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Will Second-Half Growth Justify Stock Market Gains?

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The assumption of many on Wall Street has been that the economy would pick up steam into the second half. So now, it's show me time.

As the second half begins, investors will be watching to see if the economy's performance is strong enough to justify the first half's double-digit stock price gains. The S&P 500 is up more than 12 percent year-to-date, and the stock market is typically seen leading the economy by about six months.

Economists, however, are divided on whether growth will really accelerate or just chug along at a 2 percent rate for the next six months. At the same time, the Federal Reserve has confused the picture.

Its forecast is that growth will accelerate, and if that's the case and unemployment improves, it has promised to move before year-end to reduce its bond purchases.

The idea of its quantitative easing program, or QE, coming to an end sent market players scurrying in the past weeks to dump bonds, stocks and other assets, ahead of rising rates. The Fed's comments also sparked a rapid move up in Treasury yields that were already beginning to move higher on better-looking economic data.

(Read More: Jobless Claims Fall; Consumers Keep Rolling)

The bond market stabilized this past week, and yields steadied but the damage was done. Mortgage rates have jumped, with the 30-year fixed rate at 4.46 percent, up from last week's 3.93 percent, in the biggest one-week rise since 1987.

Under QE, the Fed is currently buying $85 billion in bonds each month, $40 billion of which are mortgages and the balance, Treasurys.

"A month ago, I would have said I think the American economy is going to strengthen in the second half of the year. It's become a more difficult question. What makes it more difficult has been the incredible spike in mortgage rates," said Richard Bernstein, CEO of Richard Bernstein Capital Management.

"Mortgage rates are up 120 basis points since the beginning of May. Even though they are extremely low, they are extremely low on an absolute basis, and it has to affect the marginal borrower."

Housing has been one of the engines of the economy this year, after slowly climbing out of years of crisis and paralysis. The Fed's easing policy has clearly been a positive influence on lending rates, and real estate prices are rising as sales pick up.

Pending home sales in May were up more than 12 percent from year ago levels, and are currently at a six-year high. Actual sales of existing homes in May rose 12.9 percent above last year's level to an annual rate of 5.18 million, the best since November 2009.

Deutsche Bank's chief U.S. economist, Joseph LaVorgna, said housing is one bright spot that makes him optimistic the economy will start to grow faster.

"Housing is turning and the housing share of the economy has come a long way and still has a ways to go as far as getting back to an equilibrium level," said LaVorgna. "The housing market is telling me that growth should be better in the second half."

LaVorgna said this year the economy is far better off than last year when the Fed began a new round of asset purchases. He expects second-quarter growth of 2.3 percent, after the economy grew at a revised 1.8 percent annualized rate in the first quarter.

For the third quarter, he sees the economy growing by 3 percent, and 3.5 percent for the fourth quarter. The Fed's forecast is for GDP growth for the year of 2.3 to 2.6 percent, and for 3.0 to 3.5 percent in 2014.

Some economists see those forecasts as too rosy.

"We're still looking for 1.5 percent real GDP growth in the second quarter," said Dean Maki, chief U.S. economist at Barclays.

"We think growth will remain modest in the second half. We're looking for 2 percent growth in Q3 and Q4. We have quite a different view than the Fed, which is looking for 3 percent growth in the second half. We think a key reason for this is the sequestration cuts are still to occur. For example, the defense furloughs don't even start until July. We think the second half will be weighed down by the budget decline."

One factor shaping these varied views is that economists disagree on the extent and timing of the economic impact from the sequester, or automatic spending cuts that hit the federal budget. They also vary on how much impact there was from tax hikes, including the rollback of a 2 percent payroll tax holiday.

"We know on the defense side there are massive cuts which I believe are largely a function of the sequester. In the last two quarters, we cut defense spending at a 17 percent annualized rate. That is the second-largest two-quarter decline in the post-World War II period, trumped only by what took place in the middle of 1954. It hit in the fourth quarter last year just when people were getting ready for the cutbacks," LaVorgna said.

LaVorgna said the economy has adjusted to the higher taxes and spending cuts, and he believes there will be "a watering down" of the sequester by Congress when it works on the 2014 budget. "That fiscal drag, I don't believe will be as potent come August/September."

Peter D'Antonio, head of U.S. economic forecasting at Citigroup, said the tax hikes did hit the economy. "Early on there were people that were saying we're not going to get a hit because we didn't see it," he said. "By our measures, we did see it. It has happened. We had a breakdown of consumer spending. This was a tax event. You just can't look at overall consumer spending. What you really need to do is focus on the stuff that's discretionary. You want to look at necessities. It turned out in the first quarter, [the percent of] necessities shot up."

D'Antonio pointed out the quarter started out after the warmest December on record and ended with an unusually cold and stormy March, "in the process, we had a run up in utility bills. That was a part of it, but not all of it. But necessities did well and discretionary flattened out completely. We saw a hit but it was less and that has given us more confidence that our underlying story is coming through."

When revised first-quarter GDP was released this past week, first-quarter consumer spending was knocked back to a gain of just 2.6 percent, from an earlier estimate of 3.4 percent. Consumer spending accounts for two-thirds of economic output. The Commerce Department released data for May Thursday that showed consumer spending rose 0.3 percent in May, erasing a loss of the same size in April.

In May, consumers went for big-ticket items like cars and spent more at retailers for home improvements and sporting goods. Consumer sentiment, reported Friday, rose to its strongest level in six years. The Thomson Reuters/University of Michigan's final reading was 84.1, just below the six-year high reached in May of 84.5.

Economists had expected a lower reading, but consumers believe the economic recovery has upward momentum, according to the surveyors.

"I think just in general the economy has surprised us by being a little more resilient than I thought," said D'Antonio. "Home prices have increased at a faster pace than I thought and frankly the financial conditions are better."

The S&P/Case Shiller home price index this past week showed a 12 percent increase in 20 cities in April, from a year earlier, the largest gain since 2006.

"What we're seeing is each one of those factors that has been holding us down is fading, and as those drags dissipate we could find ourselves in a better position. I would expect growth to accelerate as we go through the second half," D'Antonio said. He expects 2.5 percent growth in the third quarter and about 3 percent in the fourth.

D'Antonio said the housing recovery can withstand the increase in rates. "Of course affordability comes down, but it's still way above where it was in the housing boom. The thing that was really holding them back was the lack of price appreciation for homes," he said, noting that has clearly changed.

He said the improvement in the economy will be in large part because of the consumer. "I think the business sector will do well also. We saw some pretty nice numbers on durable goods," he said. "They fit with my story that we're going to get not great, but OK business investment."

Durable goods orders rose 3.6 percent in May, the same as April's gains. Much of the increase came from an increase in aircraft orders but there were also increased orders for computers, communications equipment, machinery and metal.

LaVorgna said he's optimistic the economy could take off, though job growth is still sluggish. "It's almost like the GDP numbers aren't accurately reflective of how things feel … if you look at housing construction and home prices, you would say the economy looks pretty strong, all things being equal. I think it feels a lot different, and I think attitudes are much better now than they were a year ago, when we were worried about the Greek exit and what the ECB would do, which is what led us up to QE3 in the first place."

Maki said he expects the Fed to start to pare back its bond purchases in September, and he expects the pace of unemployment to begin to fall more rapidly than the Fed predicts because of the drop off in work force participation, the result of baby boomers retiring from the work force.

He expects the unemployment rate to be 7 percent early next year, a level the Fed expects to see when it is finishing its asset purchases.

"We think the Fed will be tapering despite the sluggish growth," Maki said. "We view the default now as tapering and data would have to deteriorate for them not to do so."

How the markets react to that has yet to be seen. "It's an odd time for the Fed to be talking about tapering, when GDP growth is slowing, job growth is slow and inflation is about half the rate they expect it to be," Maki said.

Bernstein expects the stock market to move higher in the second half. "We still think things are going to improve but the trajectory may not be as strong as it was, and that's why we had this little correction here. People are trying to figure out what's going on. This is a normal discussion for a midcycle environment. In a midcycle environment, there's always a tug-of-war between the negative effects of a tightening of monetary policy versus improvement in the fundamentals," he said. "And in the normal midcycle environment, the fundamentals win, and the Fed is late."

—By CNBC's Patti Domm.

  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

  • A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

  • CNBC's Senior Personal Finance Correspondent

  • JeeYeon Park is a writer for CNBC.com. Follow her on Twitter: @JeeYeonParkCNBC

  • Rick Santelli joined CNBC Business News as an on-air editor in 1999, reporting live from the floor of the Chicago Board of Trade.

  • Senior Producer at CNBC's Breaking News Desk.