Stocks, Economy Feel a December Chill

A series of disappointing data releases sent major indexes lower this week. Is the "soft landing" in jeopardy?

An ongoing debate over the U.S. economic outlook may have just gotten a little clearer (see, 11/30/06, "The Economy: Not Looking Like Christmas"). On one side, Federal Reserve policymakers have continued to express more concern about inflation than a slowing economy, maintaining a bias toward further interest-rate hikes. In the opposite camp, many economists have been predicting rate cuts as early as the first quarter of 2007.

Score one for the rate-cut crowd. In the week ended Dec. 1, a post-Thanksgiving harvest of economic data seemed to contradict the Fed's upbeat talk (see, 12/1/06, "A Downbeat End to November's Data"). Third-quarter economic growth was revised upward, but reports on manufacturing activity, construction spending, jobless claims, and consumer confidence all missed analyst expectations. As of early Dec. 1, futures markets were pricing in an 80% chance of a rate cut by Mar. 21, 2007, with 100% odds of a cut by the end of the second quarter.

"Although the Fed's Beige Book was upbeat, the data were not," says David Wyss, chief economist at S&P. "In particular, weak retail sales and a drop in consumer confidence in November create worries about the consumer; home sales and prices are dropping; and the manufacturing sector appears to be retreating for the first time in over three years."

From Drag to Stall?

For investors, the disappointing economic readings raised new questions about the so-called "Goldilocks" environment. Some analysts say such weakness is to be expected as the economy glides into a "soft landing" scenario and the Fed gradually warms to the idea of rate cuts. Others say the markets will have to withstand some even gloomier numbers first.

Either way, the downbeat data put a lid on Wall Street's recent rally. On Dec. 1 the Dow Jones industrial average and Standard & Poor's 500-stock index each limped to their second straight weekly loss. The tech-heavy Nasdaq composite posted its worst session since July.

An end-of-week economic double whammy spurred much of the decline. On Dec. 1 the Institute for Supply Management's (ISM) manufacturing index sank to 49.5 in November, well below an expected 51.5 reading. October construction spending fell 1%, vs. an anticipated 0.2% dip. "It appears that housing and autos are having a more significant drag impact on the economy at the start of the fourth quarter than we expected," says John Ryding, chief U.S. economist at Bear Stearns, in a note to clients.

Fed Pushes Inflation Concerns

For its part, the Fed kept up a positive tone. On Nov. 28, Fed Chairman Ben Bernanke reiterated the central bank's tightening bias (see, 11/28/06, "Questions for the Fed Chairman").

After the weak ISM report, other officials stuck to the Fed chief's ground. "Inflation is higher than I'd like it to be," Philadelphia Fed President Charles Plosser said on Dec. 1. The same day, Chicago Fed President Michael Moskow said additional rate hikes may be necessary.

However, the weak economic numbers suggest the Fed won't be able to act on its tough inflation talk, analysts say. "This basically takes the whole Goldilocks scenario and throws it out the window," says Barry Ritholtz, chief market strategist at Ritholtz Research & Analytics. "People seem to forget that a soft landing is very unusual."

The Importance of Employment

Ultimately, it may take a downturn in the employment picture to shift the Fed's stance, others say. "Where the weakness has to come in is in the jobs picture," says Joe Balestrino, fixed income market strategist at Federated Investors. "That's what's holding it all together."

In the week ended Nov. 25, initial jobless claims posted their biggest rise in more than a year. On Dec. 8 investors will receive a monthly report on the labor market. Nonfarm payrolls are expected to rise 100,000 in November, up from 92,000 in October, says Action Economics.

Still, some market watchers say the downside ISM surprise isn't as dismal as investors might fear. "Historically, the ISM has dropped below 50 three to six months after the end of the Fed's midcycle series of rate hikes," says Jeff Kleintop, chief investment strategist at PNC Wealth Management. "It is part of the regular midcycle soft landing pattern of economic activity." Stocks have performed well during this phase in previous cycles, Kleintop notes.

How Long Will the Bull Run?

Investors also have seasonal factors in their favor. Since 1945 the S&P 500 index has posted an average November-December gain of 4.5% on the 10 previous occasions when the benchmark advanced in the tricky months of August, September, and October. "Even though past performance is no guarantee of future results, any end-of-year rally is not a bad gift for an aging bull market that recently celebrated its fourth birthday," says Sam Stovall, chief investment strategist for S&P Equity Research, in a report.

Eventually, the Fed's interest-rate outlook and the market's expectations will come into alignment, analysts agree. More weeks like this one could bring that date closer—for better or for worse.

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