Stock markets and bond yields in the U.S. and abroad fell sharply last week. This does not mean that the economic environment is fragile: In 2004, there will be strong, sustainable U.S. growth, built on small businesses, business investment, consumer resilience, the improved U.S. tax structure, and the 5.6 percent unemployment rate.
Those who argue against the bullish scenario say the consumer debt burden, idle capacity, and global uncertainties about politics and terrorism will restart deflation. But with the dollar still weak and the U.S., Japan, China, and Europe holding interest rates at very low levels, sustained growth (and even “overheating”) are more likely scenarios than a slowdown.
That’s not to say the bad news can be overlooked.
‐Internationally, the terrorist bombing in Spain brings a sharp reminder of the risk-aversion that existed in 2001 and 2002.
‐At home, On March 10, the Senate amended its 2005 budget resolution to reinstate pay-go restraints on tax cuts. Four Republican senators — Collins, Snowe, McCain, and Chafee — joined in the 51-48 vote. While the House will not likely agree on this provision, the Senate vote increases the uncertainty about President Bush’s ability to extend the 2003 tax cuts and adds importance to the November Senate races.
‐Banks have poured $100 billion into U.S. government and agency bonds in the last six weeks. This “carry trade” is a bet that risk-aversion and the 1 percent federal funds rate will continue.
‐Oil prices are near a high. Venezuela is unstable and the U.S. continues to fill the Strategic Petroleum Reserve at a rapid clip. While more of the oil price gain reflects dollar weakness, if sustained, expensive oil will weigh on the expansion.
‐Wholesale inventories in January grew on 0.1 percent to $296 billion, reflecting the continued risk-aversion of major corporations.
‐Corporations are rapidly deleveraging — investing less than their cash flow — showing more caution than in the past. Although a positive view of this is that corporate cash flow has been growing even faster than their investment spending.
‐Commercial and industrial loans by U.S. commercial banks have remained weak. These loans, however, should grow coincident with inventory when interest rates start moving up, with this “get it while you can” reaction accelerating the economy during the first several rate hikes.
So even the bad news is lined in silver. As for the good news, there’s plenty of it. The economy is not slowing. First-quarter growth looks strong and should come in at 5 percent, following 6 percent growth for the second half of last year.
Here’s what’s happening segment by segment:
‐Retail sales, including autos, were strong in January and February, up 0.2 and 0.6 percent month-over-month. This indicates an annualized retail sales growth rate so far in 2004 of 5.7 percent, underpinning strong first quarter growth expectations. Despite high weather and high gasoline prices, non-auto retail sales were also strong.
‐President Bush has criticized “economic iconoclasts” and has started his campaign on extending the 2003 tax cuts. This pro-growth message is a clear, market-friendly alternative to the threats of protectionism and tax increases.
‐Initial jobless claims were 341,000 in the week ending March 6. Federal Reserve chairman Alan Greenspan recently said that “In all likelihood, employment will begin to increase more quickly before long.” But while so many are discussing a jobs crisis today, it’s important to note that at this point in the 1996 presidential re-election cycle, initial claims were at 370,000 with unemployment at 5.5 percent, contributing to a strong environment for growth and equities.
‐Commodity prices remain near their recent highs, in contrast with the signal from bonds. The current level of the dollar is mildly inflationary, supporting the commodity view rather than the bond view.
What side do you want to be on? The good-news side or the bad-news side? Well, each side has a story to tell, but taken together the conclusion looks the same: This economic environment is not fragile. Strong, sustainable growth is the direction for the U.S. in 2004.
– David Malpass is the chief global economist for Bear Stearns.