Market Insider

Economy Needs Help From the Stock Market and Washington

The economy is increasingly at risk of falling into recession, and could be more so if the stock market doesn't find its sea legs sometime soon.

In the past week, a number of economists downgraded their growth forecasts to levels that show the economy to be barely moving forward.

"I think we're right on the edge," said Mark Zandi of Moody's "I think confidence is extraordinarily fragile, and consumer and businesses are frozen in place. The numbers going into Q3 are tracking less than 1 percent. It's still early but the debt ceiling drama, the S&P downgrade and what's going on in Europe have done serious damage on the collective psyche."

Add to that a tumultuous stock market that has scared investors to the sidelines, and a bond market that now promises little yield to fixed income investors for two more years. The Fed earlier this month said it would keep rates at extremely low levels until mid-2013.

There are some positives. "Oil prices are down, and interest rates are way down. The manufacturing base seems to be turning. Industrial production was strong in July. All the things we thought would be helping are helping, but they got swamped by the debt ceiling debate," he said. Zandi expects second half growth of 2 percent, and his forecast is for growth is higher than some others on the street who see 1-1.5 percent.

Economists also point to the strength in corporate profits. So far, companies are not broadly firing workers, which would be indicative of recession. There have been, however, layoffs across the banking industry with UBS the latest, announcing this week it would lay off 3,500 workers.

"We haven't seen deterioration in jobless claims," another positive, says Credit Suisse economist Jonathan Basile. He does note, however, that the expectations in the last University of Michigan consumer sentiment survey showed a big jump in unemployment expectations to 46 percent from 31 percent. "When you get really sharp moves, that's always like a red flag," Basile said.

Basile said he has increased his view of the likelihood of a double-dip recession from about 20 percent to 40 percent in the past several weeks.

Against this backdrop is the Fed's annual symposium in Jackson Hole, Wyo. Friday and the high expectations in markets that Fed Chairman Ben Bernanke will hold out hope for a new quantitative easing program. It was at that meeting last year that Bernanke first mentioned a quantitative easing program, which later became known as QE2. The $600 billion Treasury purchase program was widely credited with driving capital into equities and other riskier assets, like commodities.

"The desire on the part of the Fed to act I think is lessened. The forward outlook on inflation is more stable and firm now than it was a year ago," said Citigroup economist Steven Wieting. He said the Fed could, however, move toward easing if the labor situation were to deteriorate.

Wieting trimmed his view of the economy last week, and says a long period of extremely low growth is "untested."  He trimmed his 2011 GDP forecast to 1.6 percent from 1.7 percent, and 2012 to 2.1 percent from 2.7 percent.

"We have increased our odds of a double dip recession," said Leo Grohowski, chief investment officer at BNY Mellon Wealth Management. "We have doubled the chance from 10 percent to 20 percent. We are not where many are in terms of a greater chance of a double dip. That's driving our view that the Fed needn't step in here for another round."

Grohowski said it's also not clear how effective the last round of quantitative easing was. 

"Very sadly, I think that between now and November it wouldn't be unreasonable to expect there would be little clarity to take the stock market out of its trading range," said Grohowski. He expects the S&P 500 to trade in the range of 1100 to 1250. "That's a trading range I think investors should expect between now and Thanksgiving."

"I do think we'll look back at 2 percent (10-year) yield and a 12 PE and say that wasn't a bad point of entry for stocks," said Grohowski

The S&P 500 hit an intraday low of 1101 in the recent sell off.  "We are still maintaining a 1300 to 1350 target for the S&P at year end," Grohowski said. "...some of that is based on a hope that the committee of 12 can surprise relative to very low expectations right now. We all know that hope should not be a strategy but I have to confess there is a bit of hope baked in to that committee of 12's work."

Grohowski was referring to the bi-partisan Congressional committee tasked to develop budget and deficit reduction plans by late November.

The committee's work could also play a big role in the economy's progress. "There could be more downside risk than upside risk on the policy front in the event of gridlock. We'd get more tax increases in the mix in the event of gridlock," said Wieting. He said the committee's work could prove positive if it tackles long term issues like restructuring entitlements.

Zandi also believes the committee's work is a key to the economy  dodging a recession , and he thinks the Fed should do more easing.  "If the Fed got aggressive, if the Europeans expanded their bailout fund, which I expect they will do and if Congress and the Administration could just follow through on the debt ceiling deal" the economy could avoid a recession, he said.

He said policy makers could go a long way toward shoring up confidence if they beat low expectations on the deficit reduction plan.

"If anything else goes wrong, we're in the soup," said  Zandi.

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