California Controller's CEA Chief Economist, Lynn Reaser: Stocks To Correct 10% In 3 Months, Q3 GDP Up 3%

by: Harlan Levy


10% stock market correction likely in next 3 months, but it won't be worrisome.

Q3 GDP up 3%, 2015 slightly under 3%, interest rates up mid-'15.

Strong U.S. sectors: autos, energy exploration and development, and tech. Weak: consumer non-discretionary, retail, agriculture.

Lynn Reaser is Chief Economist for the California State Controller's Council of Economic Advisors. Previously, she was managing director and chief economist for the Investment Strategies Group at Bank of America.

Harlan Levy: Is the economy really gaining strength, looking at the July jobs report - the sixth month in a row of more than 200,000 new jobs, the four-week average of initial unemployment claims going down, the labor participation rate rising to 62.9 percent from 62.8, second-quarter Gross Domestic Product up 4 percent and consumer confidence sharply up?

Lynn Reaser: The economy does appear to have gained significant strength over the past few months. Part of this reflects the substantial bounceback from the harsh winter and the rebuilding of inventory. The economy rarely moves in a straight line, and as a result, it is too early to declare that we have, in fact, moved to a much stronger growth track.

GDP growth is likely to still be quite strong in the third quarter, at about 3 percent. Next year, it is likely to be slightly below 3 percent, as opposed to closer to 4 percent, as we saw in the second quarter.

Q: Has the good economic data caused investors to worry that the Federal Reserve will raise interest rates sooner than later, in spite of the Fed saying the labor market still has slack?

A: The recent strength in the economy is causing a problem in the market. The jump in consumer confidence in the second quarter, the increase in the employment index in the second quarter jolted financial markets on Thursday with the fear that the Fed could tighten earlier than the middle of next year.

Some Fed members generally believe that there's considerable slack in the labor markets, but that view is not unanimous, and recent wage data has been somewhat conflicting.

The question also persists as to whether the job market's slack may primarily be related to long-term unemployed people who may not have the skill sets to find jobs. The Federal Reserve may be able to do little to help these individuals.

Q: When do you think the Fed will raise rates?

A: The most likely time that the Fed will raise rates at this point is the middle of 2015, but the risk is that they will be led to raise rates sooner, should inflation begin to move higher.

Q: Is more-than-expected inflation in the cards, and what would that do to the economy?

A: I think there's a risk that inflation will be moving higher, not immediately, but over the next three to four years. Then interest rates would definitely move higher, which would particularly affect housing, which has been on a relatively sluggish recovery track in the past year.

Q: What do you glean from the latest housing data?

A: The latest housing data has been mixed. We are seeing some slowing in price appreciation. First-time buyers are still not a factor in the market because of student debt burdens and problems in accessing credit. The housing market is not providing the boost in economic activity at this point in the economic cycle. This is particularly concerning, given the fact that interest rates are relatively low and expected to go higher.

Q: In light of last week's sharp stock market drop, do you expect a 10 percent correction in the near term, and would that worry you?

A: I think a 10 percent correction could very well happen in the next three months, but it would not be truly worrisome, given the sharp run-up in stock prices to high levels at this point. A correction is likely, because markets are torn between, on the one hand, an economy that would be sluggish and limit profit growth and, on the other, a stronger economy that would cause a Federal Reserve rate hike.

Q: What do you think of the earnings reports so far?

A: Earnings reports have been mediocre. They have not been stellar, but they have been satisfactory. They clearly reflect domestically the improvement in the economy, with companies with greater overseas exposure having suffered with the more muted growth rates in countries abroad.

Q: What sectors of the economy look strong, and which ones look weak now?

A: The auto sector remains very strong, as are companies such as steel that are feeding that sector. Second, energy exploration and development companies remain very robust, although the sector badly needs to export oil and natural gas overseas. The third good one is technology. Innovation remains extremely vibrant, as witnessed in Silicon Valley in California, with Tesla, Google and other firms.

Weak sectors are many of the consumer non-discretionary companies, manufacturers of cereal and soft drinks. They are facing relatively soft U.S. demand, as well as weaker sales from abroad. A second weak sector is retail, where retailers continue to battle the inroads of e-commerce. Third, agriculture, like corn, is experiencing a significant drop due to the increase in supply.

Q: How much of an impact on the U.S. economy do you see from what's happening in Europe, Ukraine, and Israel and Gaza?

A: International events remain a significant threat to the U.S. economy and even a greater threat to financial markets. The Middle East remains a particular concern because of developments in Israel, Gaza, Syria, Iraq and Iran. Meanwhile Russia remains a wild card, with sanctions amplified. China also remains active in the Far East, and North Korea is totally unpredictable. The direct impact on U.S. economic activity could be muted for a while, but financial markets are worried about the potential impact, including oil prices going forward. Investors are already nervous about the high level of stock prices, and one international spark could cause a sell-off.

Q: How debilitating is what seems to be a permanent standoff between Republicans and Democrats in the paralyzed Congress?

A: Congress has been accomplishing nothing. This means that we will likely have a continuing resolution rather than a budget when the new fiscal year begins Oct. 1. There are only two months left, and the Senate has not approved one appropriations bill.

Second, there are issues crying for action, including addressing the problem of foreign children crossing the border into the United States, the overhaul of immigration laws and a major reform of corporate tax law. Infrastructure also needs to be addressed.

This causes companies and corporations to leave their cash overseas, rather than deploying it domestically. The lack of a budget causes havoc for companies depending on government contracts, and the lack of action on Capitol Hill only aggravates business uncertainty.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.