After a sizzling start this year, the stock market took a breather in April and May. The early rally in equity markets, coming alongside tentatively optimistic news about jobs, housing, and the economy at large, seemed to suggest that the slow recovery of the past few years finally was gaining momentum. But now that the major stock benchmarks have stumbled, many investors are worried that, once again, the economy’s advance may slow to a crawl.
So which is it? Does the recent dip reflect deeper problems? Or is it merely a reasonable pause before stocks resume their surge?
If you consider what happened during the year’s first quarter, it seems to support the notion that the downturn is temporary. During those three months, stocks gained nearly 20%—and almost in a straight line. It’s certainly not unusual that markets would calm a bit and even retreat after such a strong rally.
Still, at least some of the recent volatility can be attributed to signs of economic headwinds. Reports on unemployment released in late March and late April both were disappointing after three months of strong numbers. The April news that only 115,000 jobs had been created in March fell significantly short of the 160,000 that economists had predicted. Yet when you look beyond the headlines, the latest jobs reports seem a little better. It turns out that there was a net gain of 275,000 positions in January, up from the 243,000 that first was reported, and the figure for February was revised upward to 259,000 from 249,000. Even the disappointing March data, showing only 115,000 new jobs, got bumped up to 154,000, much nearer the original estimate of 160,000. These latest numbers suggest that employment growth at the beginning of the year was stronger than originally thought, and the slowing since then may not have been as pronounced as it first appeared. Moreover, although federal, state, and local governments have continued to pare their work forces, the private sector has kept adding new jobs, and workers in nongovernment jobs also have seen their wages rise. With gasoline prices starting to ebb, consumers are likely to have more money in their pockets—potentially good news for an economy in which consumer spending is responsible for 70% of growth in gross domestic product (GDP).
But for now, underwhelming expansion in U.S. GDP is adding to unease in equity markets. The first government reading of GDP growth in the first quarter was 2.2%, down from 3% during the final quarter of 2011. But this latest bit of data, too, will be subject to revision as statisticians gather more information, and there’s a reasonable chance it could fall. One narrower economic indicator, wholesale inventories, came in approximately $2 billion lower than expected in May, and these latest numbers have led some analysts to predict that GDP growth for the first quarter could drop to 1.9% in the next government release, due at the end of May. That, too, likely would weigh on financial markets.
But if growth seems to flag again, would the Federal Reserve take additional steps to bolster the economy? Among the Fed’s many moves since the global financial crisis exploded in 2008 have been two programs of “quantitative easing,” with the U.S. central bank first buying mortgage-backed securities and then Treasury bonds. It followed up more recently with “Operation Twist,” in which the Fed sold short-term securities and used the proceeds to buy longer-term bonds. With the economy seeming to move to firmer ground at the beginning of this year, it appeared that the Fed would hold back on additional stimulus, and its statement after the April meeting of the Federal Open Market Committee (FOMC) gave no indication that there would be additional easing.
The Fed’s previous actions helped fuel stock rallies, and the lack of new support may have discouraged some investors. Yet it’s clear that if the economy truly stumbles, the central bank will step in again—and that the absence of further moves indicates that chairman Ben Bernanke and his fellow Fed governors believe conditions are improving. Ultimately, investors should take that as positive news. A rise in bond yields also would signal further economic healing. Meanwhile, the fact that analysts keep revising their estimates for corporate earnings upward suggests that business activity is on the upswing and that the markets soon could rebound.
Finally, investors are continuing to weigh the prospect of what independent economist Fritz Meyer calls a fiscal cliff: In the face of a ballooning federal deficit, Congress must decide soon whether to extend current tax laws yet again or let them expire, as scheduled, at the end of the year. If legislators do nothing, tax rates will rise sharply in 2013, and though that could help reduce the budget shortfall it also could restrain economic growth. Most observers expect no action from Congress until after the fall election, and lingering uncertainty about what will happen probably contributed to the recent market slump. Yet while such questions and others could keep things volatile for a while longer, the overall outlook is largely positive, suggesting that the year’s strong early stock rally eventually will resume.