US real growth in the second quarter half of 2004 was slower than predicted, only 3% per annum, but the first quarter was revised up sharply to 4.5% from 3.9%, so the first half average growth was only marginally below 4% per annum. Inflation was up to about 3% or so for the GDP deflators, although a little higher for the CPI. Excluding galloping food and energy prices, the so-called core rates were between 1.8% and 2.5%. Profits were up further in the first quarter. Before taxes, non-financial corporations registered a $165 billion increase in operating profits over the past twelve months, as defined in the national income accounts, while financial institutions earned $40 billion more. Despite the rapid growth and higher inflation the Federal Reserve didn't raise interest rates at all until the very end of the second quarter. Then they inched up the Federal funds rate to a still minuscule 1.25%. At the same time, Fed officials more or less guaranteed they would keep to 25 basis point increases for the next few FOMC meetings, unless inflation did worse than their predictions. Fed estimates of GDP growth, even taking for granted that they were plugging higher interest rates into their equations, were for close to 5% per annum during the second half of the year and a sturdy 4% or better real growth rate for 2005. They also predicted inflation would be no higher in 2005 than their original forecasts for 2004, meaning they were expecting negligible inflation in the second half of the year. Strong growth, mild inflation, modest increases in Fed interest rates: what could be better?
The bond markets seemed to believe these forecasts and liked what they saw. The yield on long-term US Treasury obligations is roughly the same as it was at the beginning of the year and not that different from a year ago, when deflation talk was in vogue. But the stock market has stayed in a bad mood. Despite the mainly favorable economic news and the upbeat forecasts of the Fed and their many followers among Wall Street economists, stocks are down for the year to date. The S&P 500 benchmark is 1.25% lower, the Dow-Jones industrials are 3.25% lower, and the NASDAQ is 6.5% lower.
So what is the stock market worried about? Terrorists, for one thing. The increase in the warning level for New York and Washington, along with some details on terrorist planning, triggered a modest decline in the market at this morning's opening. But there are other considerations weighing on investor sentiment:
Retail investor disinterest: According to some market professionals, the retail investor appears to have abandoned the market, even the well-off beneficiaries of the Bush tax cuts who have spare money to invest. Some of the reticence to increase equity holdings may reflect ongoing concerns that the corrupt practices discovered in the mutual fund industry may not all be out in the open yet. But that wouldn't explain hesitancy on the part of richer individuals who don't need to pay high fees to mutual fund operators to manage their stock portfolios. They apparently aren't putting new money to work in the stock market, either. Some of that may reflect the fact that a lot of money is going into housing. Home prices are up 10% or more nationwide over the past year. In some upper income enclaves the increases have been more like 25%-30%. So the pockets of bubbling in the housing market may be drawing funds that might otherwise have gone into the stock market. Or maybe they just think that stock prices are too high, notwithstanding the better-than-expected earnings and the favorable economic outlook. Or maybe they are worried about…
Energy costs. Investors with long memories remember the bad old days of the 1970s, when energy prices soared and seriously wounded the US stock market. Erstwhile industry experts and oil company economists keep telling people that they expect crude oil prices to sink to $30 per barrel by the end of the year. But one accident after another keeps getting in the way. A few weeks ago, there were terrorist threats in Saudi Arabia and sabotage by Iraqi insurgents. Today the story is that Yukos has been ordered to stop production at some facilities. The Yukos saga ought to remind market participants (as well as security strategists) that Russia isn't a normal country quite yet in many respects. But if a modest shortfall in Yukos output is enough to send world oil prices up to a record high, it just shows how fragile that market is – and how strong demand is globally. That alone should induce the Fed's economists to reassess why they have been saying that upward pressures on the rate of inflation in the first half of the year were "transitory." Because higher energy costs have the habit of percolating through the economic system, equity investors have good reason to view the Fed's highly optimistic inflation forecast with some skepticism.
Or investors may be worried about something else entirely, such as…
Politics. Kerry is tied with Bush in the polls. The Democratic Party platform is crystal clear that they intend to roll back Bush tax cuts that benefit those with incomes higher than $200,000 per year. That's not all that high in many large metropolitan areas, like New York, Boston, Washington, Chicago, Los Angeles, and San Francisco, to name a few. There is a likelihood that legislated tax relief on dividends or on capital gains may also be reversed under a President Kerry if the Democrats were to win back control of the Congress. This is perhaps a low probability scenario, but to many equity investors it introduces a set of risks that had been almost completely disregarded until recently.
Shrinking profit margins: Finally, equity investors may have read carefully the spot in Fed Chairman Greenspan's testimony where he pointed out that profits have gotten to be an exceptionally large share of the national income, 12% instead of the more familiar 7%. Markets would adjust, he warned. And one of the ways markets would adjust is through more strident wage demands, should the labor market continue to improve, as it doubtless would if the Fed's GDP forecast came true. Higher unit labor costs may not be offset by unusually strong gains in productivity indefinitely. And one of the sources of higher cash flow, the temporary liberalization of depreciation rules on equipment purchases, is due to expire at the end of the year.
It is often asked why it should be that the stock market and the bond market seem to be reacting to the same economic data in a seemingly contradictory way. It is more common than many suspect. What usually happens is that new information leads to a reconciliation. Suppose that the strong growth forecast of the Fed comes true, but at the expense of its optimistic inflation forecast. Then the bond market will sell off and bond yields will rise. But corporate profits will stay firm and the stock market will be pleasantly surprised. Or suppose that the Fed is too optimistic on both growth and inflation. Then the bond market may fear the higher inflation and sell off, while the stock market may fear the slower growth and sell off.
The conclusion is that these are unusually uncertain times in financial markets. The world is not at peace; there are potential geopolitical shocks in many places. That leaves the most important ingredient in world trade at risk, the global oil market. And large imbalances, ranging from the US budget and trade deficits, to the huge financial surpluses being run up by Asian central banks and government institutions, will test stability in the foreign currency markets too. The implication is that volatility of stock prices, bond prices, and exchange rates will all escalate in the months to come, irrespective of trends in market prices or whether terrorists strike again at the US Homeland.