Economic conditions 'too good' for stocks: Market veteran Jim Paulsen

  • The economy is a bigger challenge to the stock market than a possible trade war, veteran strategist Jim Paulsen says.
  • "It is too good, and that's kind of the problem," he says.

The economy is a bigger challenge to the stock market than a possible trade war, veteran strategist Jim Paulsen told CNBC on Friday.

He anticipates real gross-domestic-product growth will hit 4.5 percent in the second quarter. On top of that there is a tight labor market, with the unemployment rate at an 18-year low of 3.8 percent, and inflation is picking up.

"It is too good, and that's kind of the problem," said Paulsen, chief investment strategist at The Leuthold Group.

The Atlanta Fed's GDPNow tracker is now forecasting second-quarter GDP may hit 4.8 percent.

"A big part of this stock market, when it did the best was when Main Street was not doing the best. We had a lot of excess slack, and you could grow the economy and not create any cost pressures, any interest rate pressures, any inflation pressures," Paulsen said on "Power Lunch."

There was also no need for the Federal Reserve to tighten its monetary policy, he added.

Now, there is a completely different situation.

"Good growth is no longer good for financial assets outright," Paulsen explained. "It does raise profits, but it also raises the interest rate pressures, the cost pressures, the pressure of profit margins. It forces the Fed to restrict the money supply and liquidity conditions. And we're dealing with all that."

The Fed began gradually raising interest rates in December 2016. Earlier this week, it again hiked its benchmark short-term interest rate a quarter percentage point and expects two more increases this year.

The central bank also began to unwind its balance sheet late last year.

Meanwhile, even if the U.S. economic growth slows to 2.25 percent to 2.5 percent for the second half of the year, it is enough to push wages and inflation higher, Paulsen said.

"Weaker growth may cause some to question their earnings estimates for the year but it won't be enough to stop the Fed from maybe having to lift rates or the bond vigilante from having yields going higher," he said. "That to me is a much bigger challenge than trade war," said Paulsen.

The term bond vigilante was coined by market historian Ed Yardeni in the 1980s. It refers to investors who sell their holdings in an effort to enforce fiscal discipline. Having fewer buyers drives prices down — and drives yields up — in the fixed-income market. That, in turn, makes it more expensive for the government to borrow and spend.

On Friday, the stock market slashed losses from earlier in the day. The Dow Jones industrial average fell as much as 280 points but ultimately ended just 84.83 points lower at 25,090.48.

The morning drop came after the Trump administration said it would impose a 25 percent tariff on up to $50 billion in Chinese goods. China later announced retaliatory tariffs on $34 billion of U.S. goods.

However, David Spika, president of GuideStone Capital Management, also thinks there is more to the market action than trade war anxiety.

"Not only is the market reacting to trade fears about trade policy and the potential impact on the economy, but this is coming in the midst of significant monetary policy tightening," he told "Power Lunch."

"Investors are thinking, 'OK, we've got potential economic slowdowns. We're seeing it in Europe. Trade policy could impact that here," he added. "At the same time we're having the Fed tighten monetary policy to an extent that we haven't seen before because we've never been in this period of such stimulus."

— CNBC's Jeff Cox and Fred Imbert contributed to this report.