BoA/Merrill Lynch's Ethan Harris: Be Cautious in July

Includes: AGG, DIA, QQQ, SPY
by: Harlan Levy

Economist and author Ethan Harris is managing director and head of North America economics at Bank of America Merrill Lynch (NYSE:BAC). 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.

Harlan Levy: How worried are you about the debt crisis in Europe spreading globally and infecting the U.S. economy?

E.H.: Our best guess is that the debt crisis will abate a bit in the coming weeks. That should create an intermission in the unfolding Greek tragedy and ease some of the pressure in financial markets.

However, there's a third act in this tragedy and that is that Greece still faces major fiscal challenges and an eventual Greek default remains a significant risk. So we think the immediate crisis will fade, but longer term risks remain.

H.L.: If Greece does settle down do you see additional problems?

E.H.: The Greek crisis is just one in a series of modest shocks to the global economy and global markets. We are just now seeing the oil shock fade a bit. We hope that the Greek shock will also fade in the coming weeks.

However, we expect investor concerns to focus on the debt ceiling debate and it's important to recognize that there's a significant risk of a bad outcome from that debate.

We see two risks: One is that politicians agree to disagree. They fail to raise the debt ceiling and this causes a dramatic cut in government spending and a technical default on U.S. Treasury debt. That in turn will probably provoke a sell-off in the markets and that in turn would finally force action to raise the debt ceiling. So one risk is that the politicians do nothing and wait for the markets to force their hands.

The second risk is that policymakers do too much and agree to a large upfront cut in government spending. In our view the economy is too weak to handle an immediate cut in spending. We need an austerity plan that is phased in gradually but steadily over time.

Our forecast and hope is that common sense prevails and we get a modest deficit reduction plan and an extension of the debt ceiling at the very last minute. But over the course of July, we expect the market to become increasingly concerned about the lack of action in Washington. So don't be overweight in the markets. Be cautious.

H.L.: If the debt ceiling issue is resolved in a sensible manner, what do you expect?

E.H.: Absent shocks, the economy should improve modestly in the second half of the year. With some easing in gasoline prices, consumers should be in a little bit better mood. With recovery in Japan, auto and electronics producers would be better able to maintain production. And assuming that Europe does offer Greece another bailout package, the Greek crisis should ease back a bit.

Absent a serious fiscal mistake, growth should rebound back to about 3 percent in the second half of the year and into 2012, but we remain vulnerable to any kind of negative news.

H.L.: What do you think of the stock market's bipolar actions and what do you advise?

E.H.: I think the stock market is justified in its negative response to recent events. The economy has slowed significantly and there is considerable uncertainty about the economy in the coming months. This suggests that investors should take a cautious attitude until these uncertainties diminish. Most important, investors should watch developments in Washington. If Congress converges toward a sensible compromise, that should reinvigorate the stock market.

On the other hand, policy mistakes in Washington could prolong both the weakness in the economy and the weakness in financial markets.

H.L.: Do you see the jobs picture in the U.S. improving any time soon and how much of an influence on the economy is it?

E.H.: The jobs picture is very much hostage to these shocking developments. If we can get growth back to 3 percent we should be able to see healthy job gains of 150,000 to 200,000 per month, but if shocks continue to hold growth down to 2 percent, then job growth will remain below 100,000 per month.

These two scenarios are very different: solid job growth heals the other wounded sectors of the economy. It helps the housing market. It helps state and local finances and it helps the banking system.

By contrast, anemic job growth leaves festering wounds in these areas of the economy. So, yes, getting solid job growth is essential to a healthy recovery in the economy.

H.L.: In the housing market, foreclosure notices are declining, but the number of unsold foreclosed properties increased in April and May. In light of that, how do you see the housing market and its effects on the economy?

E.H.: There is a tremendous amount of excess inventory in the housing market. We believe it will take another two years to clear that excess inventory. Over the next two years, we expect a modest decline in bad loans, so once that inventory of homes is sold into the market, we think there will be a smaller new set of homes coming into the market for sale. That suggests that there's another two years of tough times in housing, but there is a faint light at the end of the tunnel.

As I noted before, some recovery in the jobs market is essential to working through this excess housing inventory.

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