Equity Markets and Economy Have Turned for the Better

Why Economic Activity may not Accelerate as Dramatically as Expected this Year

A combination of ongoing stimulus and recent economic momentum has induced many economists to ratchet up their 2011 forecasts and there are plenty of reasons to be optimistic.  Consumer spending has been rising, with retail and food services sales up 7.7 percent between November 2009 and November 2010.  Auto sales have also been edging higher, including among America’s big three automakers.  The holiday shopping season was the best in several years.

It also helps that financial markets have been recovering.  On March 9th of 2009, the Dow Jones Industrial Average sank to 6,469.95 intraday.  As of this writing, it stands at well above 11,600.  Since financial market performance often foreshadows broader economic performance, the implication is that the economy is in for some better times ahead.

While it is true that 2011 is very likely to be a year a solid growth, it is possible that members of the dismal science have become a bit too optimistic in their projections in recent months.  There are (at least) ten factors that could act as speed governors on the U.S. economy this year.

• Consumers tap their brakes

  Though household spending was unexpectedly strong in 2010, in the absence of substantial income growth, this is unlikely to continue particularly if consumers are spooked by unemployment rates that still hover near double digits.  Many consumers may feel buyers’ remorse during this year’s first quarter as credit card statements tumble in.

• Housing market recovery scrubs much of its speed  

  The fear had been that once the first-time and move-up buyer tax credits expired, the housing market would begin to swoon.  That is precisely what happened, with existing home sales slumping since May and new home sales performing even more sluggishly.

• Federal spending cuts diminish momentum
  
  Congress has not been as serious about deficit reduction since arguably the early 1990s.  Already, the newly-seated Congress is talking seriously about substantial cuts to discretionary spending, including within the Department of Defense budget.
• State/local tax increases become a source of slippage

  At least 46 states struggled with fiscal shortfalls when adopting budgets for the current fiscal year, which in most states began July 1st.  The collective budgetary gap for 2011 and 2012 is $260 billion.

• The stimulus turbocharger cuts off

  Though much of the $787 billion associated with the American Recovery and Reinvestment Act of 2009 has yet to be spent, by some point in 2011, the federal stimulus driver will begin to wind down, and that remains another reason to believe that another economic downturn could be headed our way.

• European debt crisis is no formula for success

  Greece, Portugal and Spain have all experienced debt downgrades.  Greek debt has now reached junk status.  Though members of the European Union have established a $1 billion bailout fun, there is still the possibility of a sovereign default going forward.  Nearly 100 European banks are being stress tested.

• State and local government spending further deflates aggregate demand

  Despite ongoing assistance from the federal government, it is clear that most state and local governments have begun to decelerate spending.  While there is something positive associated with the rationalization of spending levels, in the short-term the impact is negative including upon contractors.

• Government spending cuts in other parts of the world puts global expansion into neutral

  At the most recent G-20 summit, nations from around the globe agreed to slash their deficits over time.  A number of countries in Europe, including Greece and Spain, have initiated austerity programs through a combination of tax increases and spending adjustments.  Not surprisingly, recent data indicate that global economic expansion is beginning to soften.

• Bond market continues to fade

  Bond traders have become increasingly unnerved by sovereign debt issues, growing fears of inflation and the temptation to leave fixed-income assets for equities.  If the bond market continues to experience outflows, interest rates could rise further, slowing economic progress in the process.  According to Barron’s, bond mutual funds redeemed nearly $15 billion in December, the heaviest outflow since October 2008.

• Unemployment remains high and private job growth has not picked up sufficiently 
  
  The key to sustained economic momentum is income growth.  With employment growth still lagging and with the public sector now retrenching, the prospects for a significant acceleration in wage/salary income growth next year are weak.

Looking Ahead

Despite these risks to the economic outlook, this year is shaping up to be a good one for the U.S. and Maryland economies.  The nation’s economy is positioned to expand at 3 percent or better adding an estimated 1.6 million jobs in the process.  Unemployment should be closer to 9 percent by the end of the current year.  Maryland is positioned to add more than 40,000 jobs this year, respectable performance by historic standards.

Based on that, more substantial exposure to equities appears warranted.  Though investors must always remain vigilant, there is now more transparency regarding the direction of the U.S. economy than there has been for several years, and that has been and likely will be good for stocks in general.

Anirban Basu is Chairman & CEO of Sage Policy Group, Inc., an economic and policy consulting firm in Baltimore, Maryland. Mr. Basu is one of the Mid-Atlantic region’s most recognizable economists, in part because of his consulting work on behalf of numerous clients, including prominent developers, bankers, brokerage houses, energy suppliers and law firms. On behalf of government agencies and non-profit organizations, Mr. Basu has written several high-profile economic development strategies, including co-authoring Baltimore City’s economic growth strategy. His opinions do not necessarily reflect the opinions and beliefs of 1st Mariner Bank.