Is the current market optimism justified?

Regarding the much-worse-than-expected US GDP statistics, this contrarian view is almost certainly right. The figures were severely distorted not only by superstorm Sandy but also by huge cutbacks in government spending, especially on defense equipment, that were probably related to November's election and precautionary moves ahead of the year-end 'fiscal cliff'.

Excluding government spending, US GDP increased at an annualised rate of 1.4% in the fourth quarter, and while this private-sector growth rate was the slowest since the recession, the shortfall was entirely explained entirely by an inventory effect that is certain to be reversed in the coming months. In terms of the fundamental drivers of economic activity—consumer spending, corporate investment and housing—the fourth quarter figures were actually quite decent. Most importantly, consumption accelerated to 2.2% growth in the fourth quarter from 1.6% percent the quarter before.

The strengthening of personal consumption and robust reports from major retailers on holiday and January sales, in turn, casts doubt on the post-election plunge in consumer confidence. Perhaps this decline has mainly been a reflex reaction to alarmist headlines about political gridlock and rising taxes, conveying little or no information about Americans' willingness to spend.

This optimistic interpretation, which is essentially the bet that financial markets are making, is likely to prove right in the short term for three broad reasons relating to economics, politics and global conditions. Looking ahead, however, are at least two dangers that investors and business leaders may not have fully recognised could puncture the euphoria, though probably not until the second half of this year.

The three reasons for optimism have been discussed before in these columns. First, the fundamental drivers of the US economy look much stronger than at any time since 2007. Housing construction, which has been the biggest obstacle to economic recovery since 2009, is finally rebounding. House prices are also rising, rescuing millions of households from underwater mortgages. Employment is slowly but steadily increasing. Credit conditions are gradually returning to normal. And cutbacks in government employment, the most powerful element in economic recovery after housing, are ending as state and local government revenues rebound.

... contd.

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