The Corner

The Heart of the Business Situation

Despite yesterday’s 2 percent drop in stock prices, driven by high anxiety credit fears over corporate and housing loans, today’s 2nd quarter GDP report brings some very good news: an annualized inflation adjusted 3.4 percent pace – the strongest economy growth rate in a year.

While consumers spent at a somewhat slower pace, business construction and investment picked up the slack. Exports were particularly strong, reflecting the huge global economic boom that Treasury Secretary Hank Paulson describes as the greatest worldwide surge in his professional lifetime. In addition, the depressed housing sector was less of a drag than in recent quarters.

Also noteworthy is the fact that 2nd quarter business profits are coming in 2-3 times better than expected. So there is considerable value in the stock market, despite the current loan worries.

Another key statistic in today’s GDP report was a rock bottom 1.4 percent core inflation reading from the Fed’s personal consumption deflator target. Averaging the 1st and 2nd quarters together produces a picture of slower growth and very low inflation. During the first half of 2007, real output averaged 2 percent and the core deflator, 1.8 percent.

There’s a lot of gloom and doom on Wall Street right now from yesterday’s market drubbing and the cumulative 4.5 percent corrective stock slide from the 14,000 peak reached last week. But the economy is expanding, profits are rising, and inflation is muted. So stocks look pretty attractive. (In fact, they look almost downright cheap.) At fifteen times forward earnings, the S&P 500 yields about 6.5 percent, a very high equity risk premium compared to a 4.8 percent yield on 10-year Treasury bonds.

Moreover, the steady stream of rising profits is the best guarantee for the credit worthiness of corporate loans. As classical economist Benjamin Anderson wrote in the 1920s when he was the top economist at the old Chase National Bank, “profits are the heart of the business situation.” Down through the years, I have always paraphrased that as profits are the mother’s milk of stocks and the economy. It’s time to add credit worthiness to that list.

What we are witnessing now is not a true credit crunch, but a temporary credit freezing-up. Banks have a lot of loans from the financing of buyout deals and right now the credit freeze has stopped them from selling these loans to institutional customers. Loan markets have been over leveraged by private equity funds that over the past year or so have completed deals with too little cash equity and too much loan leverage.

Now, private credit markets are disciplining the buyout mavens and forcing much better balance between equity and debt. This is a good thing. It is a market driven corrective that will add rationality to corporate finance. The key point here is that more than ample business profitability makes these over leveraged loans sitting in bank hands good paper, not bad.

When the dust clears and credit markets resume functioning, bankers will be able to divide up these loans and resell them in tranches at handsome interest rates to pension funds, insurance companies, and other investors all around the world. Again, what makes all of this possible is the strong profitability of the business sector.

The Democrats in Congress could enhance this corrective process if it would quit threatening to raise taxes on the very buyout firms and hedge funds whose ears are being pinned back by the bond market vigilantes who are demanding more equity and less loan leverage from the buyout financiers.

This is no time to raise capital costs and reduce investment returns by repealing the Bush tax cuts or by raising new taxes on the very entities which are struggling. A case in point is former Senator John Edwards’s bad new idea to raise the capital gains tax rate to 28 percent from 15 percent, and to drive up the top personal tax rate to at least 40 percent from its current 35 percent. Senators Clinton and Obama are thinking along the same lines, though their pronouncements have not yet been as specific as Mr. Edwards.

Larry Kudlow — Larry Kudlow is CNBC’s senior contributor. His new book is JFK and the Reagan Revolution: A Secret History of American Prosperity, written with Brian Domitrovic.

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