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Job Gains, Stronger Economy Boosting Stock Markets

John W. Schoen
Wednesday, 6 Mar 2013 | 4:53 PM ET
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More than four years after the worst financial collapse in a lifetime, the lingering effects that have been holding back the U.S. economy are finally fading away.

That, at least, is what investors in the stock market seem to be thinking these days as they push the Dow Jones Industrial Average to ever-new heights.

The latest evidence to support that renewed confidence came from a report Wednesday showing solid job gains in February, based on monthly data collected by payroll processor ADP.

Employers added nearly 200,000 jobs last month after hiring 215,000 new workers in January, a revision that boosted that month's pace of hiring by 23,000 more than ADP initially reported. The report suggests that the government's February jobs report, due Friday, may beat economists' forecasts of about 150,000 jobs added last month.

Those forecasters are also expecting the government to report that the unemployment rate dipped to 7.8 percent from 7.9 percent in January.

"It feels like underlying job growth continues to improve and the current pace should be enough to bring down the unemployment rate," said Mark Zandi, Moody's Analytics chief economist. "The economy is not in full swing but we're moving in the right direction steadily by surely."

After more than three years of a wobbly recovery, the emerging confidence that the U.S. economy is healing has put stock market investors in a buying mood. So far this year, the Standard and Poor's 500 index is up by 10 percent, extending a rally that has sent stocks 20 percent higher since last June.

Though job growth is still weak by historical standards this far into a recovery, the gains are broad-based, according to the ADP figures. Small businesses—which had been all but sitting out the recovery in hiring—have also begun adding to payrolls.

(Read More: 6% Unemployment Rate Still 3 Years Away—Bernanke)

The pickup in hiring in February has also returned to the housing industry, which had been all but left for dead after the worst collapse since the Great Depression. Though the pace of homebuilding is still far below peak levels during the 2000s boom, the industry has begun getting back on its feet. That recovery is expected to continue this year—some analysts expect it to accelerate.

And after nearly two years of uncertainty about the potential damage to the economy from large federal budget deficits and the ongoing budget battle in Washington, a clearer picture is beginning to emerge.

"We have to deal with Medicare and Medicaid, these are ticking time bombs," said Nariman Behravesh, chief economist at IHS Global Insight. "The guys in Washington punted on all of that, but we're not done with this. The good news is in terms of getting the deficit and debt levels down, we are making progress."

Since the budget battle began more than two years ago, Congress has pared the growth of federal spending by roughly $4 trillion over the next 10 years. The improved economy has also helped shrink the deficit by increasing tax receipts and reducing the cost of programs put in place to blunt the recession's impact.

Still, federal budget-cutting remains a drag on growth. The latest round of tax increases and government spending cuts, including $85 billion in spending cuts mandated by the so-called sequester, is expected to force some government layoffs and reduce hiring this year by as many as 700,000 new jobs.

But private sector employers—apparently convinced that the worst of those federal spending cuts won't bring on another recession—are expected to more than offset those job losses.

(Read More: An Uneven Recovery for Dow Companies)

"The economy has more momentum right now as we enter into this sequester phase than most people expected," said Howard Ward, chief investment officer at GAMCO Investors. "We're getting strength in housing, and autos and energy and aerospace, and consumer spending is holding up pretty well. So the economy will have more momentum going into this headwind of cutbacks."

To be sure, there are plenty of forces and potential surprises that could derail the stock market rally. Europe remains mired in recession. Though households have recovered much of the $16 trillion in wealth that was wiped out in the housing collapse, many of them have little in the way of a nest egg to invest.

And the political gridlock that has sapped confidence from investors and consumers in the past shows no signs of abating. It remains to be seen just how much economic damage is felt from the sequester cuts, which are concentrated on a relatively small portion of the $3.7 trillion federal budget.

Zandi believes the drag on the economy will also be concentrated in the third quarter of this year, as the impact of slower growth in federal spending flows through the economy. Unless Congress moves to soften the blow, the full impact could knock as much as two percentage points from gross domestic product in the third quarter.

"That's a lot of drag," he said. "The fact that the private sector can navigate through that—and we think it can—is testimony to the increasing strength and the resilience of the private sector economy. On the other side we should be in pretty good shape. As the stronger private sector shines through, we'll get much better growth in jobs."

That's why investors are buying stocks now: They expect that the economy will be on more solid ground next year, companies will generate stronger profits and the unemployment rate will continue to fall.

The stock market rally is also being fueled by the Federal Reserve's historic effort to hold interest rates near zero. That's forced many investors to move money from the traditional safe haven of bonds.

"You don't make much buying bonds," said David Blitzer, head of the index committee at Standard & Poor's. "On top of that, if rates go up, bond prices will come down sharply. So the risk in bonds is substantial."

The central bank has pledged to keep rates low until the unemployment rate reaches 6.5 percent. But if, as many economists expect, the pace of hiring picks up next year, Fed policymakers may soon have to grapple with the task of unwinding the central bank's mammoth holdings of Treasury debt.

The risk of that "exit strategy" ending badly could spook investors.

"We don't have any experience on how this ends, because in our lifetime we've never seen a Fed this aggressive," said Robert Kaplan, a Harvard Business School professor and former Goldman Sachs vice chairman. "There could be some disruption when it's time to exit, and they're going to need to start thinking about it because what they don't want is rates to start spiking up."

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