I think the current environment is more like the October 1987 equity crash, when equities closed the year higher, than the September-October 2008 crash when equities continued falling for six months. While the current problems are immense, there’s no equivalent to the disastrous Lehman bankruptcy filing which immediately paralyzed the interbank and commercial paper markets worldwide. Nor is there an equivalent to the abrupt federal takeovers of AIG, Fannie Mae and Freddie Mac, all critical market players that became even more disruptive when they were absorbed into the government.
As in 1987, economic growth in 2011 should be stronger in the second half than the first despite the equity market weakness. We should get a boost from auto production, corporate profits, growth abroad, business investment and some job growth. Recent data has bolstered the case that the economy is improving – Friday’s 0.5% gain in retail sales gains, Thursday’s decline in jobless claims to 395,000, July auto sales and the wage gains in the July payroll report. And some of Japan’s rebound from the earthquake and tsunami are spreading into second half global growth, with China’s July import and export data surprisingly strong.
I’m looking for 2 percent third quarter U.S. GDP growth, up from 1.3 percent in the second quarter, and then an acceleration to 3.5 percent in the fourth quarter. If so, equities will do very well but bonds and gold will do badly as the fear trade subsides.
Volatility is scary. Equities have been gyrating under the confusion from the uninspiring debt limit deal, the S&P downgrade and Europe’s slow-motion bailout. Just as there were at the end of the 2010 soft patch a year ago, there are widespread forecasts of a double dip recession and sentiment is deeply negative. Yet in 2010, second half growth and corporate profits drove an equity market surge.
Adding to the 2011 turmoil, the Fed issued a statement after its Tuesday meeting that was disastrously gold-inflating at a time when gold is already in a bubble. The Fed threatened two more years of near-zero rates and dangled QE3 in front of financial markets by saying it was considering using “the range of policy tools available to promote a stronger economic recovery.”
With the Fed threatening desperate measures, investors have to worry simultaneously about deflation – that’s Bernanke’s constant excuse for expanding the Fed balance sheet even though CPI inflation is running 3.6% -- and inflation from the Fed’s nearly $3 trillion in liabilities. This fear pushes investors into the anti-growth “barbell trade” in which investors buy bonds to protect against deflation and gold to protect against inflation, leaving less capital for growth.
My August 5 Wall Street Journal article Weak Dollar, Weak Economy explained the harm from last year’s Fed splurge into QE2 -- the more bonds the Fed bought, the weaker the dollar and the weaker the economy. In its latest move, the Fed is locking in negative real interest rates even longer, souring the investment climate. Fortunately, growth may start up any way, and that’s what financial markets will be watching.
Amid market turmoil, government actions will be important in rebuilding confidence and animal spirits. Any Administration proposals on clearer bank regulation, growth-oriented tax reform or spending cuts would be well received by markets. Let’s dream for a minute. Say President Obama calls his cabinet together to prepare a list of spending cuts as many governors and foreign heads of state have been doing. There would be a massive market celebration, lifting the value of equities world wide.
David Malpass is former chief economist for Bear Stearns.