Bob Doll examines the outlook for the US economy in the aftermath of Hurricane Katrina.
Last week, the news was dominated by Hurricane Katrina and its horrific aftereffects. On the economic and financial front, much attention was occupied by questions regarding what the hurricane's impact might be on energy prices and economic growth. Despite the uncertainty, stocks rallied last week.
For the week, the Dow Jones Industrial Average gained 0.5% to close at 10,447, the S&P 500® Index added 1.1% to finish at 1,218 and the Nasdaq® Composite climbed by 1% to 2,141. Not surprisingly, energy was the best-performing sector of the market, and was up over 5% for the week.
The fixed income market also performed well last week, with the yield on the 10-year Treasury (which moves in the opposite direction of prices) moving from 4.22% to close the week at 4.03%, its lowest level in several months.
Our explanation for last week's market performance is that following the storm, it now appears less likely that the Federal Reserve will continue raising interest rates, a situation favorable for stocks. Prior to last week, the fed funds futures curve was predicting a year-end fed funds rate of 4.25%, which equated to three additional 25 basis point rate hikes from the current 3.5% level.
Following Hurricane Katrina, the curve is now predicting only one additional rate increase this year, which would bring the year-end rate to 3.75%. Some observers, in fact, believe that the Fed may be finished for the year, and are predicting no additional rate increases.
Regarding the storm's effect on economic growth, economists have all sorts of different views. Our best guess (and given the limited information available, a guess is really all it is) is that the hurricane will subtract as much a 1% from real gross domestic product growth in the third quarter. For the fourth quarter, the effects of the storm could be either a plus or a minus, depending on how high energy prices stay and how much effort goes toward reconstruction.
As we have discussed in recent commentaries, we have been seeing signs of slowing economic growth for several weeks now, and our belief is that soaring energy prices and worries about shortages of gasoline and heating oil could trigger the economic slowdown we have been forecasting. If energy prices stay high and if the economy does, in fact, slow, the Fed may not do much more of anything in terms of raising rates.
If, on the other hand, energy prices fall, the Fed could continue to increase interest rates.
Either way, the combination of energy prices and rate hikes will likely contribute to slowing economic growth.
We do not believe, however, that the economy is headed into a recession. Although corporations may be growing increasingly cautious about hiring and investments, balance sheets remain strong and profit margins are near record levels, which bodes well for long-term economic growth.
Additionally, inflation remains reasonably low, which puts less pressure on the Fed to raise rates to a point that could trigger a recession. We believe that we are entering the mid-expansion economic slowdown we have been discussing for some time. This period will likely last for several months, and perhaps several quarters, and should create some buying opportunities for higher risk assets, including equities, corporate bonds and commodities.
Bob Doll expressed these views on 6 September. Merrill Lynch Investment Managers has over USD 473 billion in assets under management.