Wall St.'s view: Despite solid US economy, dim profits ahead

The nerve-wracking anxiety that's gripped the U.S. stock market might seem oddly unmoored from economic reality: Economic growth is strong, unemployment ultra-low and consumers exceptionally confident.

Indeed, on Friday, the government reported that the U.S. economy grew at a healthy 3.5 percent annual pace from July through September. In the previous quarter, annual growth was an even stronger 4.2 percent. The two periods marked the strongest consecutive quarters of growth in four years.

Unemployment, at 3.7 percent, has reached its lowest point since 1969. And Americans' optimism over the economy, as measured by the Conference Board's consumer confidence index, is running at an 18-year high.

Yet many investors are increasingly seized by fear, and their primary worry is the corporate profits — which drive stock market gains — are poised to weaken. An array of threats to company earnings have emerged in recent months: Interest rate hikes by the Federal Reserve. A Trump administration-led trade war. An economic slowdown in China, which could depress global growth.

Caterpillar, Ford and other U.S. corporate giants have been warning investors that the higher Trump tariffs will mean higher costs and lower profits.

Including Friday morning's renewed sell-off on Wall Street, the Dow Jones industrial average has shed more than 2,240 points — or more than 8 percent — since Oct. 3.

The Fed has raised its key short-term rate — a benchmark for loans throughout the economy — three times this year. And it's expected to do so again in December and at least twice in 2019. Rising rates make borrowing costlier for consumers and companies. And they tend to hurt stocks by leading many investors to shift money out of stocks and into bonds to capture rising yields.

Higher U.S. rates also draw foreign money to the United States, thereby strengthening the value of the dollar. Indeed, the U.S. dollar has risen more than 6 percent since mid-April against a basket of other major currencies. A stronger dollar makes American exports costlier overseas. It also makes it harder for foreign companies that have borrowed in U.S. dollars to repay their debts.

On top of all that, President Donald Trump has started a high-risk trade war by imposing tariffs on imported steel and aluminum and on about $250 billion in Chinese products. Trump has invoked national security in justifying his attacks on what he calls other nations' unfair trading practices. Trump's import taxes have triggered retaliatory tariffs from China, the European Union, Canada, Mexico and other U.S. trading partners. A result is that trade hostilities have escalated to levels not seen since the 1930s.

The president has threatened to go further and tax an additional $267 billion in Chinese goods. If he does impose those further tariffs, it would mean his administration had imposed import taxes on just about everything China ships to the United States.

All of that has contributed to growing fear that the U.S. economy, as sturdy as it may appear now, could weaken in the months ahead.

"The trade war could go off the rails," said Mark Zandi, chief economist at Moody's Analytics.

This month, the International Monetary Fund downgraded its outlook for the global economy and for emerging-market countries in particular. In doing so, the IMF pointed to rising rates and global trade frictions. Last week, China, the world's second-biggest economy, reported that economic growth in the July to September period decelerated to its slowest pace since early 2009.

For stock investors, "some of the pessimism is anchored in dimming growth forecasts and rising interest rates," said Eric Lascelles, chief economist at RBC Global Asset Management. Traditionally, "those have not been friendly to stocks."

Tumbling stocks often signal a recession warning, the concern that growth will not only slow but stall.

Not so this time. Most economists sound confident that there's life yet in the U.S. economic expansion that began in 2009.

"We'd guess this cycle can last at least a little bit longer," said Lascelles, who foresees the U.S. economy growing 3 percent for 2018 and a still-decent 2.5 percent in 2019.

Likewise, Zandi at Moody's Analytics downplays Wall Street's October sell-off as "a garden-variety correction."

The Dow, up a sharp 11 percent from late June to early October, might have been due for a pullback.

"It's not signaling a recession dead-ahead," Zandi said.

The economy is drawing fuel from $1.5 trillion worth of tax cuts Trump signed into law late last year. Still, the deficit-financed jolt won't last forever. Zandi reckons that "it starts running out this time next year, and it's gone by early 2020."

By then, the loss of government stimulus, combined with higher borrowing rates and a slowdown in household and corporate spending, would raise the risk of a recession.

Mindful of the threat posed by higher rates, Trump has repeatedly criticized the stewardship of his hand-picked Fed chairman, Jerome Powell, calling the central bank's rate hikes "my biggest threat."

But Zandi, echoing other economists, said the Fed's gradual rate increases are a "textbook" response to a strong economy, which over time can raise inflation to dangerous levels.

"They're doing exactly what they need to do," Zandi said of the central bank. "The president is just looking for a scapegoat, setting the Fed up to be the fall guy when the economy does start to struggle."

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