Jubak's Journal
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Get ready for a nice growth surprise
A smaller trade deficit will push the first-quarter growth rate higher than first estimated. But will the surprise be big enough to calm worried investors?
By Jim Jubak
I interrupt today's regularly scheduled gloom and doom with this message: It looks like everything is falling into place for a growth surprise on May 26.
And that would mean that stocks, which interrupted the rally that began on April 20 by tumbling more than 100 points twice last week, are now buys on weakness.
I know it doesn't feel that way right now. In fact, the news recently has just seemed to go from bad to worse.
Escalating worries
It all started on April 28, when the U.S. Department of Commerce issued its advance first-quarter report. It showed economic growth in the first quarter dropping to 3.1% from 3.8% in the fourth quarter of 2004 and 4% in the third quarter.
Suddenly, nagging concerns that the economy might be slowing -- fueled by a weaker-than-expected April retail sales report -- became full-scale anxieties. Retail sales climbed just 0.3% in March, well below the 0.8% consensus expectation and behind Februarys 0.5% rate.
Those worries were compounded this month when Standard & Poor's downgraded the debt of General Motors (GM, news, msgs) and Ford Motor (F, news, msgs) to junk-bond status. Wall Street analysts, noting the two car companies had $500 billion in debt out there, immediately began to wonder who was holding the bag.
Once again, Standard & Poor's pointed the way with credit downgrades on two complex types of derivatives known as collateralized-debt obligations, or CDOs, and credit-default swaps. Both are products designed to provide insurance to a bondholder against a potential corporate default. On May 10, Standard & Poor's lowered its credit ratings on about $80 million in CDOs sold by Deutsche Bank (DB, news, msgs). The next day, Standard & Poor's downgraded more CDOs arranged by BNP Paribas (BNPQY, news, msgs). In addition to receiving a fee for managing the transactions, banks often keep a portion of some of the riskier pieces of each derivative, which also carry the highest yields, for their own portfolios.
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Nobody was saying it out loud, but quietly traders worried that a financial institution had kept too much of a derivative that went sour. A big enough bet could put an entire, seemingly sound, company at risk of a default on its derivative contracts that would ripple through the financial markets.
And Wall Street knew that there was enough evidence coming in from hedge funds, some of the biggest purchasers of derivatives, to show that some players in the market were taking large and unexpected losses. A few European hedge funds had been telling investors that they'd taken losses of as much as 5% on some of their funds in April, and the fear was that May would bring even worse news. Feeding the fear was the knowledge that some derivative products weren't performing as designed. Instead of providing insurance, they were actually adding to the losses suffered by investors.
A vicious cycle
Fears like these feed on themselves. In the financial markets, fearful investors decide to sell ahead of the bad news they expect -- and that creates exactly the selling and lower prices they anticipated. This, of course, generates more selling.
That kind of negative feedback even works with economic forecasts. A month ago, the 56 economists surveyed regularly by The Wall Street Journal were projecting 3.7% growth for the second quarter of 2005. The economists have grown much, much more pessimistic and are now projecting 3.2% growth. That's a big 14% drop in the projected growth rate. Is it the result of new data that shows the economy is slowing or just a reflection of the pessimism that grips the financial markets right now?
I'd argue the latter -- that the economists' pessimism is more a reflection of where we are than a projection based on new data for the future.
And I'd argue the data started to turn for the better May 12, the very day that the Journal published the economist's downgrade of the U.S. economy.
Good news is out there
Also on that day, the Commerce Department reported stronger-than-expected retail sales for April, which followed a soft March number. Retail sales climbed 1.4% in April, almost double the 0.7% growth rate expected by economists on and off Wall Street.
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