Interview With Ethan Harris: Tax Hikes And Spending Cuts Guarantee Weak First Half

Includes: DIA, QQQ, SPY
by: Harlan Levy

Economist Ethan Harris is managing director and co-head of global 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 make of the January job gain number, the revised number for December, and the jobless rate going up to 7.9 percent from 7.8?

Ethan Harris: This was a very mixed employment report. The good news is very solid gains in jobs in the fourth quarter of last year and on only a modest slowing in January.

The bad news is that in spite of the job gains the employment rate actually ticked up a tenth of a percent. The unemployment rate has been essentially flat, just under 8 percent, for six months now. So, despite the job gains, unemployment remains disturbingly high. Clearly we need a much stronger job market to bring full healing to the economy.

H.L.: So how do we get that?

E.H.: The main thing missing from the economy right now is business confidence. In recent years the corporate sector has been very reluctant to hire and invest because of repeated shocks. The crisis in Europe and the U.S. fiscal cliff are two of the more dramatic examples of these confidence shocks.

Our hope is that by later this year, as the fiscal cliff recedes in memory, the corporate sector will start to feel a bit better and start to expand its workforce. But that will require a period of confidence-building, and before we get there we first have to face the challenges of tighter fiscal policy in Washington.

The combination of $200 billion in tax increases and major spending cuts almost guarantees a weak first half. So any kind of sustained strength in the job market will have to come only after adjusting to this fiscal shock.

H.L.: How do you think Congress will deal with the fiscal challenges ahead: the spending sequester that kicks in March 1 ($1.2 trillion in cuts to defense and domestic spending), the challenge of passing a continuing spending authorization by March 27, and then the issue of raising the debt ceiling by May 19?

E.H.: Congress has given itself a set of remarkably high hurdles to leap over in the next few months.

We think that Republican leaders have decided to focus on the sequester as the main battleground. We believe that the Republican leadership has decided that the debt ceiling is too dangerous a mechanism for forcing cuts. Violating the debt ceiling would mean a shutdown of the government and a downgrade in the U.S. credit rating. Their concern would be that they would take the blame if this were to happen.

We think the focus will be implementing the sequester. On March 1, absent new legislation, there will be roughly $110 billion in spending cuts spread over the next 12 months. This is probably the best opportunity, from a Republican perspective, to rebalance the deficit reduction in favor of spending cuts rather than tax increases. So we expect most or all the sequester cuts to happen.

The good news is that this will further progress in reducing the U.S. budget deficit. The bad news is that on top of the tax increases already enacted, this will create further downward pressure on growth. We expect GDP growth in the second quarter of just 1 percent.

H.L.: What does the fourth-quarter Gross Domestic Product number tell you about the economy?

E.H.: Despite the very weak GDP report, the U.S. economy ended 2012 with steady, moderate growth. The GDP report showed a one tenth of a percent drop in activity in the fourth quarter, but most of this weakness was in the more erratic components of the report. The parts of the report that we focus on - consumer spending, business investment, and construction - were all healthy. So we view this report as unusually distorted and believe the true trend in the economy at year end was 2 to 2.5 percent growth.

Last year ended on a reasonably healthy note, but now we have to face the major fiscal challenges of the new year.

H.L.: How is the housing market?

E.H.: The housing market is still quite positive. The housing market is steadily gathering momentum, with inventories of homes for sale falling, with less distressed properties being dumped into the market, and with price increases in most regions.

We expect the housing market to weather the fiscal storm in the coming months and continue to grow but at a somewhat diminished pace. Looking further ahead, we expect a full recovery in the housing market by 2015. That would mean a return to normal levels of construction activity and a reversal of about half of the price decline during the crisis.

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

E.H.: The stock market has had a great start for the year, reflecting continued healthy earnings and continuing healthy economic data. The market is also benefiting from reduced tail risks. The risk of a break-up of the euro zone has dropped dramatically, and we believe that the risk that the U.S. debt ceiling will be violated has also dropped.

However, we wouldn't be surprised if there's a pause in the stock market rally in the next several months, as the markets absorb weaker economic statistics. So our longer-term outlook for the stock market remains positive, but in the near term we're positive.

Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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