The Economy Looks Good

Although some investors appear puzzled about the current state of the U.S. economy, S&P sees sustainable growth ahead

By Joseph Lisanti

Is the economy's glass half full or half empty? Or perhaps we should ask if it is too full? In any event, questions about the state of the economy have led to increased stock volatility in recent days.

The market is unable to decide if the third-quarter spurt in gross domestic product should be considered a harbinger of more to come, or if it was a flash in the pan. If it is an indication that the economy is strengthening, should we worry that the Federal Reserve will have to raise rates to cool any incipient inflation? On the other hand, if the economy isn't going into high gear, are stocks too pricey?

We doubt that the Fed will raise rates soon. Although the producer price index surged 0.8% in October, S&P chief economist David Wyss notes that much of the rise was the result of unusual circumstances in auto pricing that are unlikely to be repeated. Underlying inflation remains subdued, with the core consumer price index up only 1.3% from a year ago.

The recovery appears on track. Industrial production is up and consumer sentiment has improved, but investors are worried because sales at the mall declined for the second straight month. The retail sales numbers should not be a surprise, says Wyss. Consumers spent their tax rebate checks this year, but because there was no sharp decline in their spending during the last recession (thanks to low interest rates and mortgage refinancings), there is no pent-up demand now.

We continue to believe that the slowly improving labor market is likely to provide a solid underpinning to consumer spending. Wyss expects consumption to increase about 4% overall in 2004.

Nevertheless, the best news about the economy is behind us. The third-quarter spurt in gross domestic product can't be sustained. That doesn't mean that the economy is tanking, just that it's returning to a sustainable level of growth -- a plus for stocks.

Lisanti is editor of Standard & Poor's weekly investing newsletter, The Outlook

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