Interview With Merrill Lynch's Ethan Harris: Middle East Is the Top Economic Concern

by: Harlan Levy

Economist and author Ethan Harris is managing director and head of North America economics at Bank of America Merrill Lynch. Previously he worked at Lehman Brothers, where he was chief U.S. economist since 2003. Before that he worked at the Federal Reserve Bank of New York.

H.L.: Unrest in the Middle East, the situation in Japan, and sovereign downgrades in the European euro countries: Have they receded in importance to the global economy?

E.H.: I think we’re still in the middle of a big risk flare in terms of shocks to the global economy. My guess at this stage is that the Japan crisis will settle down over the next couple of months and will have a relatively moderate impact on the global economy and global markets.

I’m much more concerned about the Middle East. We’ve already had one major oil producer go offline – Libya -- and if we were to have a second producer go offline, oil prices could rise to $150 per barrel or higher. History shows that oil price spikes play a significant role in many recessions. So this is a risk that investors need to pay very close attention to.

When you get into the $150 to $200 range for oil prices you begin to worry about recession. The economy is particularly vulnerable when energy prices hit new record levels, because not only does that divert income from other spending, but it can have a psychological sticker shock effect. The bottom line from an investor perspective is that some caution is warranted until we get better clarity on events in the Middle East.

H.L.: What do you see happening in June when the Federal Reserve finishes its $600 billion quantitative easing Treasury bond purchases?

E.H.: I think it will take a very big change in the economic picture to change the course of the Fed. They’re very likely to complete the buying program and will only initiate a new buying program if the economy weakens substantially. As long as the unemployment rate inches lower, the Fed is likely to sit and watch the economy evolve.

I believe the end of the Fed buying program will only have a very small impact on the markets. It’s already been broadly advertised that the Fed will end its program in June, and I think the markets can survive on their own without the constant infusion of cash from the Fed.

H.L.: Is the stock market still ignoring the states and cities’ drastic fiscal problems, or are they not so much of a threat?

E.H.: The state and local crisis is an important drag on the economy. I think we’re going to face another two years of tightening belts, layoffs, and tax and fee increases, but I don’t think the crisis will escalate into serious defaults by state and local governments. So, it will be a restraint on growth but unlikely to stop the economic recovery.

In terms of ranking the risks in the world economy today, the events in the Middle East are No. 1, and problems on the periphery of Europe and in U.S. local governments are much less important.

H.L.: Is a major correction ahead for the U.S. stock market?

E.H.: At this stage we are in a correction, and I think the markets are correctly pricing in increased risk, and however far the correction goes, the backdrop for the stock market is still healthy. Absent a very bad turn of events in the Middle East, the economic recovery should continue. The U.S. corporate sector remains in very good health, and U.S. companies continue to benefit from exposure to the stronger growing parts of the world such as the emerging markets. So in a medium-term sense, I remain optimistic about the U.S. stock market.

H.L.: Are there sectors of the market that deserve investment now?

E.H.: From a broad economic perspective there are a few key themes for the markets: First, I’m skeptical about the consumer sector. Consumers are still licking the wounds of the housing and stock market decline. They still have a long way to go in restoring their wealth, and they face considerable uncertainty about future taxes and future entitlement payments. So I would expect consumers to remain in a very conservative mode and spending to lag behind the rest of the economy.

By contrast, I’m more optimistic about companies that have exposure to global trade and to capital investment. The global economy is in better health than the U.S. economy, and export growth should remain robust. Similarly, with corporate balance sheets in much better shape than household balance sheets, corporations should be more willing to spend than households. That implies solid growth in capital spending. Companies need to make up for lost time following the long period of under-investment in their productive capacity. So, I remain optimistic about the exporters and capital spending -– the sensitive parts of the economy –- and cautionary about the consumer side of the economy.

H.L.: Where is the economy headed this year?

E.H.: I’m looking for a little under 3 percent growth for the economy, with a very small drop in the unemployment rate, and while I expect overall inflation to pick up to about 3 percent, excluding food and energy prices, I’m looking for only 1.2 percent inflation.

There will continue to be a period of high pressure from food and energy but moderate inflation in other parts of the economy.

H.L.: How do you see the jobs and housing situations to develop?

E.H.: I expect a moderate pick-up in the job market, as corporations slowly re-engage. During the crisis, companies cut some of their lean as well as their fat, so we think they will want to bring back some of the over-fired labor force.

I’m much more pessimistic about the housing market. We would expect continued high foreclosures and some slight downward pressure on prices. We don’t expect the sustained recovery in the housing market until 2013.

H.L.: How do you think Congress will end up dealing with our fiscal mess, and what do you think will be the effect?

E.H.: Unfortunately, politicians in Washington are now arguing over nickels and dimes when it comes to the budget deficit. The deficit is $1.5 trillion, but the debate is about cutting somewhere between 10 and 60 billion. Moreover, all the big programs are off the table. All taxes, entitlement spending , and military spending are all off limits in the current debate. This means that serious attempts to address the deficit are a long way away.

In the coming months, I expect modest cuts in the range of $20 billion to $30 billion. The good news is that will have very little impact on the economy. The bad news is that it will have very little impact on improving the budget deficit. My hope is that following the next presidential election, the two parties will find a way to work together and start serious deficit reduction. I’m keeping my fingers crossed.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.