Can the Economy Be Weak and Strong at the Same Time?

Bull_vs_Bear.jpg

Nov 2 2015

Wall Street strategists who normally live and breathe data are now pushing a curious new narrative: Don't believe the data.

More specifically, it's become routine practice lately to disparage economic numbers as being not representative of underlying strength that the headlines just don't seem to verify.

Related: The Mortgage Market Is Heating Up, but Only for Some Borrowers

The weak third-quarter gross domestic product growth was just an inventory drawdown. A decline in corporate profits turns into growth when you just throw out the numbers (in this case from energy companies) that you don't like. Even undeniably weak manufacturing numbers that are edging ever closer to recession territory are, in the words of one economist, merely "carving out a bottom" that will soon be reversed.

Why all the contradictory views?

One of the big problems is not necessarily intellectual dishonesty but rather of an economy that finds itself at a crossroads: The Federal Reserve last week upgraded its assessment of spending and investment to "solid" while also conceding that employment growth has slowed and that it still isn't time to lift the central bank's key interest rate off near-zero, where it's been for nearly seven years.

Taken together, the U.S. finds itself facing the prospect of a "deflationary expansion," an oxymoron Michael Hartnett, the chief investment strategist at Bank of America Merrill Lynch, coined to describe the unusual path ahead. 

Related: How the Fed Keeps Sowing Uncertainty and Confusion

Essentially, the term means an economy that continues to grow without wage and price pressures, allowing easy monetary policy to continue but not doing much for a sustainable growth pattern. In Hartnett's words, expressed in a note to clients, deflationary expansion entails a "slow, jerky transition to higher growth/higher rates, led by the U.S., (and a) China soft landing."

He said growth remains slow due to "debt, disruption, demographics, regulation, and buffeted by the cyclical event risks of credit, China, commodities."

"Central banks are easing because global growth is weak," Hartnett said. "Global profits are down 4 percent since February. Even the U.S. has struggled: Payroll growth has decelerated and the latest U.S. GDP growth rate was a pitiful 1.5 percent in Q3. And the level of US inventories is unambiguously recessionary."

Consequently, Hartnett said "tail risks," or less likely probabilities that could have outsized impacts, are growing. Central bank intervention both has provided a floor for equity markets but also presents troubles as the global scale of currency devaluation and easing escalates.

Related: Why Corporate Debt Is Hitting Record Levels

Should the Fed decide to raise rates in December—futures markets are pricing in a 47 percent chance — it could make the first time since 1994 that the U.S. raises rates and the European Central Bank cuts. That was a time, Hartnett reminded investors, "of bond crashes, defaults in Orange County (California) and Mexico and, most intriguingly, a weak U.S. dollar."

Companies, meanwhile, seem more devoted to boosting short-term share prices than committing to long-term investments. Since 2010, corporate America has spent $296,000 on stock buybacks per each job it has created, according to a BofAML analysis.

Still, Hartnett's peers on Wall Street are advising clients to consider the bright side.

A Fed rate hike will be the equivalent of a "Good Housekeeping Seal of Approval" on the economy that should push "investors who have stayed on the sidelines for years (to) turn towards equities — particularly value stocks," John Stoltzfus, chief market strategist at Oppenheimer Asset Management, said in a report.

Related: What’s Really Driving the Stock Market’s Big Rebound Rally?

Value has performed poorly in 2015, with the S&P 500 Value index down about 4 percent year to date, while the corresponding growth index has jumped 5.6 percent. The S&P 500 index overall has gained about 1.8 percent.

Brad McMillan, chief investment officer at Commonwealth Financial Network, likewise advised not worrying too much about the weak GDP number, reasoning that it was only a temporary lull due to decreasing inventories after a second-quarter jump.

"The dramatic drop in growth does not actually represent weakness in the real economy, but it is a result of a short-term and healthy adjustment by businesses in the inventories they hold," McMillan said in a note. "Consumers continue to grow their spending, as does the government, and business is growing spending outside of inventories."

The selectivity of that analysis is classic Wall Street, ignoring how the inventory overbuild helped inflate the second quarter's growth of 3.9 percent and focusing instead on how it deflated the third quarter's numbers.

McMillan nonetheless explains succinctly the attitude among investors coming out of a huge month for the stock market.

"Although we may have another quarter of inventory-related adjustments, the underlying growth fundamentals remain intact," he said. "This is just one more worrying headline that, when you dig into it, is reasonable and nothing to worry about. Remain calm and carry on."

This article originally appeared on CNBC. Read more from CNBC:

The perils of Paul Singer's cash for Marco Rubio 

Losing value: Why value stocks are badly lagging

Facebook could soon join a very elite club

TOP READS FROM THE FISCAL TIMES