Goldilocks And The Three Bears
Wall Street loves a “Goldilocks” economy — one that is neither “too hot” and likely to fuel inflation and higher interest rates (both bad for stocks) nor “too cold” and likely to crimp corporate profits. In some respects, we are seeing such an economy today, one that has struck a “just right” balance between growth and inflation:
• Real gross domestic product (GDP) has expanded for three consecutive quarters. For the 12 months ended March, GDP rose 2.5%, the largest year-over-year gain since the fourth quarter of 2007. The Blue Chip Economic Indicators consensus calls for real GDP growth slightly above 3% for both 2010 and 2011 — nice growth rates, but hardly the boom normally associated with skyrocketing inflation and interest rates. A 3% growth rate fits nicely into the “not too hot, not too cold” Goldilocks story.
• Interest rates remain low. The one-year Treasury bill yields just 0.3%, while the 10-year Treasury yields 3.3%. Low interest rates limit competition for equities and provide low-cost money for business and consumer borrowers.
• Inflation has been almost nonexistent. Consumer prices overall fell 0.1% in April. Over the 12-month period ended April, prices excluding food and energy rose less than 1%, the lowest since 1963.
Still, just as Goldilocks had to contend with three bears, so does this Goldilocks economy. The first bear is the euro zone. A stronger dollar versus the euro, coupled with austerity programs in several over-leveraged European countries, is likely to crimp U.S. exports to Europe and could slow growth in export-dependent Asia.
The second bear is the job market. U.S. job growth continues to be anemic — only 41,000 private-sector jobs were added in May — and economists expect the unemployment rate to remain at 9% or higher for the rest of 2010 and all of 2011. Without a revived job market, consumer spending is likely to weaken. The bears see the consumer as already wounded, citing a 1.2% decline in retail sales in May from April — the biggest decline in eight months. The good news is that corporate profit growth should at some point strengthen the labor market — more profits mean more money for corporate investment, which means more jobs, which leads to higher profits, more investment, and more jobs, and so on.
The third bear in our Goldilocks economic story is Uncle Sam. Anemic job growth and cash hoarding by corporate America look like responses to uncertainties concerning business regulation and tax policy. More regulation and higher taxes will crimp both business and consumer spending, especially in 2011.
Of course, divining the economy, from a stock-market perspective, is all about the impact economic growth has on corporate profits. Ultimately, if corporations can continue to grow profits at better-than-expected rates, higher stock prices should follow.
A slowdown in the euro zone, a lousy labor market, and an uncertain political environment are not positives for corporate profits. But investors should not forget that a slack job market has the silver lining of holding down corporate labor costs. Softness in the euro zone should be offset by continued gains in developing markets. Improvement in the “wealth” effect — household net worth rose more than 2% in the first quarter, the fourth consecutive quarter of gains — could be a positive for spending. Finally, some clarity on the political front could be evident come November and the midterm election results.
Wall Street expects the S&P 500 Index’s per-share profits to rise 33% this year. If corporate profits can meet or exceed that robust growth rate, stock prices should benefit. Second-quarter corporate profits and the accompanying second-half projections will start coming out in earnest in about three weeks. Those reports will provide an important glimpse as to whether our Goldilocks economic story has a happy ending in 2010.