Stocks Start Q3 on Upswing, but Headwinds Coming

NYSE traders
Adam Jeffery | CNBC

Stocks started the third quarter on an up note, but face the dual pressures in the second half of a still challenged economy and higher interest rates.

Add to that uncertainty about the Fed's bond purchase program, which will be wound down subject to improvements in the economy, making each economic report a more important event than usual. The biggest report this week will be Friday's June employment report, expected to show 165,000 nonfarm payrolls, down from 175,000 payrolls in May. The unemployment rate is expected to dip a tenth to 7.5 percent.

(Read More: Show of Force: More Fed Speakers Aim to Calm Markets)

Tuesday's data includes factory orders and monthly car sales, which are expected to come in at the highest sales rate since the pre-recession days of 2007. Analysts expect an annualized sales pace of between 15.5 and 15.7 million vehicles in June.

The market Monday closed higher with the Dow up 65 points to 14,974, but still 109 points below its high for the day. The S&P 500 also backtracked, and traders said the trading tone changed when it failed to hold above its 50-day moving average at 1624. The S&P ended up 8 at 1614. The 10-year yield was at 2.48 percent late in the day, below the 2.5 percent level where stocks seem to get more nervous.

"I think it's obviously always good when the market starts off with a positive note, and I think the right groups are leading today," said J.P. Morgan U.S. equity strategist Thomas Lee. Cyclically sensitive sectors, led by top performers industrials, materials, tech and energy, were the best performers of the day, with the only losing sectors, defensive utilities and telecom.

"I feel confident and our economists feel confident with the fact that growth should improve in the second half, largely because drags are fading. We're going to see better support from housing, as well as autos in the second half. I think the economy is building some momentum," said Lee. "The biggest overhang still is some of the spillover and repercussions from the selloff in fixed income. I think that we've also had, because of rising rates, essentially a form of credit tightening taking place in the market. We're going to feel some of the ramifications of that." Lee expects the S&P to hit 1715 by year end.

A widely held view on Wall Street this year has been that the economy would pick up in the second half and accelerate into 2014. Economists, however, are divided on whether growth will really accelerate or just chug along at a 2 percent rate for the next six months.

"The economy is expected to reaccelerate but from what? The current quarter looks like 1.5 from 1.8 in the first. That's not really great," said Diane Swonk, chief economist at Mesirow Financial.

The Fed also sees acceleration, but it has confused the picture with talk about reducing its bond purchases. A swarm of Fed speakers has tried to clarify what the Fed is doing in speech after speech last week. New York Fed President William Dudley speaks again Tuesday at 12:30 p.m. ET at a Connecticut business council on the regional and national economy.

"Team Fed comes out to support the idea that they're not going anywhere anytime soon," said Swonk. "Bottom line, mea culpa. They're eating crow and the Fed is doing everything it can do to stop the damage."

(Read More: Fed Tapering: It's About Time!)

She said one problem is that the Fed did not put an end date on its last round of quantitative easing, as it had in the past. "It underscores the limits of an open-ended policy. I just do think communicating that is very difficult. It may look great in theory but we're actually in a real-time experiment with monetary policy," said Swonk.

After its June meeting, the Fed indicated it would slow down its quantitative easing program, or QE, sometime this year and it could stop buying bonds by mid-2014 if the economy improves. That launched a wave of selling in credit markets, as market players rushed to the exits, dumping not just bonds but 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. The 10-year yield last week reached a high of 2.66 percent, up sharply from its low of 1.62 percent in early May.

In an unusually coordinated commentary, the more than half dozen Fed officials emphasized that the Fed is nowhere near ready to raise short-term rates, and that its decision to "taper" its bond purchases will be dependent on the economy improving, not a timetable. They also more than once noted that the markets had overreacted.

"The markets just can't handle this much information," said Swonk, noting the Fed's message was too complicated.

Helped by the Fed speakers, the bond market stabilized last week, equities went higher, and yields steadied but the damage was done. Mortgage rates jumped, with the 30-year fixed rate rising to 4.46 percent last week, up from 3.93 percent the week earlier, 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.

(Read More: Why Bond Selling Hysteria Is Overdone)

"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.

(Read More: Fed Speak Could Shape Trading Day)

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.

(Read More: Can US Stocks Weather This Taper Tantrum?)

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."

Wild Card

But Swonk said she still sees sequester cuts as a wild card for the economy. She expects growth of 2.1 percent in the third quarter and 2.4 percent in the fourth quarter.

"It's not the greatest economy. I think people have underestimated the impact of the sequester. A lot of the first quarter was defense spending going down. We're also unwinding two wars. We have a lot of things going on at once that are a drag on the economy," she said. "Consumption was revised down. That was the tax impact. Here we thought we had done so well on consumption. We did okay, but not terrific."

When revised first-quarter GDP was released last 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.

(Read More: US Stocks Regain Positive Footing)

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.

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.

(Read More: New math Makes It Easier to Lower the Unemployment Rate)

"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 mid-cycle environment. In a mid-cycle 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 mid-cycle environment, the fundamentals win, and the Fed is late."