Upside Breakout On The Horizon?
It's more likely than not.


David Malpass

Some economy watchers have been looking for a slowdown, but a speed-up is more likely. Right now the U.S. is in the early to middle stages of a long, durable, and relatively fast expansion — one that has positive implications for U.S. and foreign equities (but not for bonds). The growth engines include the dollar’s exit from deflationary territory in 2002, low interest rates, the 2003 tax cuts, and the increasing level of U.S. employment.

Except for the third quarter of 2003 when GDP grew at 7.5 percent, annualized quarterly growth has been between 3.3 percent and 4.5 percent for each quarter since the second quarter of 2003. In all likelihood, growth for the fourth quarter of 2004 (soon to be revised) and the first quarter of 2005 will fall within that range.

When the U.S. breaks out of that range, it is more likely to be toward the high side than the low side. The U.S. economy will probably register a 5 percent growth quarter before it turns in a 2.5 percent quarter.

Why? Huge levels of liquidity, low inventories, unabated monetary and fiscal stimulus, a solid household balance sheet, robust investment activity, and continued strength at retail are all part of today’s economic story. This is the stuff of accelerations, not slowdowns.

Despite these robust indicators, the slowdown theories persist. The bears claim that initial jobless claims have been too high for fast growth, that the consumer is tapped out, that the decline in bond yields points to a slowdown, that the Institute for Supply Management (ISM) manufacturing index also points to a slowdown, and that expensive oil and higher interest rates are growth-stoppers.

True, the U.S. growth rate has been held down — but that’s because of cash hoarding at big companies. It’s hard to see this problem getting worse.

As for the consumer, January retail sales were strong, continuing the 2004 trend. Overall retail sales (volatile due to autos) fell a
less-than-expected 0.3 percent in January after a 1.1 percent rise in December. Sales excluding autos posted a solid 0.6 percent increase. Over the last twelve months, overall retail sales have risen 7.2 percent, while retail sales excluding autos were up 7.6 percent. The consumer does not appear to be tapped out.

Consumption growth, in my view, is related to employment and income growth — not an unhealthy profligacy or a dependence on the wealth effect from asset growth. Both employment and income growth look solid.

Initial unemployment claims have dropped significantly. The four-week average of weekly claims, at 312,000, is its lowest since November 2000. At 0.24 percent of employment, this is on a par with the very fast employment growth conditions of the latter 1990s.

Meanwhile, job and dividend growth are generating fast growth in personal income. The latest jump in income growth to 6.4 percent year-over-year in the fourth quarter of 2004 included the special dividend paid by Microsoft, but the prospects are still good for robust income growth in 2005. As for dividends, the S&P recently reported that it expects cash dividends to set another record in 2005, rising 12.2 percent to $203 billion from the 2004 record of $181 billion.

Finally, the ISM manufacturing index remained at a high 56.4 reading in January, considered by ISM to be consistent with 5 percent GDP growth.

– David Malpass is the chief economist for Bear, Stearns.