Posted on April 1, 2011
Good News Really Can Be Good
The global economy is rebounding significantly despite the alarming number of black-swan challenges.
Stock markets are rallying in tandem, reflective of the improving economic and financial backdrop. Ironically, the good news has led many to question the need for further monetary stimulus, while at the same time some suggest that without the Federal Reserve’s quantitative easing, the stock market would still be in the doldrums.
Surely, this gives QE2 far more credit in its near-term effectiveness than any econometric analysis would warrant. The recent decline in credit spreads and rising demand for even the riskiest assets could not be predicated on something as unlikely as another round of quantitative easing, and the consensus would certainly agree that the Fed will call a halt to this policy in June as expected. To the contrary of the naysayers, the recovery in the U.S. economy is real. The good news really is good and is not reflective of a Fed-created monetary bubble. While food and energy prices have certainly been rising, it has little if anything to do with G-7 monetary policy and it is, therefore, hard to imagine why rate hikes in Europe or the U.S. would be warranted.
With excess capacity and intense competition, wage inflation is nonexistent. What’s more, the rise in these prices narrows business profit margins and reduces the pace of consumption of nonessentials, putting downward pressure on overall economic activity. Nonetheless, it appears that the ECB is poised to hike interest rates despite the drag on economic activity presented by the substantial fiscal tightening in the region. It would be even more dangerous to economic well-being if the Bank of England were to raise rates as the U.K. economy is already battered by tax hikes and meaningful cuts in government spending and public sector payrolls. The Bank of Canada has a better case for rate hikes given the apparently faster-than-expected narrowing of the output gap and the larger resource-related sector that sees profit windfalls from rising commodity prices, encouraging stepped up hiring and potential wage pressures.
Also, in Canada, unlike the U.S., the construction industry is doing very well as nonresidential construction is booming in some parts of the country and condo building remains strong as well. BoC rate hikes are likely to resume by the summer, but will not in themselves derail the stock market. The fundamentals remain positive and the rise in short-term interest rates is likely to remain moderate. The latest employment numbers for the U.S. were particularly encouraging because the fall in the jobless rate to 8.8% was not reflective of a rise in discouraged workers, as had been the case in past months, and private payroll growth is now topping 200,000. And, the fall in the unemployment rate from 9.8% to 8.8% in just four months, even allowing for the decline in the participation rate, is still a rapid decline by any measure, especially while the construction industry remains very weak as the housing market continues to decline and state and local governments are laying off workers owing to budget constraints. No one, however, is cheering while 13.5 million people remain unemployed, which is why the Fed will be very slow to raise interest rates. The rise in the average duration of unemployment suggests that many of those seeking work may have longer-term difficulties in meeting the job requirements of the future. This is a structural problem, however, that macro policy measures can address only in part.
The Bottom Line:The economic fundamentals are pointing upward, but that doesn’t mean that inflation will be the next black swan. Even if the U.S. nonfarm payroll numbers were to accelerate to 300,000 net new jobs per month, there would still be considerable labour market slack by the end of next year. The upside surprises in corporate profitability might be more muted in non-resource businesses owing to the rise in energy costs, but that could well be offset by the continuing growth in demand from the emerging world and the improvement in the trade balance. Fiscal policy will remain a drag on the economy. All in, we are in store for 3%-plus growth. Business hiring intentions are rising and new product development will be strong. This boosts the technology sector. Financial services profitability continues to rise and cyclical stocks are in for further gains. Good news—but not too good—is a solid underpinning for investors.
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