheless, we believe the prevailing environment is a good one for stocks, and we believe the cyclical bull market remains in effect, suggesting that equities have further to go in the intermediate term.
