There are seemingly two stories going on in the US economy right now.
On the one hand, financial markets have had a stressful few months and suggest an economy on the verge of recession.
On the other hand, the real economy is still showing solid, albeit slow, growth with few signs activity is about to completely roll over.
And eventually, one of these divergent themes will win out, according to Barclays economist Michael Gapen.
“In particular, US data will need to firm enough to substantially reduce fears that the economy is on the brink of recession,” wrote Gapen in a note to clients.
“We stand by our original thesis: something’s got to give. The longer financial market uncertainty persists, the more likely it is that the give will come from activity.”
Gapen’s thinking goes like this: the market’s sentiment is so bad — signalling a 70% risk of a recession — that eventually it will spill over into consumer and business behaviour if economic data does not show a clear pick-up in growth.
This concern is particularly worrying as recent data has been mixed.
“Economic fundamentals point to an ongoing, albeit moderate, expansion in activity even as financial market stress remains high; the risk that market uncertainty spills over to activity data remains elevated,” wrote Gapen. “In addition, although we read the incoming data as solid overall, the deterioration in import growth, the softness in consumption growth, and decidedly mixed housing data at year-end were concerning.”
The worry then becomes that if data continues to be mixed, the market’s narrative will win out, changing the future economic outcomes it was merely anticipating in the past.
As Business Insider’s Myles Udland noted Sunday, Torsten Sløk, chief international economist at Deutsche Bank, laid the same problem out as the “Fed story” and “market story”.
The market is viewing the current economic state as glass half-empty, while Fed (and by implication Gapen’s “real economy”) is seeing it as glass half-full. Here’s Sløk’s breakdown:
“The Fed story is that by keeping rates at zero for seven years, the Fed has created a robust recovery and we have now gotten to a point where unemployment is 4.9% and there are clear signs of an uptrend in consumer prices and wages… If the market tightens financial conditions faster than expected the Fed will simply decide to be more gradual.
The market story, on the other hand, is that by keeping rates at zero for seven years the Fed has inflated asset prices to levels that are inconsistent with expected future cash flows. As a result, investors who bought risk assets over the past seven years will sell equities and credit when interest rates go higher because companies will not be able to deliver enough earnings growth going forward. According to this view, the Fed will not be able to raise interest rates because higher short rates will be associated with much lower equities and much wider credit spreads, and a higher dollar, which taken together will push the US economy back into a recession…”
For his part, Sløk believes that the Fed story of a strong underlying economy will win out and the market will eventually come around.
“Combined with an upward revision to 2015 Q4 GDP, solid credit growth and solid job creation and solid wage increases it continues to be the case there there is simply no evidence in the data that the US economy is about to slow down dramatically, let alone enter a recession,” he concluded.
Gapen’s view generally agrees with this assessment, but merely adds the caveat that if data does not firm and market sentiment remains as depressed as it is, the market could drag the rest of the economy with it.
“With financial conditions an ever-stronger headwind to growth, we will remain attentive to any signs that elevated uncertainty is weighing adversely on US activity,” wrote Gapen.
Basically, the real economy usually wins out, but totally ignoring the market’s concerns is unwise.