The Economy Is Sluggish and Weighed Down by Washington's Gridlock. So Why Are Stocks Soaring?

Catherine Hollander
National Journal

The Dow Jones Industrial Average hit a fresh high on Wednesday after it had earlier in the week pushed past a record set before the financial crisis hit in 2007. Analysts predict the Standard & Poor's 500 could soon set a new record, too. 

But the stock market gains might do little to cheer many of the millions of Americans who are out of work. The jobless rate remains just under 8 percent. Washington’s partisan gridlock, creating budget crisis after budget crisis, threatens to put a further damper on an already modest pace of growth. So why is Wall Street so ebullient while Main Street frets over its future? Here are some reasons for the surge in equity prices and some caveats about the gains:

The Fed. Since 2008, the Federal Reserve has announced three massive rounds of asset purchases known as “quantitative easing,” injecting money into the economy and driving down long-term interest rates in an effort to get the recovery rolling. Under the most recent round of QE, the Fed has been buying $85 billion in Treasury bonds and mortgage-backed securities each month in an attempt to revive the economy. Even as officials within and outside the central bank worry that it may be time to pull back on the easy-money policies, Chairman Ben Bernanke and Vice Chairman Janet Yellen have made clear in recent weeks they are not ready to end the stimulus program yet.

So, what does that mean for Wall Street? Treasury bonds and other fixed-income securities are often considered attractive investments because of their safety but the ultra-low bond yields have led portfolio managers and other investors to search for higher returns in the stock market.

Companies are feeling better. The surge on Wall Street reflects a healthier corporate sector. Corporate profits have climbed over the past three years and are at all-time highs.This hasn’t translated into jobs, The New York Timesreports, as increases in productivity gains have allowed employers to hold off on hiring and the large number of unemployed people means there’s little pressure for companies to raise salaries. But it has fueled the climb in stock prices. 

The sequester. Markets slid in the summer of 2011 when Standard & Poor’s downgraded the United States’ top AAA credit rating following the weeks-long debacle over raising the nation’s borrowing limit to avoid default. In January, another ratings agency, Fitch Ratings, said it would consider downgrading its U.S. rating if lawmakers didn’t take steps to begin bringing down the nation’s debt. So even though the sequester—$85 billion in across-the-board spending cuts that went into effect on March 1—is expected to knock 0.6 percentage points off of growth this year, markets may be taking some comfort in the steps it takes toward reducing the nation’s deficit and avoiding a downgrade, said David Bianco, chief U.S. equity strategist at Deutsche Bank. At the very least, investors are shrugging off the risk the cuts do pose to the economy.

It’s looking forward. Growth hasn’t been gangbusters; sluggish, lackluster, tepid, and torpid are the adjectives economic writers have been deploying to describe the pace of the recovery. But despite the uncertainty posed by a looming year-end fiscal cliff (a combination of tax hikes and spending cuts that was largely avoided in a Jan. 1 deal) and the sequester, which was implemented after a long back-and-forth between Democrats and Republicans over how best to avoid it, the economy has largely held its own, even if its pace of expansion is less than impressive. In 2012, gross domestic product rose by 2.2 percent, up from 1.8 percent in 2011. It’s expected to grow at a similar pace this year, with the strongest gains in the second half. And the economy is showing signs of strength in areas that have been weak spots, including the housing sector. 

Before we move on to the caveats... Bianco sums up the situation nicely: “The equity markets are basically rallying on what’s been a continuation of earnings growth amidst a low interest rate environment.” Jim O’Sullivan, the chief U.S. economist at economics consultancy High Frequency Economics, wrote in a note released Wednesday that the Dow’s nominal high was “fully justified,” as the relevant economic fundamentals are stronger today than they were in 2007. But, he cautioned, “relative to potential, both the economy and the equity market are still far from recovered.” 

With that, keep these two points in mind:

The Dow reached a record, but not if you adjust for inflation. Jeff Cox of CNBC pointed out that in inflation-adjusted dollars, the Dow will need to reach 15,731.54 to beat its previous record. On Wednesday, it closed at 14,296.24. And HFE's O'Sullivan points out that relative to current nominal GDP, the equity market is more than 10 percent lower than it was in 2007. Beware the headline numbers (and headlines), in other words.

And oh, what a minefield awaits. In the summer of 2011, stocks plunged in the days leading up to the deadline for raising the nation’s borrowing limit or facing default, and then in the days after when Standard & Poor’s downgraded the country’s credit rating. Many obstacles loom in 2013, fiscal fights (next up is a resolution to continue funding the government) and the threat of a resurgence of the eurozone crisis among them. There’s also concern that interest rates will rise too quickly when the Fed attempts to tighten monetary policy, or there could be an inflation scare that hits stocks. And as some economists and policymakers have warned, there is the possibility that the central bank is creating a new asset bubble with its easy-money policies, one that would eventually burst.