Numbers coming out this week should continue to build the case for a solid liftoff into economic growth this quarter. Among the positives should be a sharp rise in retail sales, reflecting the impact of the cash-for-clunkers on vehicle sales and higher gasoline prices. In addition, industrial production should have posted a second consecutive monthly increase in August, helped by surging auto output and the increased electricity production associated with heavy air-conditioning demand in a hot August.
Housing starts should be close to flat following some recent strong gains and unemployment claims could back up a little after a very welcome 26,000 drop last week. Inflation measures should be relatively benign, with few price pressures outside of the always volatile energy area.
For the U.S. economy, and indeed economies around the world, the start of the recovery appears to be unfolding relatively smoothly. Having said this, given the depth of the recession it will take years to get back to full employment and deflation rather than inflation seems to be the greater threat. Importantly, the case for a “new normal” of unusually low economic growth is still unproven – credit is tight but may well loosen as the economy expands while on the supply side productivity growth remains solid as is the long-term growth of the labor force.
However, for a while at least there may be a “new normal” when it comes to how investors perceive risks and react to volatility.
Treasury interest rates appear much too low and will likely move higher. But the very fact that people will buy Treasury bonds with such paltry yields speaks to the very risk-averse nature of investor attitudes at the end of a long and turbulent decade.
Equally, future earnings prospects, should justify further stock market gains even given the extraordinary advances of the last six months. But it may well be that stocks have a hard time getting back to a normal relationship with long-term earnings, given the repeated disappointments meted out by the stock market over the last decade.
In other words, for now, the recovery trade, whose major theme is being overweight stocks and underweight bonds, with minor threads of being short the dollar and long commodities still seems appropriate. However, the limits of this trade are very difficult to gauge, given the potential impact on investor behavior of the last extraordinary year.
David Kelly is chief market strategist for J.P. Morgan Funds.