World financial markets will re-price favorably upon Iraq’s disarmament, which should happen within weeks. Yes, there was a February slump in the U.S. economy, but expansion is set to resume in the near term.
The U.S. lost 308,000 jobs in February. This lowers employment to 130.5 million, down from a peak of 132.5 million in February and March of 2001, but still up 20.7 million from ten years ago. Futures contracts on the federal funds rate are predicting an 0.25% interest-rate cut to 1% by summer, implying a continued slump. But there should not be any more rate cuts after that. The current environment — 2.9% GDP growth in 2002, 2.6% inflation, 5.8% unemployment, low inventories, and a weaker dollar — would normally invite much higher interest rates.
Meanwhile, S&P equity futures are exhibiting “backwardation” — meaning lower prices in the future than at present. This puts sentiment, as measured by backwardation, at its most pessimistic since September 1982 (which was a major market bottom).
But there is significant good news out there today:
— U.S. financial markets and the dollar rallied on March 7 in the face of the disappointing jobs number. — Despite dollar weakness, bond yields have remained low, and show no sign of inflation risk or aversion to U.S. assets.
— The unemployment rate is still only 5.8%, well below previous business cycles.
— Wages are growing relatively fast, reflecting a productive, flexible labor force. Over the last twelve months, nominal wages rose 3.2%, an indication of labor-market tightness more consistent with the 5.8% unemployment rate than with the recent weakness in job growth. Labor-market weakness after the 1990-1991 recession was worse, causing wage growth to fall to 2.2%, with 7.6% unemployment. In inflation-adjusted terms, the wage gap in favor of the current cycle would be even wider since core inflation is much lower.
— Corporate earnings are growing again and have gained substantial ground relative to market capitalization. On a year-over-year basis, after-tax corporate profits grew 13% in the third quarter of 2002, 12% in the second quarter of 2002, and 22% in the first quarter of 2002.
— Comparing price-to-earnings ratios today, equity valuation (having bubbled in the late 1990s) has fallen back toward bond valuation. The equity P/E ratio is now similar to where it was in the mid-1990s and well below the peak in the third quarter of 2000.
Here’s the bottom line: The economic and market pessimism of recent months is directly related to Iraq uncertainty. There will be a substantial re-pricing of financial markets upon Iraqi disarmament. Investors, be ready.
— Mr. Malpass is the Chief Global Economist for Bear Stearns.