Despite Fear: Economy Still Strong

With all the turmoil and volatility in financial markets,
we understand investor unease. However, because the
Fed is not tight (and never was), tax rates remain low (and
are protected by the threat of veto), trade protectionism is
more bark than bite, technology continues to proliferate,
and productivity remains robust, we do not foresee any
serious economic slowdown.

Yes, the housing market is down sharply, and yes
credit markets are in turmoil, but these problems are
localized. Exports are booming, real GDP grew 3.9% in
the third quarter, and the labor market remains stout.
Moreover, since the GDP report was released last
Wednesday, new data on construction, shipments of
capital goods and inventories point to an upward revision
to above 4%. Meanwhile, October ISM reports show
continued expansion in both manufacturing and nonmanufacturing
sectors of the economy.

Unfortunately, investors have become so pessimistic,
strong economic data is virtually ignored. For them, the
goal-posts have been moved. Many suggest that since the
credit crunch did not start until August the strong third
quarter growth rate was a mirage. Just wait until data for
the fourth quarter starts to roll in and clear signs of a
slowdown become obvious, they say.

But there is a problem with this line of thought. All of
this was well known months ago and most forecasters still
underestimated the strength of the economy. The same is
true for third quarter earnings of S&P 500 companies,
with upside surprises still running at the same 65-70%
level they have had for many years now.
What appears to be happening is that just like recent
periods of economic stress, the fundamentals of this huge

economy remain intact. And as long as they do, the US
economy will remain resilient. Some early data already
suggest that this is the case.

The most important piece of data so far for the fourth
quarter arrived on Friday and it was excellent news.
Payrolls expanded by 166,000 in October and the number
of hours worked in the private sector hit a new record
high. Meanwhile, although October vehicle sales were
down from September, they were still above expectations.
True, housing will remain a drag on real economic
growth. But home building’s share of GDP has already
shrunk roughly 30%, meaning that sector’s weakness has
less of an impact on the overall economy. Moreover, the
trade deficit is shrinking rapidly as exports boom.

Exports are taking up the slack of a housing slump.
The disparity between the conventional wisdom and
actual economic performance continues to resemble what
happened after both the 1987 stock market crash and the
1998 credit market freeze. On both occasions, pessimism
about the economy was palpable. Yet, real GDP actually
accelerated. It grew 3.2% in the year before the 1987
crash and 4.1% in the year after. For the so-called
“seizing-up” of financial markets in 1998, the economy
grew 3.7% in the year before, and 4.4% in the year after.
On both occasions, faster than expected economic
growth forced the Federal Reserve to retract its
emergency interest rate cuts and eventually move rates
higher than when the financial market turmoil began.

We expect this time to be no different. With strong economic
growth through at least 2008 will come higher interest