JPMorgan’s David Kelly: Potential and momentum in the week ahead

The following is a weekly commentary written by David Kelly, chief market strategist at JPMorgan Funds.

In physics, the law of conservation of energy states that, in a closed system, energy can neither be created nor destroyed but only converted to from one type to another. As an example, a bowling ball rolling softly on the top of a kitchen counter contains both potential energy, by virtue of its weight and position, and kinetic energy due to its movement. As it gently rolls off the counter top and heads towards your toe, energy is converted from potential energy to kinetic energy. Still the same amount of energy – just being expressed in a different way. The latest readings on the economy, like a bowling ball on a countertop, are exhibiting little momentum but still, underneath, have plenty of potential.

This lack of momentum should be just as evident this week as last. Last week saw declines in both main measures of consumer confidence for February and both new and existing home sales for January, along with an increase in weekly unemployment claims.

This week, while unemployment claims could fall back some, it looks like Friday’s employment report will show a further decline in payroll jobs, an increase in the unemployment rate, and a fall in the average workweek. In addition, we may see a decline in pending home sales and a fall in light-vehicle sales. There are some smaller positives to offset the negative tone of these releases but overall they suggest an economy in the doldrums.

Some of this can be blamed on the weather. In particular, the February jobs data will be based on the week, Sunday through Saturday, which contained the 12th of the month. Unfortunately, this week also contained two major snowstorms in the Northeast which probably reduced both hiring and the average workweek. In fact, adding in last week’s blizzard and using NOAA’s North East Storm Impact Scale, it now appears that February contained no fewer than three of the most disruptive Northeast storms in the last 50 years. Unusually lousy winter weather probably also reduced retail sales, housing starts and vehicle sales. Having said this, it’s not like people in the Northeast have never seen snow before and there is little doubt that, outside of the rebounding manufacturing sector the economy appears to have significantly less momentum than in the fourth quarter.

However, as we finally move towards spring, the potential for the economy to post strong growth for the rest of the year remains intact. Vehicle sales, housing starts and business equipment spending remain extraordinarily low for an economy this size, particularly given improvements in corporate and household balance sheets and extremely low interest rates. In addition, in the fourth quarter of last year, business inventories fell for the 7th quarter in a row. Just getting these sectors back to their average levels of the last decade, (that is without actually satisfying any pent-up demand), has the potential to add 2.8% to U.S. GDP. Added to this should be the delayed impact of federal stimulus package, which one year after its enactment, has still seen only 36% of $787 billion total paid out. Finally, the global economy continues to recover, albeit unevenly, providing growing markets for U.S. exporters.

Despite a modest gain for the stock market in February, investors remain deeply skeptical and weekly data from the Investment Company Institute suggest that last month will have been the 26th consecutive month in which net flows into bond funds have exceeded net flows into equity funds. Despite recently disappointing economic numbers, this positioning is probably too conservative, as looking at the economy’s potential as well as its momentum suggests an increase in both bond yields and stock prices in the year ahead.

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