COMMERCE BANK ECONOMIC REVIEW - MAY 2007

A Soft Economy and Soaring Stock Prices: Perfect Together?

BY JOEL L. NAROFF, PH.D., CHIEF ECONOMIST, COMMERCE BANK

Once again, because of recent weak economic reports, the question about a recession has come to the forefront. Yet, despite the less than robust economy, the stock market just keeps going and going and going. Can these two seemingly contradictory economic trends continue to coexist? Good question. 

We knew the economy had eased early this year, but we weren’t prepared for how much.  First quarter growth came in at an anemic 1.3% pace. This was the weakest performance in four years and marked four consecutive quarters of subpar growth. But although the headline growth number was discouraging, the details weren’t that bad. For example, consumers continued to shop ‘til they dropped. And businesses started spending a little more. Okay, there wasn’t a whole lot of investment demand, but it was better than the decline posted at the end of last year. However, the faltering housing market and continued manufacturing weakness kept the economy in check.

Adding to the uncertainty was an employment report that raised real questions about the labor market. In April, businesses added the smallest number of jobs in 18 months and the unemployment rate edged up. We had slower increases in wages and hours worked declined. That does not bode well for income growth, and it has been consumer spending that has kept the economy going. So when you put it all together, the economy was soft in the early part of the year and it is likely that sluggishness will continue at least through the spring and into the summer. 

With growth slowing, what will the Fed do? If we are to believe the statement from the most recent meeting, not much anytime soon. The members appear uncertain about the direction of both the economy and inflation. Thus, they may simply bide their time until conditions become clearer. 

Which brings us to the ebullient stock markets. Records have fallen and the winning streaks keep piling up. How can that be? Well, when it comes to equity markets, it is all about earnings. And when it comes to profits, it is normally all about the economy. So, how is it that strong profit growth has been sustained despite an economy that has expanded by a tepid 2.1% over the past year?  It hasn’t been easy, but there actually is an explanation.

A number of factors have helped power the strong earnings gains. The consumer spending boom has obviously been key. Lowered costs from several years of large productivity gains, coupled with extensive offshoring of production, allowed firms to limit the rise in labor costs. And critically, the declining dollar has enabled firms to book significant increases in overseas profits. The worldwide economic expansion has played a major role in the earnings boom and a weak dollar and solid international business growth are likely to help for months to come.

But let’s never forget the economy. The stock market has been on a roll, supported by robust earnings. But the economic fundamentals point to additional sluggish growth and continued labor cost pressures, and those factors should be considered carefully. 

Joel L. Naroff, Ph.D., is Chief Economist for Commerce Bank. Commerce Bank, America’s Most Convenient Bank, is a leading financial services retailer with more than 430 convenient stores in New Jersey, New York, Connecticut, Pennsylvania, Delaware, Washington, DC, Maryland, Virginia and Southeast Florida. Commerce Bancorp (NYSE: CBH) is headquartered in Cherry Hill, NJ and has more than $47 billion in assets. For more information about Commerce, please visit the company’s interactive financial resource center at commerceonline.com.