Personal Finance: The economy looks strong. Why aren’t investors happy?

Gail MarksJarvis
Gail MarksJarvis Chicago Tribune

Just as analysts were beginning to fixate on risks to the U.S. from a fragile global economy, a new report last week melted away the gloom.

At the moment, the U.S. appears to be in surprisingly good shape. In fact, the service economy – or the great majority of the U.S. economy – surged to the highest level in a decade in July, according to the Institute for Supply Management non-manufacturing report.

The ISM report, closely watched by economists and investors, shocked analysts because it indicated surprising strength across a wide range of industries – from education services, entertainment and health care, to the wholesale trade, retail and transportation. In addition, hiring continued its 17-month climb, reaching the highest level since 2005.

The report “was good news all around,” said Ksenia Bushmeneva, economist for TD Economics. “There is definitely no summer lull in the U.S. services sector.”

Economist Jim O’Sullivan of High Frequency Economics said, “The data show good momentum.”

In contrast, the nation’s manufacturing economy has not been strong. Economies in Asia, Europe and Latin America have been reluctant to make purchases; a strong U.S. dollar has made American products expensive to foreign customers.

The service economy is “less exposed to weakening in foreign demand,” said O’Sullivan.

While the Dow Jones industrial average first surged 100 points upon the release of the service sector data, the gains gave way to concerns from investors who fear the data will provide a green light for the Federal Reserve to start raising interest rates.

The Dow closed down 10 points to 17,540 the day the report came out.

Interest rates have been near zero since the Fed started using stimulus to bring life to the recessionary economy. As low rates have persisted, they’ve been a knee-jerk signal to investors to buy stocks even when the economy has been troubled. With bonds paying little interest due to the Fed’s low-rate policy, stocks were perceived as the only game for investors who wanted to earn some income.

Now, if the Fed takes the pacifier away by raising interest rates in September, there is a concern that investors’ knee-jerk reaction will be to sell stocks. Presumably the stock market would dip from recent lofty levels. Yet just how far or how sustained that decline might be has been hotly debated. Some analysts point to history showing that the stock market typically rises, rather than falls, when the Fed starts raising rates, because the Fed action means the economy is strong. Other analysts say history is worthless because of unprecedented action by the Fed during the last few years to manipulate the economy and the stock market after the recession.

With investors anticipating a rate increase soon, the stock market has stalled this year. But the Standard & Poor’s 500 has climbed about 90 percent during the last five years.

Unemployment rates will be watched closely for another signal about the Fed’s next step. Until recently, Federal Reserve Chair Janet Yellen has said there were too many people without well-paying jobs, so the Fed had to keep interest rates low. Her tone seemed to change after the Fed’s July meeting. Last week, Dennis Lockhart, president of the Federal Reserve Bank of Atlanta, said it’s time for the Fed to start raising rates.

Economists increasingly expect the Fed to begin raising interest rates in September. They think concerns will persist about the potential drag on the U.S. from weakness in the global economy but assume that modest strength in the U.S. will last.

Deutsche Bank economist Joseph LaVorgna said in a note to clients last week that very few people have lost their jobs recently. “Initial jobless claims remain near a 42-year low,” and the taxes people are paying to the IRS from their paychecks have “been growing at a healthy 5 percent annual rate.”

Further, he added, “July motor vehicle sales were a robust 17.5 million units, which bodes well for hiring because households typically do not purchase big-ticket consumer goods if job and income prospects are not improving.”

Gail MarksJarvis is a personal finance columnist for the Chicago Tribune.