"Land Mines Pockmark Road to Recovery
The stock market has erased almost all its losses for the year, yields on long-term government debt have returned to something like normal, and commodity prices have been surging -- all evidence that the worst of the economic crisis may have passed.
But the road to recovery is far from smooth, or even assured. As investors ponder their next moves in this unusually unpredictable cycle, they are confronted with a confounding array of potential risks.
Last Friday, they got a taste. The government's announcement of the lowest job-loss numbers since September didn't much faze the stock market. But the market for U.S. Treasury debt had its worst day in nine months, driven by worries about inflation and higher interest rates.
In today's jittery markets, good news on one front can have surprisingly bad effects elsewhere. At stake is the fragile confidence that's been restored in the financial system.
A jump in economic growth, for example, could send commodity prices sharply higher. On Friday, oil briefly traded above $70 a barrel, due partly to economic optimism. Worries about inflation would cause interest rates to rise, hurting the housing market. Higher commodity prices could also be a drag on economic recovery, pushing job losses higher and leading to more mortgage defaults.
Many strategists and economists hold a relatively hopeful view: that a wave of government stimulus will hit the economy in time to unleash pent-up consumer and business demand, without stoking too much inflation. Such an outcome -- a classic "V-shaped" recovery marked by a quick bottoming out and a lasting rebound -- would enable stocks and other assets to keep rising in the second half of the year.
But the risks to that orderly scenario are high. It is possible that government stimulus could make the economy run too hot, fueling inflation that would force the government to slam the brakes on growth, creating a double-dip, or a "W-shaped," recovery. The spike in yields on Treasurys on Friday was driven by the view that the Federal Reserve would need to raise interest rates sooner than expected, possibly slowing the economy too fast, too soon.
It's also possible that the government stimulus will be ineffective at a time when households are staggering under the weight of debt and the loss of trillions of dollars in net worth. In that case, a sluggish recovery would be more likely. That could prevent inflation but make unemployment worse, in turn leading more people to fall behind on their mortgages, hurting the housing market and causing a new round of losses at banks.
Here's a closer look at three broad scenarios -- certainly not the only possible ones -- for markets and the economy in the months to come.
Hefty government stimulus -- easy Federal Reserve monetary policy and $787 billion in government spending, tax breaks and other perks -- encourages consumers to spend and businesses to hire. This bolsters economic growth, keeps a lid on unemployment and finally ends the pain in the housing market.
At the same time, the massive structural problems facing the economy, including burdensome debt on consumer and government balance sheets, keep just enough of a brake on growth to keep inflation in check.
Under this scenario, corporate profits and economic growth limp their way back to recovery through the second half of the year, setting up a stronger 2010. Stocks rise, though perhaps not by much. The consensus view among many strategists is that the broad Standard & Poor's 500-stock index will stagger its way to somewhere between 1000 and 1100 by the end of the year, a 17% gain from Friday's close.
In such a sluggish recovery, the Fed can keep short-term interest rates low for longer without fearing inflation, even as commodity prices continue to rise. The Fed might feel comfortable that long-term interest rates can drift higher. Yields on 10-year Treasury notes recently have risen to 3.86%. In the just-right scenario, they might not rise much higher.
"I don't think that modestly higher rates, which is how I would characterize what we've seen so far, would be a bad thing," says Leo Grohowski, chief investment officer at BNY Mellon Wealth Management in New York. "It would help keep the lid on the serious inflation threat."
The massive liquidity being pumped into the market by the Fed and other central banks adds fuel to the recent rally in stocks, corporate bonds, commodities and other risky assets. The S&P 500 already is up 39% since March 9 and high-yield bonds are up 31%. Oil has doubled since February.
"The market is very prone to liquidity floods, where money on the sideline floods in," says James Swanson, chief investment strategist at MFS Investment Management. "That's not a good beginning of a sustainable bull market."
Under the too-hot scenario, surging asset prices trigger worries about inflation, hurting the dollar and causing the interest rate on government debt to rise. That might force the Fed to buy more Treasurys to keep interest rates low -- yields move in the opposite direction of prices -- fueling more worries about higher inflation and a devalued dollar.
A whiff of this potential outcome has haunted the market lately, contributing to the jump in Treasury yields and shaving more than 9% from the dollar's value against a basket of currencies since March 9.
"We're not inflating assets because of sound economic policy. We're inflating them by printing money," says David Joy, chief market strategist at RiverSource Investments in Minneapolis. "To some extent, it's an appropriate response because the private sector is flat on its back. But it's a dangerous path."
Booms like these can be powerful, but can also end painfully. Despite being burned by two bubbles in the past decade, investors have eagerly jumped into risky assets recently.
Under this scenario, high debt levels, weak banks, and a terrible job market overwhelm government stimulus, keeping the recovery weak.
"I've seen this movie before, in 2002," says David Rosenberg, chief economist and strategist at Gluskin Sheff, a Toronto-based investment-advisory firm for wealthy individuals. Back then, unemployment rose sharply, the recovery was anemic, and the stock market plumbed new lows. It was not until March 2003 that the market began a lasting recovery.
The economic fundamentals are far worse this time around. Unemployment, already at 9.4%, could climb above 10% as businesses wait for a durable recovery. Cautious companies might hold off on rebuilding their depleted inventories, short-circuiting one of the economy's healing forces.
Home prices could fall further. That would keep the pressure on bank balance sheets, keeping credit tight.
This pessimistic scenario is a recipe for retesting the stock market's March lows. In the longer run, it could also lead to deflation, in which prices tumble as consumers keep delaying purchases. Deflation can be long-lasting and have a chilling effect on stock markets.
Write to Mark Gongloff at firstname.lastname@example.orgPrinted in The Wall Street Journal, page A1