Interview With Ethan Harris: GDP Growth About 1% Next 4 Quarters

Includes: IVV, SPY
by: Harlan Levy

Economist 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.

Harlan Levy: What do you see ahead for the efforts to solve the euro zone countries' sovereign debt problems and the effect on the global and U.S. economies?

Ethan Harris: Unfortunately, the Eurozone crisis is far from over. The pattern in Europe has been for policy makers to wait until the crisis is acute and then do just enough to calm the markets, but not solve the crisis. We expect this pattern to continue, resulting in a series of shocks to confidence and an ongoing recession. Europe is causing significant collateral damage to the US and global economy through trade, banking and confidence effects. This will continue in the year ahead.

H.L.: How much of an effect on stocks and the economy at this point is our divided Congress's refusal to deal with the looming fiscal cliff -- the automatic $1.2 trillion year-end defense and social program budget cuts and the end of the Bush tax cuts?

E.H.: What we are seeing in Washington is a failure of governance. Rather than compromise, the two parties have delayed almost every tough decision to right after the election. The resulting fiscal cliff is massive: $200 billion in spending cuts and $500 billion in tax increases that all kick in if the two parties can't compromise and pass new legislation by year-end. The fiscal cliff creates two kinds of uncertainty: macro uncertainty because it threatens a recession next year and micro uncertainty because with changes in so many tax rates and spending programs it is very difficult to plan for next year. So far the fiscal cliff is a relatively small factor constraining growth and the markets. However, as the cliff approaches we expect businesses and households to start postponing big spending commitments, waiting for clarity around the cliff. When you are driving toward a cliff in a thick fog of uncertainty you slow down. We expect very weak growth in the second half and a shaky stock market.

H.L.: If we go over the fiscal cliff due to Congress's failure to do anything, what would that do to our economy?

E.H.: If all the tax increases and spending cuts go through and are maintained for more than a couple months the economy will likely tumble into a full blown recession. However, we expect pressure from the markets and the economy to act as a wake up call, forcing compromise in Washington. Thus, ultimately some of the cliff will be averted, avoiding the worst case scenario.

H.L.: What kind of growth in the U.S. economy do you expect this year and next year in light of poor job growth and a stagnant housing market?

E.H.: We expect GDP growth of about one percent in the next four quarters as the fiscal crisis in Europe and the US damages confidence. The housing market has shown some signs of life in recent months, and absent the fiscal cliff, a real recovery could emerge. However, we think the cliff could cause a partial reversal in this recovery. If politicians had adopted a sensible 10 year plan for deficit reduction, the economy would probably be picking up speed as many of the wounds of the financial crisis are starting to heal. However, the improvement in the private economy is being overwhelmed by policy dysfunction in Washington.

H.L.: What's ahead for jobs?

E.H.: As with the economy as a whole, the job market is likely to stall in front of the cliff, with very weak payroll gains and an uptick in the unemployment rate. We expect a number of companies to put hiring plans on hold as they wait for clarity around the cliff.

H.L.: What do you see ahead for the stock market?

E.H.: Absent the fiscal crises, the stock market would likely grind higher. Corporations are in excellent health and the market is conservatively valued. However, the stock market hates uncertainty. Potentially dramatic changes in tax policy will make it very hard to plan portfolios and the risk of a recession will likely cause risk aversion in the markets in general. In the near term the market is being supported by hopes of further easing by the Fed, but the Fed can only partly offset the damage to growth from the cliff. We expect a weak market in the run-up to the cliff and until it is resolved.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in AAPL over the next 72 hours.