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Optimism for the U.S. economic outlook ran high as we entered 2014 ... and for good reason. Data showed that growth had accelerated in the second half of 2013 to a pace that was almost double the first half's growth rate.

The December jobs report in early January was very weak, but it was so out of line with other data at the time that no one was willing to see it as anything but an outlier. The expectation was that the ramped up growth momentum of the second half of 2013 would continue into 2014 and beyond - with the U.S. economy finally reaching a sustainably elevated growth trajectory.

But then all of a sudden, we started getting data that didn't fit in with the prevailing optimistic narrative. We have had false starts in this recovery earlier as well, with optimistic estimates at the beginning of each year subsequently getting ratcheted down. We are not seeing that this time around, at least not yet. Weather is justifiably getting most of the blame at this stage. But irrespective of the cause, there is growing evidence that the economy has lost some of its mojo in recent days.


The Economic Freeze

The most important report that raised doubts before Friday's jobs disappointment was the January manufacturing ISM report. The index suffered its biggest monthly loss in more than two years, though it remained in expansionary territory at 51.4. All key components of the index fell, though the weakness was particularly notable in the production and new orders sub-indexes. Unlike the manufacturing ISM, the service sector ISM reading showed gains, though even there the export and import components lost ground. Data for durable goods, factory orders and motor vehicle sales showed similar losses of momentum.

The jobs reading was particularly disappointing. Not only did the 'headline' number come in short of expectations, but the widely expected revision to the prior month's sub-par tally failed to materialize. The report's internals didn't point towards weather as the culprit, as the weather-sensitive manufacturing and housing sectors reported decent gains. The household survey, which forms the basis for calculation of the unemployment rate, showed strong gains in the month, resulting in a downtick for the unemployment rate despite a modest bump in the labor force participation rate. These nuggets of positivity aside, the report overall didn't paint a very inspiring picture of the economy.

This week's retail sales and industrial production numbers are unlikely to change the conversation in any meaningful way. Retail sales were expected to weaken in January anyway after solid gains in the preceding two months, and weather definitely didn't help either. The extreme temperatures may have helped utilities, but the rest of the industrial production report will likely reflect what we saw in the ISM survey.


The Fed & Emerging Markets

The market didn't show any signs of nervousness on the jobs disappointment. Perhaps investors were encouraged by the household survey, which did show some improvement. Or maybe they are hoping for a go-slow approach from the Fed on the Taper front. The buzz and anticipation surrounding the new Fed Chairwoman's first Congressional testimony tomorrow likely reflects these hopes.

I don't think these Fed hopes are justified. The Fed has decided to get out of the QE business and likely has a very high bar for making changes to its Taper program. They would want to steer clear of doing or saying anything that could be interpreted as indicating their concern about the economic outlook. I strongly feel that Janet Yellen's testimony tomorrow will repeat all the usual comments that we have heard in the past from Ben Bernanke. Importantly, the bond remains well behaved, thanks to the safe-haven flows due to the emerging market issue.

The emerging market problem has the potential to 'bleed' into the U.S. economic outlook though the trade link. Even though the U.S. economy is less trade dependent than others, weakness abroad will have a negative effect on the margin. It's way too early for that, however, to be the cause of the recent soft economic data. But if the problem persists longer, then it will be a net negative for the U.S. outlook.


Putting It All Together

Weather seems like a good enough explanation for the recent run of soft economic data. It doesn't make sense for the economy to lose steam for no reason from the second-half 2013's strong trajectory. That said, some of the more aggressive growth estimates may need to come down. Growth this year should still be modestly better than what we saw in 2013, but extrapolating the second half 2013 forward may not be justified.

The emerging market issue remains a problem, a more immediate one for the market than the economy, but nevertheless a problem. It prompts investors to recalibrate their risk exposure and makes them more critical of corporate and economic fundamentals. A longer lasting turmoil will have a bearing on the U.S. economic outlook as well. But I remain confident that even a severe emerging market contagion along the lines of the late 1990's Asian crisis wouldn't be enough to push the U.S. into a recession.

This reassuring outlook doesn't mean that the coast is clear for the stock market. Far from it. I continue to be of the view that last year's strong gains reflected corporate and economic expectations that are unlikely to pan out. In other words, the market was priced for perfection and will most likely keep losing ground as long as ground realities remain less than perfect. As such, I don't think the market's rebound late last week was the end of the pullback.


Focus List Update

We made two changes to the Focus List this week, adding and deleting one stock each.

The deletion was of Energizer (ENR), which fell to Zacks Rank #4 (Sell) after its weak quarterly results and guidance.

Replacing Energizer, we added Actavis (ACT), a low-beta specialty pharmaceutical company that offers strong growth potential in the current uncertain backdrop and is in-line with our current strategy to beef up the portfolio's defensive attributes.

Sheraz Mian is the Director of Research for Zacks and manages our award winning Focus List portfolio inside of the Zacks Premium service.




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