Economy Eases Back From the Brink for Now

"While still fragile, sentiment has stepped back from the edge of the abyss — the potential of financial collapse and a hard-landing of the economy," wrote Liz Ann Sonders, chief market strategist at Charles Schwab, in a May 23 commentary. "The $168 billion stimulus package is likely playing its part in the short term, and the Fed's rate cuts will increasingly work their way through the economy. Even former Fed Chairman Alan Greenspan's characterization of the economy has improved from being in the 'throes of recession' in early April to an 'awfully pale recession' just last week."

Avoiding the worst isn't a triumph. Consider the 1.7% drop for the S&P 500 stock index in May as proof. Still, the prognosticators who pegged this recession as short and shallow are seeing some evidence to support their views, thanks to a mix of federal policy moves and continued strong global sales that have propped up U.S. company earnings.

Strategist Thomas J. Lee, at J.P Morgan, wrote May 12 that key data points, including an Institute for Supply Management Survey and a reduction in jobless claims, were healthy signs, relatively speaking.

"Our base case remains for the U.S. to exit the short recession sometime this summer, and recent economic data is slightly better than this, namely the stronger nonmanufacturing ISM reading and [lower] jobless claims suggest a stabilizing economy," he wrote. "Moreover, we believe investors will revisit the 'underperformers' as they anticipate a cyclical recovery, positive for financials and discretionary [sectors]."

That's not to say there's nothing ahead but blue skies and clear sailing. Ed Yardeni, president of Yardeni Research and a consistently upbeat voice amidst earlier fears of a severe recession, put himself in the middle of the predictions pack in a May 21 note, providing a laundry list of potential bad tidings.

"I guess I am smack in the middle of the consensus," he wrote. "So it's time to think about better and worse scenarios. It's not hard to imagine what could still go wrong. Oil prices might continue to soar. Consumers really do finally retrench. Home prices don't stop falling. Home and auto sales head still lower. Mark-to-market write-offs mount at the banks and so do bad loans as delinquencies soar on home, auto and credit-card debts. The stock market plummets. The Fed cuts the federal funds rate by another 100bps to 1.0%, but it doesn't do much to revive economic growth."

Spiking oil prices are high on the list, with crude still at $124 a barrel after topping $135 in late May. That's having a dampening effect on any cause for optimism and could accelerate a reversal of a rate-cut policy that helped pull the markets back from the edge, wrote Jeffrey Kleintop in a May 27 commentary for LPL Financial Services.

"The rise in price of oil has weakened demand for the physical commodity, but it has boosted demand for the financial commodity, since more investors are chasing the returns with oil prices tracking the path of the Nasdaq during the 1990s," he wrote. "Past bubbles have required Federal Reserve rate hikes to end them. The Fed is expected to begin to hike rates later this year. Until then it is possible oil continues to climb and weigh on stocks contributing to the volatile, range-bound performance likely in the coming months."

Also, Europe is starting to feel the pinch from across the pond, and that could surprise investors, warned Citigroup's Tobias Levkovich in a May 19 note.

"International strength has bolstered U.S. profits, but this seems likely to change," he wrote. "With Europe accounting for nearly half of American public companies' foreign sales, a European slowdown could meaningfully affect future profits and stock prices, especially given such trends do not seem to be built into expectations yet. Softer U.S. and European demand may be felt in developing economies as well."

Additionally, warns Pimco's Bill Gross, rising inflation is a much bigger issue than Americans realize, but its effects have been muted by making global comparisons, particularly to fast-growing emerging-market economies that obscure its impact.

"Sure, inflation was legitimately much higher in selected hot spots such as Brazil and Vietnam in the late '90s and the U.S. productivity 'miracle' may have helped reduce ours a touch compared to some of the rest, but the U.S. dollar over the same period has declined by 30% against a currency basket of its major competitors which should have had an opposite effect, everything else being equal," Gross wrote in his June Investment Outlook. "I ask you: Does it make sense that we have a 3%-4% lower rate of inflation than the rest of the world?"

In the collapse of booms all over, from housing to credit, Merrill Lynch's chief investment strategist on May 13 urged an outlook from the Byrds, the '60s folk-rock outfit that scored a hit with "Turn, Turn, Turn," a song that noted: "To everything there is a season."

"There is a time to grow, and a time to shrink," Richard Bernstein suggested a bit less melodically. "We think that this might be the time for investors to shift their focus from expansion to consolidation. Since the end of the dot-com bubble, expansion has been the order of the day. Success in the financial sector has been largely driven by balance sheet expansion, for example, and the success of many of the 'hot' emerging markets has been based on the expansion of productive capacity."

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