Growth and Market Could Struggle Until US Election

Ben Bernanke’s semi-annual testimony to congress will be the markets' big focus this week, with investors looking for clues on whether weaker economic data will see the Federal Reserve governor indicate he is ready to pull the trigger on a third round of quantitative easing or QE3.

Federal Reserve Chairman Ben Bernanke speaks during a press conference announcing that the Fed will take no action on interest rates at the Federal Reserve Bank on January 25, 2012 in Washington, DC
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Federal Reserve Chairman Ben Bernanke speaks during a press conference announcing that the Fed will take no action on interest rates at the Federal Reserve Bank on January 25, 2012 in Washington, DC

Data on retail sales, the housing market and inflationwill also give investors clues on whether the recent slowdown in economic data is becoming a trend, amid uncertainty over the so-called fiscal cliff and the euro zone debt crisis.

The fiscal cliffrefers to a critical fiscal deadline at the end of 2012 when several tax cuts enacted under President George W. Bush will expire and mandatory spending cuts resulting from the debt ceilingfight last summer would begin to phase in.

“The three year old recovery’s upward momentum, modest as it has been, has stalled in recent months, and we do not anticipate a significant reacceleration until after the November election,” said High Frequency Economics Chief U.S. economist Jim O’Sullivan on Monday.

O’Sullivan says U.S. growth will slow going into the fourth quarter, before rebounding in 2013 when we get more clarity on economic policy from whoever wins the White House.

Despite more encouraging data from the housing market and a fall in gasoline prices. O’Sullivan is predicting the Fedwill act on QE3 before the end of the year.

On Friday, analysts at Danske Bank downgraded their U.S. growth estimates. Predicting growth of just 2.1 percent and 2.2 percent in 2012 and 2013 respectively Danske says America’s success over the winter is now becoming a problem.

“Undoubtedly, the boom-bust profile in economic activity over the past eight months has partly been driven by warm winter weather spurring activity in the winter months followed by a payback in spring,” said Danske senior analyst Signe Roed-Frederiksen in a research note.

“However, the weakness has now carried over into the summer and it is increasingly difficult to dismiss this as a pure seasonality issue,” said Roed-Frederiksen who believes unemployment will not fall below 8 percent until voters decide between Barack Obamaand Mitt Romneyin November.

Problems in Europe continue to weigh on sentiment in the U.S., according to Roed-Frederiksen who predicts a rebound in Chinese growth could be a double-edged sword in the fourth quarter.

“We expect Chinese growthto gain speed in the fourth quarter this year, putting upward pressure on commodity pricesagain. This implies that the tailwind from oil prices will be significantly lower in the final months of the year and could turn into a headwind," he said.

The fiscal cliff is expected to drag on economic growth next year as government spending is cut back but both Roed-Frederiksen and O’Sullivan predict the politicians will not cut back as significantly as some market participants fear.

“We do not expect the entire fiscal cliff, amounting to almost 5 percent of GDP , to be realized but we expect a drag of around 1.0-2.0 percentage points on 2013 GDP growth,” said Roed-Frederiksen.

How you trade this economic environment is difficult to call, and High Frequency Economics' O’Sullivan believes his forecasts are positive for stocks and negative for bonds. “We have more near-term confidence that equities will rise than that bond prices will fall," he said.

With the Fed ready to act if the economic data gets worse, O’Sullivan thinks stocks would get another boost if QE3 where to be put on the table, something others believe is having less and less impact on risk appetite.

“The stock market seems to be struggling in the face of disappointing news on corporate profits as the second quarter earnings season gets into full flow,” said Capital Economic John Higgins in a research note.

“Even if the profit share doesn’t drop back that much from its highest level in many decades and the Fed eventually launches QE3, we continue to expect the weakness of the global economy and the euro zone crisis to curb investors’ enthusiasm for risk,” said the senior market economist.

“The bottom line is that we are sticking with our end-2012 forecast of 1,350 for the S&P 500 with the risks skewed to the downside,” said Higgins.

By CNBC EMEA Head of News, Patrick Allen