Israel Advances, Stock Markets Rally?

Larry Kudlow
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Posted: Aug 01, 2006 12:08 AM

The U.S. stock market and world equity bourses are important measures of fear, hope, security, and the health of the world’s economy. And while you might not know it from today’s magnified headlines about war, terrorism, higher oil prices, and rising interest rates, the stock market message is one of reasonable hope, confidence, and optimism about the state of the world.

Could it also be that world stock markets are rallying as Israel and its freedom agenda advances toward a Hezbollah-free Lebanese border, highlighting a significant defeat not only of the thuggish and cowardly Hezbollah murderers, but their totalitarian backers in Syria and Iran?

At the close of business last Friday -- after another violent week in the Middle East -- Bloomberg chronicled the impressive performance of world stock markets: U.S. share prices had their best gain since November 2004; Canadian and European stocks had their top weekly performances all year; British and Brazilian equities rose for the second straight week; Asian stocks posted their strongest gain in over a month; Japan was up 3.5 percent; and India surged near 6 percent.

The wartime stock market is saying that things might be better than most people believe.

Think of it: On the world stage, there is more capitalism, free trade, and economic interconnectiveness (to use defense analyst Thomas Barnett’s term for bringing the worse-off countries online with the best-off nations) than ever before. Because of this, literally hundreds of millions of share-owning investors are voting daily on the great issues of war, peace, prosperity, and hope for the future. And their vote is optimistic.

Here at home, many groused about the 2.5 percent GDP report for the second quarter: Bears called it the first step into recession while bulls argued for a soft landing and an end to Fed rate hikes. But the whole debate may be misrepresenting a fundamentally strong economy. After all, GDP grew by 5.6 percent in the first quarter, making for a two-quarter trend of 4 percent growth. Over the last year, GDP is trending at 3.5 percent, which is pretty impressive for a fifth-year recovery buffeted by high gas prices, rising interest rates, and the uncertainties of war and terrorism. Since the June 2003 investor tax cuts, growth has averaged 4 percent.

While there are traces of higher inflation, non-energy price increases are still running just above 2 percent, about the same as 2004 and 2005. It’s also worth noting that inflationary expectations have been pulling back ever since the Fed’s May 10 rate hike to 5 percent and late-June hike to 5.25 percent. Gold prices are down about $100, inflation-sensitive commodity stocks have dropped 11 percent, and the bond-market yield curve has inverted again, with short-term rates popping above long-term yields. These are all non-inflationary signals.

In fact, the bond market is saying the Fed has tightened enough. A model of inflation-indexed bonds now shows the real fed funds rate to be above the real 10-year bond rate. This suggests that money is becoming scarce and that inflation is much less of a threat than it was a year ago.

Along with lower tax rates, strong profits, and ample bank credit, the entrepreneurial-driven growth model of the eminent classical economist Joseph Schumpeter is alive and well. Wall Street economist Michael Darda calls this “The wellspring of entrepreneurial capitalism, innovation, and wealth creation in the dynamic capitalist system.” It’s also what Tom Barnett means when he talks about global interconnectivity. Economic freedom both inside and outside the U.S. remains a critical (though much underestimated) factor in the world economic outlook.

If freedom, democracy, individual liberty, and economic liberalization are all vital cornerstones of the successful City on the Hill experiment that is the United States, campaigns such as Israel’s only mark an expansion of this freedom. Israel may be a relatively small hill in global terms, but the battle it is waging is incalculably large on the world stage. As Israel inflicts more punishment on Hezbollah, the more Syria and Iran will have their Axis of Evil ears pinned back. This is a huge positive step for democracy and a big potential defeat for totalitarianism. Does the global investor class get it? How could it not?

For a long two weeks Israel and Hezbollah have been going at it hard, and world stock markets have chosen to climb. The backward-looking media pessimists won’t see this, but the real world, real money votes of the global investor class should be noted and digested by all the rest of us. Indeed, I believe world investors are thankful for Israel’s courageous efforts in the cause of freedom, independence, security, and hope for the future.

Of course, the stakes are very high in this game. But that is exactly why global investors are cheering Israel’s advance.