By Martin Wolk Executive business editor
updated 3/12/2004 5:47:48 PM ET 2004-03-12T22:47:48

Even before this week’s terrorist attack in Madrid, stock prices were fading and investors were pouring money into the safer haven of bonds on growing nervousness about an economic recovery that has yet to hit its stride.

Major Market Indices

Although stocks recovered Friday, major indicators hit their lowest levels of the year this week and analysts agreed the market is in the midst of a full-fledged correction. The Dow Jones industrial average gained about 112 points or 1 percent Friday but was still down 3 percent for the week. The Nasdaq Composite Index is down nearly 8 percent from its recent peak six weeks ago.

Meanwhile mortgage rates, after rising most of last summer, have fallen sharply in recent weeks -- low enough to spur talk of a new wave of refinancings.

Many factors are playing on financial markets, including a growing consensus that the Federal Reserve will leave rates low for many months to come and suspicion that al-Qaida may have been involved in Spain’s worst terror attack.

But despite three years of nearly unprecedented government stimulus in the form of tax cuts and low interest rates — and the strongest half-year of GDP growth in two decades — investors, analysts and consumers cannot seem to shake fundamental concerns about the long-term prospects for the economy.

“The message of the bond market rally and equity market selloff is that people are increasingly concerned about the sustainability of the recovery with such weak job growth,” said Don Straszheim of Straszheim Global Advisers. “In the long run, if jobs don’t grow the consumer sector will fail and with it the whole economy.”

Last week’s report that the economy added only 21,000 payroll jobs in February, rather than the 125,000 expected, is still reverberating through financial markets, sending one-year adjustable-rate mortgages to the lowest level seen in the 20 years financing giant Freddie Mac has been tracking the figure.

The drop in ARM rates stems from the conclusion of a growing number of analysts that the Fed is unlikely to raise overnight lending rates this year from the current 46-year low of 1 percent. In fact, Goldman Sachs senior economist Ed McKelvey raised eyebrows this week by suggesting that the Fed might not even hike rates before Chairman Alan Greenspan’s term on the board expires in 2006.

“It’s a legitimate question, given how much slack we believe there is in the economy,” McKelvey said in an interview. He stressed, however, that the brokerage’s analysts believe the most likely scenario is that the Fed will begin tightening in mid-2005.

Other analysts have raised the prospect that with inflation at the low end of the Fed’s preferred range, the central bank might cut rates further if the economy fails to create jobs as expected. But that could backfire, said Sung Won Sohn, chief economist for Wells Fargo.

“If the Fed were to actually cut rates again it could send a very negative message to the marketplace, so I think they have to be very careful about what they do,” Sohn said.

For the record, analysts expect no change in rates when the Fed’s policy-making Open Market Committee meets Tuesday. But traders will be watching closely to see how the Fed describes economic conditions in its post-meeting statement.

In congressional testimony this week Greenspan acknowledged that new job creation is “lagging badly” -- stronger language than the Fed has used in the past.

McKelvey noted that recent Fed meetings have been followed by statements that offset the concern about weak job growth by stressing improvement in other labor indicators, notably a decline in new claims for unemployment.

“You can only say that for a little while before you say, yeah, but where’s the beef?” McKelvey said.

In the short term, the lack of job growth appears to be having only a limited impact on the economy’s health. Retail sales were stronger than expected in February, led by a rebound in auto sales.

And the latest drop in mortgage rates could help keep the housing market strong and spur additional refinancing, giving some families a bit of additional disposable income. But strong gains are unlikely after three years of record home sales and refinancing activity.

Fannie Mae, which provides financing for the mortgage industry, this week projected lenders would process $2.43 trillion in housing loans this year, up from a previous forecast of $1.9 trillion. But that would still be well below last year’s record $3.7 trillion.

Most analysts remain confident about growth reasonably strong growth of about 4.5 percent in the first half of 2004. And many believe a surge in tax refunds and the expiration of an attractive tax credit could sustain growth at nearly the same pace in the second half.

But without job growth, the outlook could turn shaky. Personal income in the latest quarter was up 3.9 percent over a year earlier, but wages and salaries were up only 2 percent, barely keeping up with inflation.

“While overall income growth is still pretty good now, it is the wage and salary component that is ultimately the most important component,” Straszheim said. “We have an enormous amount of both monetary and fiscal stimulus, and yet there is some question about the recovery. … That is a commentary on the seriousness of the job weakness.”

John Silvia, chief economist at Wachovia Securities, said he has few concerns about the economy until 2005, when the final crumbs of fiscal stimulus are gone. Even if President Bush is re-elected, Silvia notes that the first year after an election is typically the weakest of the presidential cycle, especially if tax hikes or spending cuts are on the agenda.

But for now, the economic outlook is bright for people with steady jobs, Silvia said.

“For those people who have jobs this is truly a Goldilocks economy,” he said, referring to growth that is not too hot and not too cold but “just right.”

With inflation low, interest rates low and taxes falling, young people just beginning their careers enjoy excellent conditions for buying cars, homes and appliances, Silvia said. “For young people 25 to 35 this is just an amazingly good economy for them.”

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