✔ The U.S. economy has expanded for eight years now, the job market has tightened, and valuations in the stock market are stretched.
✔ The two largest economies, the United States and China, are raising interest rates.
✔ Consumer sentiment in the U.S. is not rising among the people who have the greatest ability to increase spending.
The U.S. economy continues to add jobs, and the market keeps climbing higher. In our latest check-in with Lisa Emsbo-Mattingly, Fidelity’s director of asset allocation research, we asked whether she thinks those trends can continue. Her answer: No one can say what the markets will do in the short term, but investors shouldn’t expect conditions to improve much from here—making this a time to stay diversified and avoid big bets.
What’s your take on the state of the U.S. economy and stock market?
Emsbo-Mattingly: I’d sum it up by saying this is probably as good as things are going to get for a while. It’s not that I’m pessimistic. But the economy has expanded for eight years now, the job market has tightened, and valuations in the stock market are stretched. It’s hard for me to make a case that the fundamentals are going to get much better from here. So although I’m not bearish, I’m not bullish either.
What tells you that the economy’s fundamentals aren’t likely to get much better?
Emsbo-Mattingly: The global economy reaccelerated during the last couple years. That happened largely because China enacted policies designed to stimulate its own economy, and greater demand out of China benefited many economies and markets around the world. The impact of that stimulus is declining now. In fact, China’s central bank has started raising interest rates.
About the expert
Lisa Emsbo-Mattingly leads the Asset Allocation Research team in conducting economic, fundamental, and quantitative research to develop dynamic asset allocation recommendations.
The U.S. Federal Reserve is raising rates too. So the world’s two largest economies are both tightening. At the same time, the Bank of Japan and the European Central Bank are stepping back from some of the extreme accommodative measures they took a year or so ago. So the monetary backdrop isn’t as supportive of growth as it was in the recent past.
Could the strong job market spur greater spending, helping the economy maintain its momentum?
Emsbo-Mattingly: I do expect consumer spending to continue to rise, but only at about the same rate as wages. One of the unusual things about this recovery, especially recently, is that consumer sentiment has improved a lot, but the improvements haven’t led to the kinds of spending increases that one would expect.
I think part of the reason is that sentiment isn’t up among the people whose spending would make the biggest difference. Consumer sentiment is up among the age 55 and older set, but people in that age group aren’t likely to boost their spending much since many are already at their peak spending rates (before slowing as they retire). By contrast, sentiment is down among people under age 35, which is the group whose spending patterns have historically been most sensitive to sentiment. For example, as this age group feels better about their job prospects, they have tended to become much more likely to buy a nicer car or a house than people in older age cohorts.
There’s a similar dynamic if you look at sentiment by education level. Sentiment is up among people with a high school education or less, but it’s flat among the college educated. In other words, sentiment is not rising among the people who have the greatest ability to spend. So while I believe we will see moderate spending increases as employment and incomes rise, we are unlikely to see a big surge in spending that would continue to push the market forward.
Dynamics in the automobile sector also are holding back spending and economic growth at this point. Car sales rose dramatically coming out of the Great Recession, because there was enormous pent-up demand. Dealers got still-cautious spenders into new cars in part by offering cheap leasing terms. Now those cars are coming off lease and flooding the used-car market. The oversupply of used cars is good for consumers, but it puts downward pressure on new car demand. That’s not good news for the long auto supply chain that’s so important to American manufacturing.
Again, I’m not predicting a recession—I just don’t see the rate of economic growth improving much from here.
How does that economic outlook inform your perspective on the stock market?
Emsbo-Mattingly: It reinforces the idea that things are probably about as good as they’ll get. Valuations look stretched to me. Meanwhile, fewer stocks are driving the market higher, in particular the “FAANGs”—Facebook, Amazon, Apple, Netflix, and Google. We’ve seen this kind of pattern late in previous long-lasting economic recoveries. At the end of the ‘60s we had the “Nifty 50” stocks, and at the end of the ‘90s there was the “Janus 20.” The rise in indexing has strengthened this trend: Rising stocks receive higher market capitalizations, so market-weighted index funds buy more of them, which pushes the stocks’ market caps up further.
Valuation doesn’t tell you anything about what the market will do in the short term—the market can always get more expensive. But buying during times of high valuations historically has led to lower long-term returns, so investors should temper their expectations for increasing their stock allocations. High valuations also increase risk, because if fundamentals come up short there is a long way for stocks to fall.
What might cause fundamentals to disappoint?
Emsbo-Mattingly: Pressure on profit margins may hinder fundamentals. The unemployment rate is low and wage growth has accelerated for a couple years. If that trend continues it will increase labor costs. At the same time, rising interest rates seem likely to boost interest costs. These factors are likely to put corporate profit margins under pressure, which could lead to disappointing earnings. Usually in this kind of environment the market gets choppy, but that’s not the case this time—instead the market’s singing the Hallelujah Chorus.
How does the U.S. outlook compare with the outlook in global markets?
Emsbo-Mattingly: While the U.S. market looks richly valued, Europe looks fairly valued. The business cycle in Europe is probably two to three years behind the cycle here, so conditions look likely to improve there. And the political environment has stabilized a bit after the election in France, which has had a calming effect on the markets. So in my opinion the outlook is more favorable in Europe than in the U.S.
What does all this mean for investors?
Emsbo-Mattingly: It means that now is the perfect time to be circumspect and to stay diversified. This is not the time to make big bets.