COLUMN - Is the current market optimism justified?

Thu Jan 31, 2013 2:37pm EST

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By Anatole Kaletsky

Jan 31 (Reuters) - The U.S. economy has just suffered its first contraction since 2009, consumer confidence has plunged since November's election and Americans' paychecks are only just starting to reflect an increase in payroll taxes averaging $70 per month. Across the Atlantic, the euro zone and Britain seem to be sinking back into recession. And conditions in Japan have become so desperate that newly elected prime minister Shinzo Abe is openly devaluing the currency and threatening to take direct control of the central bank.

At the same time, stock markets around the world are approaching or exceeding records. Money is flowing into equity mutual funds at the fastest rate since the end of the last bull market in 2000. And business sentiment, as reported from Davos, seems to be more optimistic than at any time since the global financial crisis of 2008.

Is there a rational way to explain these contradictions? Will the business and market optimism be sustainable? Or is this sudden euphoria just another financial bubble, sure to be punctured if the grim message from recent economic indicators sinks in? The likely answer to all these questions is yes.

Let us begin with the last question, on recent economic figures. If these grim statistics - especially Wednesday's unexpected report of a 0.1 percent decline in U.S. gross domestic product in the fourth quarter - give an accurate picture of global economic conditions, then financial markets and optimistic business leaders are headed for a fall. The markets and executives, however, are betting they understand conditions better than the statisticians, or, to be more precise, that the weakness implied by the figures is an aberration that lays the foundation for a strong economic rebound in the months ahead.

Regarding the much-worse-than-expected U.S. GDP statistics, this contrarian view is almost certainly right. The figures were severely distorted not only by superstorm Sandy but also by huge cutbacks in government spending, especially on defense equipment, that were probably related to November's election and precautionary moves ahead of the yearend "fiscal cliff."

Excluding government spending, U.S. GDP increased at an annualized rate of 1.4 percent in the fourth quarter, and while this private-sector growth rate was the slowest since the recession, the shortfall was entirely explained entirely by an inventory effect that is certain to be reversed in the coming months.

In terms of the fundamental drivers of economic activity - consumer spending, corporate investment and housing - the fourth quarter figures were actually quite decent. Most importantly, consumption accelerated to 2.2 percent growth in the fourth quarter from 1.6 percent the quarter before.

The strengthening of personal consumption and robust reports from major retailers on holiday and January sales, in turn, casts doubt on the post-election plunge in consumer confidence. Perhaps this decline has mainly been a reflex reaction to alarmist headlines about political gridlock and rising taxes, conveying little or no information about Americans' willingness to spend.

This optimistic interpretation, which is essentially the bet that financial markets are making, is likely to prove right in the short term for three broad reasons relating to economics, politics and global conditions. Looking ahead, however, are at least two dangers that investors and business leaders may not have fully recognized could puncture the euphoria, though probably not until the second half of this year.

The three reasons for optimism have been discussed before in these columns. First, the fundamental drivers of the U.S. economy look much stronger than at any time since 2007. Housing construction, which has been the biggest obstacle to economic recovery since 2009, is finally rebounding. House prices are also rising, rescuing millions of households from underwater mortgages. Employment is slowly but steadily increasing. Credit conditions are gradually returning to normal. And cutbacks in government employment, the most powerful element in economic recovery after housing, are ending as state and local government revenues rebound.

Second, U.S. political conditions are improving as even the most radical Republicans start seeking consensus for the reasons discussed in this column last week. This political mood may not be reflected in public perceptions for some time. But the financial and business communities have clearly begun to sense it, as evidenced by the waning interest among investors in the new "drop dead" deadlines for fiscal conflict that political pundits continue to emphasize.

A third reason for optimism is the improvement in global economic and political conditions - especially the lifting of uncertainties about a breakup of the euro zone and the leadership transition in China. These fears weighed heavily on financial and business confidence for most of last year. But China is growing strongly and is politically stable, at least for the next few years. In Europe, the currency crisis may not have been resolved, but it has been frozen, at least until after Germany's election in September. As a result, the fears of political shocks that until recently obsessed financial markets have diminished dramatically.

As always, things could go wrong. The two most daunting threats for the year ahead are the prospect of higher interest rates and the unintended consequences of Japan's generally welcome policies of radical reflation. Long-term interest rates are certain to rise in the bond markets if investors turn out to be right in expecting a stronger global recovery. In fact, this process has started already, with 10-year rates rising in the United States to over 2.0 percent from 1.4 percent in July. Thus far, rising bond rates have been a healthy phenomenon, reflecting improved economic conditions, but if 10-year rates rise above 3.0 percent or 3.5 percent, they will become a headache for financial markets and corporate investors.

In much the same way, Japan's expansionary policies are a welcome boost to global recovery hopes. But if the yen continues to depreciate, competitive pressures will intensify, especially on companies in Europe, where the central bank seems willing to let the euro rise without limit while Japan and Switzerland manage their exchange rates down.

By the second half of this year, the pincer movement of rising long-term interest rates and a falling yen could well cause a revival of Europe's financial and political crises. For the next few months, however, the optimism in financial markets and the business community looks justified.

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California state worker Albert Jagow (L) goes over his retirement options with Calpers Retirement Program Specialist JeanAnn Kirkpatrick at the Calpers regional office in Sacramento, California October 21, 2009. Calpers, the largest U.S. public pension fund, manages retirement benefits for more than 1.6 million people, with assets comparable in value to the entire GDP of Israel. The Calpers investment portfolio had a historic drop in value, going from a peak of $250 billion in the fall of 2007 to $167 billion in March 2009, a loss of about a third during that period. It is now around $200 billion. REUTERS/Max Whittaker   (UNITED STATES) - RTXPWOZ

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