What if the U.S. Economy and Markets are Even Better Than They Look?

What if the U.S. Economy and Markets Are Even Better Than They Look?

Jeff Sommer

You won’t lose much money if you’re prepared for the worst.

While the stock market has been hot lately, warnings of trouble ahead have been multiplying. And the odds of a recession by 2020 are mounting, or so the warnings go.

But what if the good times that are evident in important sectors of the markets and the economy just keep rolling, at least for a while?

That bullish possibility has arguably been underplayed, given the strength of the current numbers. And there is a strong, contrarian case that failing to appreciate the power of the current economy and markets will have serious implications that transcend finance and affect politics, too, generally helping Republicans and hurting Democrats.

Consider, first, that after months of setbacks, the American stock market reached new highs repeatedly over the last few weeks. In fact, it was one of the best Augusts the stock market has had in years.

What’s more, consumer confidence has soared to levels unseen since October 2000, according to the Conference Board. And the United States economy’s annual growth rate — 4.2 percent in the second quarter — was the best in nearly four years, while the unemployment rate, 3.9 percent, hovers near its lowest level in decades.

That statistical snapshot depicts a stock market and an economy that are prospering. Barring an unexpected event, the simplest prediction is that we’ll have more of the same. Why, then, are so many people worried that bad times are coming?

I’ll confess that I’m a worrier myself, having written recently that Vanguard, the widely trusted $5 trillion money manager, says the risks of a recession by 2020 have risen while the prospects for financial markets over the next decade have declined.

The Vanguard arguments are compelling: Short-term interest rates are rising faster than longer-term ones, moving us closer to a critical threshold for a dreaded inflation predictor, a so-called inverted yield curve. And credit markets are heading in a direction that often presages economic stress.

Furthermore, the long rallies in both the stock and the bond markets, which have made investing look relatively easy since early 2009, are unlikely to be sustained for years to come. At some point, they will falter. It appears that the bond market may already have begun to do so. Vanguard projects reduced returns for stocks and bonds over the next decade.

In addition, the risk that the markets and economy will be derailed by a truly major political, constitutional, military or trade crisis during the Trump administration, while difficult to quantify, cannot be easily dismissed. There are many potential calamities to choose from. Any one of them could lead to an economic disaster.

But timing is everything. Even if you are convinced that disaster is coming, deciding exactly when to take risk out of your portfolio matters tremendously.

From a purely financial standpoint, staying on the sidelines in the current bull market has been excruciatingly costly. From the beginning of this year through Thursday, for example, the Standard & Poor’s 500-stock index returned 15.5 percent. If the market keeps powering ahead, and you avoid stocks entirely because you are afraid of a crash, you will fall further behind.

There are political implications, too. There are already ample reasons to suspect that the current strength of the market and the economy is hurting Democrats in their efforts to regain control of Congress in the November midterm elections.

Ray C. Fair, the Yale professor who is a pioneer in demonstrating the predictive power — and the limits — of economics in election forecasting, has quantified that issue. He says that the surge in gross domestic product growth in the second quarter appears to have given the incumbent Republican Party a measurable boost.

His forecasts, made with an open-source program that he maintains as a teaching tool on his Yale website, are not always entirely on the mark, but they are always instructive. They disregard the specifics of campaigns and candidates, focusing only on shifts in the economy and a series of historical correlations, like the tendency of voters to become bored with incumbent politicians, counterbalanced by the tendency of a strong economy to favor the incumbent party.

Using only economic variables and data from elections over the last century, Professor Fair projects that the Democratic Party is likely to win 50.74 percent of the two-party popular vote for the House. “It is probably less than what the Democrats need to gain control of the House, although I do not have an equation that translates the vote share into House seats,” he said on his website.

In an interview, Professor Fair explained: “I don’t attempt to convert the popular vote into an actual forecast, state-by-state, with all the gerrymandering and other factors that are so important. I leave that to the political scientists.”

The second quarter G.D.P. growth — a variable in his equation that captures the good feelings generated by the economy and the stock market — had the effect of subtracting about 1 critical percentage point from the Democratic share in his projection. Another strong showing in the current quarter, which he defines as an annual growth rate of at least 3.2 percent, would move the Republicans ahead in the popular vote in November, according to his algorithm.

But he is the first to admit that his equations don’t capture the inimical style of President Trump. For the last presidential election, for example, Professor Fair’s algorithm indicated that economic as well as political factors strongly favored the Republican Party. His projections said Republicans would capture 56 percent of the popular vote, giving its presidential candidate a landslide victory. Professor Fair was off by 7.1 percentage points (though he did project a Trump victory, unlike most forecasters).

“Had the Republicans nominated a more mainstream candidate, they may have done much better — much closer to what the equation was predicting,” he wrote. Mr. Trump’s “personality” and combative approach to politics could reduce the Republican tally again in the midterm elections, according to Professor Fair, and swing the vote to the Democrats. “I just have no way of capturing that,” he said.

Mr. Trump’s unconventional approach to the presidency is undoubtedly making it more difficult, as well, to accurately assess the trajectory of the markets and the economy themselves.

Edward Yardeni, an independent stock market analyst, made that point in a series of reports in August. Mr. Yardeni, who describes himself as “a conservative-leaning fellow,” said that on contentious issues, from tax cuts to trade disputes to deregulation, financial markets have been “giving quite a bit of weight to the possibility that this all will lead to less protectionism and greater global prosperity” — and to a rising stock market.

That’s not my baseline assumption, but it could happen. What if the stock market keeps ascending, the economy continues to grow, and Mr. Trump and a flock of Republicans do their utmost to take credit for it?

I’m hedging my bets.

Follow Jeff Sommer on Twitter: @jeffsommer

This article originally appeared in The New York Times.

This article was written by Jeff Sommer from The New York Times and was legally licensed by AdvisorStream through the NewsCred publisher network.