6 Things That Could Derail the Economic Rally

Europe, housing, and Congress still represent big risks to the economy.

By SHARE

Will it last?

That's the key question on the minds of Wall Street investors, Main Street workers, and this year's presidential candidates as they ponder the latest upbeat news on the economy.

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On the surface, a long-awaited economic recovery finally seems to be growing roots. The latest jobs report showed a respectable pace of hiring and a net gain in jobs for the 16th month in a row. The stock market started 2012 with a nifty 7 percent gain that brought it back to the levels of mid-2008, before the financial meltdown. Manufacturing output is picking up. Car sales have been growing steadily and are approaching prerecession levels. All of that is making consumers more optimistic. "There are hints that a virtuous circle may be building where employment, incomes, and consumer spending move up together," forecasting firm IHS Global Insight recently advised its clients.

Prognosticators are wary, however. There have been several false starts in the so-called recovery, including a surge in economic growth early last year that was followed by a dispiriting dropoff and fears of a double-dip recession. Many forecasters expect something similar this year. IHS, for instance, expects growth to slow from about 3 percent at the end of 2011 to less than 2 percent at the end of 2012. The prospects for 2013 could be even weaker.

The experts have been wrong before, and they could be wrong again. But they've got some legitimate concerns. Here's what they're worried about:

Prolonged high unemployment. Despite recent job gains, the economy still employs 6 million fewer people than at the beginning of 2008, and the Congressional Budget Office predicts that unemployment won't drop back to normal levels of 5 percent or so until 2017, at least. Another sign of weakness: The percentage of adults who are working or looking for work is at the lowest level since 1983.

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"We expect sluggish growth in economic activity in the first half of 2012 and therefore we do not foresee the strengthening of the labor market to be sustained in the second quarter of 2012," predicts the Conference Board, which draws insights from a key confidence survey it administers. The economy can still grow with such distortions in the labor force, but it will fall far short of full output, which means less spending and less hiring in most sectors.

The next dip in housing. There's one shutter that still needs to drop before housing will be poised to bottom out: a pickup in foreclosures. Many mortgage defaults have been delayed by a nationwide investigation into suspect bank practices, which ought to wrap up soon. The surge in foreclosures that's likely to follow will represent one last bit of downward pressure on home prices in many areas, with more people doubling up with friends or family. But as that plays out, home prices may bottom out for good, with a modest housing recovery starting in 2013 or 2014.

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Recession in Europe. Recent action by the European Central Bank may have averted the financial meltdown that many investors were worried about, but recession on the continent still seems likely as Greece defaults on its debt, Portugal struggles not to be the next domino, and spending cutbacks in several other countries strangle growth. A recession in Europe won't wreck the U.S. economy, but it will weaken demand for U.S. exports and be another factor limiting growth.

Hamstrung consumers. Americans have less debt than they used to, but a big part of the "improvement" has come from loan defaults, which indicated financial stress, not health. "We've been skeptical about the purported strength of the consumer," Bank of America Merrill Lynch economists wrote recently. "With stagnant incomes, there was always a limit to how much households could draw down savings to finance consumption." Many families still need to save a lot more in order to repair their finances and plan for retirement, which will curtail economic growth in the short term.

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Slowing corporate profits. Earnings for big companies have been strong, helped along by the low borrowing rates engineered by the Federal Reserve and a spate of layoffs between 2008 and 2010 that sharply lowered costs. But profit margins may soon plateau, which could take a bit of steam out of the stock market and crimp hiring. "Earnings growth is going to be harder to come by going forward," writes Dirk van Dijk, chief equity strategist for investing firm Zacks.com. "If the results do not improve, it strikes me as likely that [the stock market] will at least pause for a while."

Congressional mayhem. Congress has to make only one major decision affecting the economy this spring: whether to continue a temporary payroll tax cut and an extension of unemployment benefits for the full year. Odds are that after the usual mudslinging and last-second posturing, those measures will pass. But after the November elections, Congress will have to make momentous decisions about a much bigger set of tax cuts due to expire at the end of this year, sizeable spending cuts scheduled for 2013, and another extension of the nation's borrowing limit.

With little room for mistakes, a misguided blend of political expediency, premature spending cuts, and ham-fisted tax hikes could undercut growth and spook markets. "U.S. policy dysfunction has taken a breather but is likely to come back in vogue," warns Merrill Lynch. As long as Washington plays such a big role in the economy, there's always a chance that something could go wrong.

Rick Newman is the author of Rebounders: How Winners Pivot From Setback to Success, to be published in May. Follow him on Twitter: @rickjnewman

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